Download Economics Power Guide

2012
2013
18
YE
AR
S
DO
Post-Soviet
Communist
Recovery
OU
RB
EDITION
ECONOMICS
ING
EST
, SO
YO
U
CA
N
ECONOMICS
POWER GUIDE
EDITOR
Christina Minich
®
the World
Scholar’s Cup®
ALPACA-IN-CHIEF
Daniel Berdichevsky
DO
YO
U
RS
ECONOMICS
POWER GUIDE
®
AUTHOR’S WELCOME...................................................................................................................................... 1
CURRICULUM OVERVIEW ............................................................................................................................... 2
FUNDAMENTAL ECONOMIC CONCEPTS......................................................................................................... 3
MICROECONOMICS ........................................................................................................................................ 14
MACROECONOMICS ....................................................................................................................................... 56
COMMUNIST ECONOMIC SYSTEMS .............................................................................................................. 98
REFORM UNDER MIKHAIL GORBACHEV...................................................................................................... 103
REFORM UNDER BORIS YELTSIN.................................................................................................................. 109
VLADIMIR PUTIN & DMITRI MEDVEDEV ..................................................................................................... 115
SECTION I - III SUMMARIES .......................................................................................................................... 119
SECTION IV SUMMARY ................................................................................................................................ 123
PRACTICE TEST ANALYSIS ........................................................................................................................... 150
ABOUT THE AUTHOR ................................................................................................................................... 152
BY
EDITED BY
CATHERINE TRAN
ROBB DOOLING
UNIVERSITY OF TEXAS: AUSTIN
SEVEN LAKES HIGH SCHOOL
ROCHESTER INSTITUTE OF TECHNOLOGY
OMAHA BURKE HIGH SCHOOL
DEDICATED TO MR. IRISH, MR. MARZEN,
AND THE 2011 SEVEN LAKES ACDEC TEAM
© 2012 DEMIDEC
DemiDec, The World Scholar’s Cup, Power Guide, and Cram Kit are registered trademarks of the DemiDec Corporation.
Academic Decathlon and USAD are registered trademarks of the United States Academic Decathlon Association.
.
Economics Power Guide | 1
AUTHOR’S WELCOME
You hold the Economics Power Guide in your hands. This may look like a pile of paper with some
words and numbers on it, but this pile of paper came into your hands through hundreds of
individual decisions. Every step of the way, someone performed a cost-benefit analysis and with
stars in their eyes said this is worth it. And you, my starry-eyed friend, will too. I promise you. So
love it. Cherish it.
My name is Catherine Tran, but you can call me Cat. I joined the Academic Decathlon at Seven
Lakes High School in search of a challenge, and I found a surplus of challenge in the Economics
event.
Mastering Economics requires the ability to harmonize concepts and facts. If you study right,
everything should click together and just make sense. The Power Guide helps you achieve this goal
by organizing all these concepts and facts in a logical way.
Critical words, names, numbers, and other testable terms are bolded throughout the guide. You
can find definitions for these terms in the Power Lists at the end of the guide, broken up into
understandable and manageable sub-lists. In addition, Power Tables synthesize related information
for efficient studying sans 1 page flipping. Here, I will integrate all bolded Russian reforms into a
table and all bolded events and years into a timeline.
See that little number one in the previous paragraph? Prepare to see many more of these floating,
little numbers. This guide includes three kinds of footnotes. First, enrichment footnotes (such as
the first footnote) provide information that will not be tested but help increase your understanding
of the material. Second, Demi footnotes include my signed comments on the material. They serve
as presumed comic relief and desperate pleas for attention 2. You will also see some signed
comments from last year’s authors and past and present beta testers. Last, I use unsigned
miscellaneous footnotes for instructional comments about the curriculum and guide.
A high score in economics demands commitment. Fortunately, this guide will supply you with a
lot to commit yourself to learning. To minimize the costs and maximize the benefits of your study
time, I suggest you first read through the entire guide once. Then focus on really understanding
the models. Being able to sketch out and manipulate models is the most powerful tool to use on
economics tests. Quizzing yourself on the terms in the Power Lists will also help.
The investment you put into internalizing this guide will bring you great rewards in the future.
You are entering a planned economy in which your target output is a 1000 on economics.
1
2
“Sans” means “without” in French
Love me! – Cat
Economics Power Guide | 2
CURRICULUM OVERVIEW
Section I: Fundamentals of Economics = 10% (5 questions)
Section I discusses the study of economics as a whole. This section covers basic
assumptions about human behavior. These core ideas form the basis for the study of both
microeconomics and macroeconomics.
Section II: Microeconomics = 40% (20 questions)
Section II narrows in on microeconomics, which focuses on the behavior of individual
markets. This section covers different types of competition, supply and demand, absolute
and comparative advantage, market failure, roles of government, and classification of
goods.
Section III: Macroeconomics = 30% (15 questions)
Section III moves to macroeconomics, which explains how to analyze a national economy.
This section covers measurement of GDP, inflation, unemployment, financial markets,
short-run fluctuations, and government policy.
Section IV: Economics of Communist and Post-Communist Russia = 20% (10 questions)
Section IV focuses on the economics of this year’s theme, Russia. This section covers the
economics of Russia before and after the fall of the Soviet Union as well as its recent (and
controversial) transition from a planned to market-based economy. It outlines the effects of
its economic reforms under various leaders.
If you have the time, focus on concepts, because these take the longest to learn. Once you
understand what demand really is, it’s not as hard to grasp what can impact it.
If you run short on time, look for the areas of greatest marginal benefit to you as a Decathlete.
Focus on the Power Lists and Power Tables—or consult the Cram Kit. Read through the section
summaries at the end of this guide and spot-check concepts that give you trouble. Good luck!
Section IV - Russia
20%
Section III Macroeconomics
30%
Section I Fundamentals
10%
Section II Microeconomics
40%
Economics Power Guide | 3
FUNDAMENTAL ECONOMIC CONCEPTS
POWER PREVIEW
This section eases the reader into the field of
economics. It begins with the logic and
common sense of economic analysis, continues
with important definitions, and concludes with
some basic assumptions of economics. Most of
microeconomics and a good portion of
macroeconomics will rely on these concepts.
POWER NOTES
 10% of the exam (5 questions) will be from this section, but
the concepts in this section can appear in questions on
other sections.
 5 questions from the USAD practice test are on topics from
this section.
 This section loosely covers pgs. 5 – 8 of the USAD
Economics Resource Guide, including the Introduction.
Introduction3
 What does economics address?
 The field of economics explains how individuals make choices about allocating scarce resources
to satisfy unlimited wants and how these choices interact with each other
 Economists study how human societies organize themselves to transform available
resources into what their members wish to consume
 The field emerged over 200 years ago
 Adam Smith established the field of modern economic analysis with An Inquiry into the
Nature and Causes of the Wealth of Nations (1776)
 Even before Smith, Aristotle wrote on topics relevant to economics
 Two main approaches
 Microeconomics analyzes individual decisions and how those decisions intersect in the market
 Macroeconomics considers entire economies and develops models to explain them
 The two fields start from different points, but assume the same basic things about human
behavior
Why Economics?
 Economics and everyday life
 While economics may appear obscure, it concerns three simple ideas
 (1) Everyday life
 (2) Choices a person makes in his or her daily life
 (3) Impact of these choices on the world around us
 Examining life through the lens of economics illuminates hidden wonders in the everyday
world around us
 The local supermarket
 The average supermarket carries nearly 47,000 4 different items
 Each item purchased at a grocery store is the result of a long chain of complicated decisions
 Nothing ensures any of these products will be at the supermarket
 No one commanded anyone to create them
USAD is not supposed to test on anything covered just in the Introduction. This has not stopped them from doing so in the past. I
recommend reading the Intro once or twice, but not to fret about it a great deal.
4
This is just the sort of obscure detail USAD would test on, even though the number is likely outdated by now.
3
Economics Power Guide | 4
Farmer
grew wheat
Milling
company
bought the
wheat and
ground it
into flour
Bakery
bought the
flour to
make a loaf
Loaf
delivered in
a timely
manner to a
store
Someone
bought the
loaf of bread
At each step along the way, each person made decisions for his or her own self interest
 This example is only one supermarket out of thousands across the country
 Supermarkets are only one of the millions of businesses in our economy
 Economics explains why our economy functions and why it does not

Basic Assumptions of Economics
 Scarcity and no free lunches!
 Humans have unlimited wants
 Economists assume people cannot fulfill their desires
 Desires are insatiable
 When one desire is satisfied, people will think of
something else that they want
 If I buy a new laptop, I will want a wireless mouse
5
 If I buy a wireless mouse, I will need batteries for it
6
 This situation can be framed quantitatively through the concept of utility
 Utility is “happiness,” or how much we benefit from something, made into a number
 Economists assume humans prefer higher utility numbers
 Consuming goods adds to an individual’s utility
 Individuals maximize their utility given their preferences
 Marginal utility is the utility obtained from getting “one more of” a good or service
 The more goods that are consumed, the smaller the marginal utility
 Example: The first slice of pizza tastes very good. The tenth…not so much.
7,8
 Marginal “anything” refers to the effect of getting one more of something
 Scarcity is an inescapable fact of our existence
 Scarcity is the finite nature of resources to which we have access
 We only have a finite amount of time to devote to our activities
 Only a finite amount of energy and capital are available for our use
 Humans have limited knowledge
 Because of these constraints, both individuals and governments must choose where to devote
resources
 Trade-offs
 Because of scarcity and unlimited wants, people must make trade-offs
5
And if you give a mouse a cookie…- Christina
And who says money can’t buy happiness? – Tad
7
Marginal costs/benefits/etcetera are covered later in microeconomics.
8
Zurich is really, really, really, really, really expensive. More often than not, I went to McDonalds because it was the only reasonably
priced “restaurant.” Except last week, when I bought three snack wraps, thinking they cost 1.50 Swiss Francs each and were snacksized. No, I wasn’t wearing my contacts and they actually cost 7.50 Swiss Francs each and were meal sized. By the third one, all I
could think was, “Negative marginal utility. Negative marginal utility. But I paid almost $10 for this thing! Must eat. Negative
marginal utility. Negative marginal utility.” – Sophy
6
Economics Power Guide | 5
To get one thing we want, we must give up something else, since we have limited wealth
 Individuals maximize utility within their budget constraints
 A free lunch would lead to a benefit without a trade-off
 This benefit would quickly be used to the point of scarcity
9
 There can only be so many free lunches in the world
 The ability to identify policies that offer free lunches is a necessity for all economists 10
 We all make trade-offs every day, even if we do not realize it
11
 Instead of reading this Power Guide, you could be sleeping
 If you decide to play video games for an hour, that is one less hour to watch Digimon
 If you choose to spend $50 on Portal 2, then you have $50 less to save for college
 Opportunity cost
 The opportunity cost of something is what you give up to get something else 12
 More formally, opportunity cost is the lost benefit of the next best alternative to a choice
 The opportunity cost of reading this Power Guide is spending the same amount of time
(and effort) on the next best alternative activity
 That other activity may pay you $50, which will enter into the opportunity cost of
reading this Power Guide
 Opportunity cost is not just monetary
 The other activity may only give you utility, but that benefit enters into opportunity
cost as well
 If a friend gives you a ticket to a soccer game, then the ticket is free

The opportunity cost of going to the game is the value of what you would have
been doing during that time had you not gone to the soccer game
 Note that the costs of an alternative do not enter opportunity cost, just its benefits
 Applying opportunity cost can be tricky
 Suppose you go to college
 The cost of attending college includes tuition, books, room, and board
 This sum excludes the cost of time
 By choosing to attend college and study, you give up time spent working
 If you did not go to college, however, you still need somewhere to live and things to eat
 Room and board therefore are not really part of the cost of college
 Factoring them into the monetary cost of college can overstate its true expense
 Human rationality
 Economists assume human beings maximize their utility given limited resources and options
13,14
 In other words, human beings are rational
 People compare the benefits of each action with the opportunity costs of the action, and
pick the action with the greatest perceived benefit
 Each person derives different amounts of benefit from certain actions
 Rationality is facilitated by cost-benefit analysis

Going along with how Zurich is really, really, really, really, really expensive: very morning, I make myself an extra sandwich or two
or three at my hostel’s free buffet breakfast. See, there really is such thing as a free lunch. – Sophy
10
Alternatively: The ability to identify places that offer free lunches is a necessity for all economics degree candidates. – Sophy
11
I think Jessica knew I’d be beta testing this guide at 3 A.M. – Tad
12
There is a very subtle distinction between trade-offs and opportunity cost. Trade-offs are the choices made. Opportunity cost is the
benefit you forgo to do something else.
13
Whether humans are actually rational is a thriving area of economic research.
14
An excellent book to read is The Social Animal by David Brooks. If you still believe humans are rational by the end of that book,
you and I need to have a chat. – Sophy
9
Economics Power Guide | 6
This process entails making a list of the pros and cons of a decision and weighing them
 Benefits come in the form of utility for consumers or profits for producers
 Rational agents have to consider the full economic cost of a decision
 Cost-benefit analysis is often intuitive and approximate
 Most people are not born with the ability to calculate costs and benefits without fail
 By studying economics, we can become better decision makers
 Gains from trade
 Individuals differ in their interests, abilities, and resources
 Therefore, we excel at and get more pleasure from differing activities
 By specializing and then trading with someone else, both parties are better off
 As long as an exchange is voluntary, everyone involved benefits—otherwise, why make it?

Comparative Advantage and the PPF15
 Why do we depend on each other for just about everything?
 Almost everything we use is the product of other peoples’ work
 We rely on people whom we do not know to supply goods for our daily lives
 Modern society is highly interdependent
 People would not engage in interdependent trade if they did not receive benefits from it!
 One of economics’ fundamental insights is that voluntary exchange makes people better off
 Simplifying trade – Mr. Robinson and Ms. Crusoe 16
 Imagine two nearby islands entirely independent of each other
17
 Mr. Robinson lives on the first island
 Durians abound on this island
 Mangosteens, on the other hand, cannot grow in the soil
 Ms. Crusoe lives on the second island, marked by a large abundance of mangosteens
 People on this island cannot stand the smell of durians and have outlawed them
 The soil is ideal for more fragrant mangosteen orchards
 Sharks and giant whirlpools infest the waters between them, so nothing can move from
island to island
 In this state, Mr. Robinson and Ms. Crusoe will consume only their own products
 Robinson will only consume durians, and Crusoe will only consume mangosteens
 Say a volcanic eruption occurs, and a land bridge forms between the two islands
 Both individuals are tired of eating just their own produce
 Trade benefits everyone as they will be able to enjoy both mangosteens and durians
 The benefits from trade are obvious in this case, but what if Robinson and Crusoe could
both produce mangosteens and durians?
 Introducing Ivan and Olga – citizens of Moscalf Archipelago
 Like Mr. Robinson and Ms. Crusoe, Ivan and Olga live on different islands and cannot reach
each other
This section was originally named “International Trade” and buried deep in microeconomics, after the material on taxes. I relocated
it here because the concept of comparative advantage ties in very closely with gains from trade.
16
Our team had a board where we would jot down some notes while studying. When we got to this subject, we drew a visual of
Robinson and Crusoe. It was very…interesting. Robinson was a scrawny guy, and he was so happy with his fish and coconuts.
Crusoe was an extremely scary, muscular girl with a serious face and a spear. – Amanda
17
It makes me feel better to imagine this island on a disk-shaped world, on the back of four elephants, on the back of a turtle flying
through space. I haven’t been reading the Discworld novels while writing this power guide, not at all…
15
Economics Power Guide | 7
 However, since the two are extremely gifted and artistic, they can both produce mangosteens
and durians
 Will the two benefit from trade?
 The Production Possibility Frontier
 A production possibilities frontier (PPF) summarizes an economy’s production options
 Because there are a finite number of hours in a day and a finite amount of exertion, Ivan
and Olga must choose between producing mangsoteens and durians
 Ivan may make a table of his possible production combinations for a day
Mangosteens Durians


24
0
21
1
18
2
15
3
12
4
9
5
6
6
3
7
0
8
Plotting these combinations will yield Ivan’s PPF
Similarly, Olga may construct a table of her production possibilities
Mangosteens Durians


36
0
32
4
28
8
24
12
20
16
16
20
12
24
8
28
4
32
0
36
Olga produces both more mangsoteens and durians than Ivan at any given point
Moving along the PPF curve substitutes production of one good for another

Producing more mangosteens must mean producing fewer durians

Any combination on the curve is completely efficient

Production cannot be expanded at the current ratio of goods

Points inside the curve are inefficient because there is a corresponding point on
the frontier that maintains the same ratio of production
Economics Power Guide | 8
B
Mangosteens
A
Durians
Points A and B are both possible production points

Both have the same ratio of durians to mangosteens, but B has more output

Any point outside the curve cannot be produced with current resources
The slope of the curve measures the opportunity cost of production

Ivan’s curve is linear because it is a straight line with a constant slope

In this case, the slope reflects the opportunity cost of mangsoteens in terms of durians

If the slope were, say, -3, Ivan would have to give up three mangosteens to get
one durian

The slope of Olga’s curve is -1

She trades one mangosteen for one durian

Their opportunity costs of production are constant since their curves are linear

PPFs are typically linear if the two goods are perfectly interchangeable in
production
Most PPF curves usually “bow
out” from the origin
A “Bowed Out” PPF

The curve bows outward
because certain resources are
better-suited for producing
Mangoone good than others
steens

As the economy uses
inappropriate resources to
produce one good, the cost of
producing that good increases

Note that this increased cost
Durians
includes increased
opportunity costs

Resources are typically suited for producing only one type of good

Using the same resources to produce another good will decrease efficiency 18
Ivan can select any point he wishes along the curve

Each point is equally efficient

The point he chooses depends on his relative preferences for durians and
mangosteens




The example my coach always used was “guns and butter”. Gun factories and butter factories simply are not suited for producing
the other good, and so a higher opportunity cost is paid.
18
Economics Power Guide | 9
 Absolute and comparative advantage
 A party has an absolute advantage for a good if it produces the good more efficiently
 Whoever uses the least amount of inputs for a given amount of production has the
absolute advantage
 Given equal inputs, if one trader’s PPF is higher on a good’s axis than the other’s PPF,
that trader has an absolute advantage for that good
 Absolute advantage compares the direct
costs of production for two traders
36

The party with the least direct costs
Olga’s PPF
has the advantage
 In our example, time and care are the only
Mangoinputs, and the market only has two goods
steens
 Therefore, the amount produced within
a fixed time period determines absolute
Durians
advantage
 Olga has an absolute advantage in both
36
mangosteen and durian production

Her PPF is above and to the right
of Ivan’s at every point
 How can trading with Ivan benefit her?
 Comparative advantages, on the other hand,
Ivan’s PPF
use opportunity costs instead of direct costs
2
 Efficiency is defined in this case to have a
lower opportunity cost
Mango Ivan, for example, gives up three
steens
mangosteens for every durian he
Durians
produces (or, 1/3 of a durian for one
mangosteen)
 Olga gives up only one durian for every
8
one mangosteen
 Therefore, Ivan is more efficient at
producing mangosteens and has a comparative advantage

Ivan gives up less durians
 Likewise, Olga has a comparative advantage in durians

Olga gives up fewer mangosteens for each durian she produces
 The two should benefit from trading
 Although a party can have an absolute advantage for all goods (like Olga), it is impossible
to have a comparative advantage for everything
 The opportunity cost of one good is the inverse of the opportunity cost of the other
Opportunity Cost of
One Durian
One Mangosteen
Ivan
3 mangosteens
1/3 durians
Olga
1 mangosteens
1 durian
Economics Power Guide | 10
If Olga’s opportunity cost of mangosteen production is higher than Ivan’s, Ivan’s
opportunity cost of durian production must be higher than Olga’s
 Comparative advantage is about how good someone is at making one good versus another
good
 Absolute advantage deals with how a trader produces relative to other traders
 A trader could be dead awful at producing everything (implying a universal absolute
disadvantage), but he will still have a comparative advantage in something
 As long as two parties have differing comparative advantages, they will benefit from
trading with each other
 Returning to Moscalf Archipelago
 From the opportunity cost table, Olga has a comparative advantage for durians, and Ivan has a
comparative advantage for mangosteens
 Comparative advantages follow efficiency in production
 Since Olga does not have to spend as much time to raise durians, her opportunity cost
of durian production is lower than Ivan’s
 A lower opportunity cost leads to a comparative advantage in producing that good
 For simplicity’s sake, we will assume both Ivan and Olga prefer to have equal amounts of both
mangosteens and durians (perhaps they are good complements)
 Ivan will produce six durians and six mangosteens for his own consumption
 Olga will farm 18 of each good
 Just as with Mr. Robinson and Ms. Crusoe, a bridge appears between the two islands
 Ivan approaches Olga and makes a proposition

Ivan
• "We can both be better off if we trade."
Olga
• "How so? I grow more durians and mangosteens than you do."
Ivan
• "Look at these numbers."
• "Right now, I am producing and consuming 6 mangosteens and 6 durians while you
have 18 of each."
• "Together, we are producing 24 of each."
• "If I grew only mangosteens, I could have 24 mangosteens."
• "Meanwhile, you could produce 4 mangosteens and 32 durians."
• "That's 28 mangosteens and 32 durians together, 4 more mangosteens and 8 more
durians than before!"
• "If we split that, then we both get 2 more mangosteens and 4 more durians. So all told, I
could consume 8 mangosteens and 10 durians!"
Olga
• "And I could have 20 mangosteens and 22 durians!"
Ivan
• "Yep. Since we are better at different things, we could pick another combination of
numbers and still benefit from trading."
Olga
• So if we stick to what we're good at doing, more gets done for everyone?"
Ivan
• "Yes, ma'am!"
Economics Power Guide | 11

Even though both traders could live by themselves, they have a very tangible benefit
associated with interdependence
 We like to be interdependent because there are economic advantages in doing so!
 Interdependence facilitates specialization in what we are good at as we can rely on
other people for everything else
Models and Economic Theory
 Building models
 Economic analysis relies on four things
 (1) Careful observation
 (2) Description
 (3) Measurement of economic theory
 (4) Theory
 We build theoretical models to capture details of economic interactions while stripping away
unnecessary detail
 In doing so, we better understand how observed economic phenomena fit together
 Models come in different forms
 Simplicity
 Models are diagrams or mathematical formulas
 These models may appear too simplistic
 The simplicity allows us to identify what assumptions and characteristics are important
 The true test of a model is how well it captures what we want to understand
Positive and Normative Economics
 Positive economics
 Positive economics uses economic theory to make provable statements about economic
phenomena
 Positive statements present reality with simple models
 They also work in the reverse fashion, predicting the result of a potential action
 A critic can disprove a positive economic statement
 Positive statements do not have to be true, but they must be able to be proven one way or
the other
 Example: “The sun never sets on the British Empire”
 This statement can be proven false by finding a counterexample, or a time at which the
British Empire is in the dark
 Example: “Spending money on technological research will increase the interest rate”
 Finding a historical counterexample could disprove this statement
 An economist could also disprove this statement by applying a theoretical model and
proving a different result
 Positive economics does not contain value judgments
 The economist just presents the information
 He does not express an opinion on the merits of different choices
 Normative economics 19
 Normative economics fill the gap left by positive economics and introduce opinion
I remember the difference because our coach used to yell “You’re positive about your facts” at us to help us differentiate. Normative
statements are always opinion based so look for words like “should” to tell you which one it is. – Tad
19
Economics Power Guide | 12


Normative statements combine economic analysis with value judgments
Tools like cost-benefit analysis structure a discussion on what choices to make
 Choosing between outcomes usually requires referring to criteria beyond the scope of
economic theory
 Some outcomes may hurt some and help others
 The minimum wage debate is subject to such criteria and analysis
Pros
•Increase income of minimum wage
workers
•Better standard of living
Cons
•Some minimum wage workers would
lose jobs
•Others would be unable to find
employment
•Less profits for employers
•Costs may be passed on to
consumers
 Normative statements describe what should be in a society, not what is
 These statements cannot be proved false directly as they are opinionated
Example: “Economists should focus on minimizing disparities in wealth as large income
gaps have deleterious social results”
 Example: “The Federal Reserve should aim for consistently low inflation rates”
 Normative statements often address the desirability of a positive economic statement
 Example: “Using monetary policy to stabilize the economy will cause long term inflation,
but economists should prioritize short term results”
 Example: “Taxing socially undesirable products produces inefficiency, but the long term
social benefits are worth it”
 Normative statements can sneak in without explicitly using the word “should”
 Example: “GDP is not a good measure of a country’s output because it does not include
necessary components of a society”
 Example: “Keynesian models of the economy lead to undesirable economic policies”

Efficiency as a Goal
 Pareto efficient
 An economic state satisfies Pareto efficiency if no one benefits without hurting someone else
 Italian economist Vilfredo Pareto (1848-1923) was the first to make use of this concept
 Pareto efficient states do not have to be equal
 Example: If one person has everything in a society, the state is Pareto optimal
Economics Power Guide | 13
In order for someone else to benefit, something must be taken away from the person
who has everything
 There is a lot of Pareto optimal distributions in an economy
 Moving from one state to another requires redistribution
 A change in a competitive market can redistribute wealth and move from one Pareto
optimal distribution to another
 Pareto efficiency provides no way to judge whether one distribution is superior to another
 Value judgements remain a part of normative economics
 Economists will often offer their own opinions with positive analysis
 Maximizing well-being
 Efficiency is an important step in maximizing well-being
 When using resources, we should not waste them

Microeconomics and Macroeconomics
 Microeconomics
 Microeconomics addresses the economy on the individual level and works its way up
 Microeconomists make assumptions about individuals and their behavior
 These assumptions create models of decision patterns for firms and households
 By putting models of firms and households togther, microeconomics can explain the
behavior of markets
 Putting models of markets together creates a model for the whole economy
 Microeconomics internalize changes on an individual level, such as changes in consumer
preferences
 Large scale phenomena, such as the money supply, are more difficult to analyze with a
strictly microeconomic approach
 Macroeconomics
 Macroeconomics takes a top-down approach
 It tries to make sense of economy-wide fluctuations
 Macroeconomists make models of broad components of the economy rather than
individual elements
 Models typically use aggregated variables, such as the price level
 Similarities
 Microeconomics and macroeconomics are closely linked
 Both share common assumptions about human behavior
 Looking at economic activity on different scales means different aspects of human behavior
become important
 Microeconomics and macroeconomics differ enough to consider separately
Economics Power Guide | 14
MICROECONOMICS
POWER PREVIEW
POWER NOTES
This section covers basic microeconomics. We will build a
model of competitive markets from assumptions about
consumer and producer behavior and then address weaknesses
in the model. In addition, we will cover concepts like basic
supply and demand and the production possibilities frontier.
 40% of the exam (20 questions) will focus
on microeconomics
 17 questions from the USAD practice test
are on topics from this section
 This section loosely covers pgs. 10 – 56 of
the USAD Economics Resource Guide
Microeconomic Basics
 Overview of microeconomics
 Microeconomics centers on supply and demand
 In our economy, the interaction between
supply and demand produces a highly
coordinated market
 The actions of buyers and sellers dominate the
market
 They determine the price and quantity of
each product or service bought or sold
 Consumers, or buyers, demand goods and
supply factors of production
 Firms, or suppliers supply goods and
demand factors of production
 Microeconomics focuses on the economic
decisions of individual agents
 Agents are typically individual consumers,
groups of consumers, and producers
 Microeconomics explains how these agents
behave and interact
 Microeconomics answers the question of how to distribute scarce resources
 It involves the determining price through the interacting behavior of economic agents
 Consumers distribute resources through utility maximization
 Producers distribute resources based on profit maximization
Perfectly Competitive Markets
 Markets
 A market consists of all of the buyers and sellers of a particular good or service
 Some markets are highly organized
 In an organized market, buyers and sellers come together at a single location
 An auctioneer sets a price at which exchanges take place
 Examples include the New York Stock Exchange (NYSE) and the Chicago Mercantile
Exchange (CME)
 Usually, markets are less formal than the NYSE and CME
 Consider gasoline
Economics Power Guide | 15
Sellers are all of the local gas stations in a town

Buyers are vehicle owners in town and anyone passing through that needs gas

Each seller posts their price

Buyers buy gas, depending on price and convenience
 Perfect competition
 A market is perfectly competitive when it has four qualities
 (1) The good or service is highly standardized or homogenous
 (2) The number of buyers and sellers is large
 (3) Everyone involved is well informed about the market price
2021
 (4) The market has no barriers to entry
 Consider the gasoline market again
 Even within a small community, there are usually many buyers and sellers
 These buyers and sellers exchange a small fraction of the gasoline
 No one can influence gasoline’s price or quantity sold

Gas station owners know other stations sell a similar product

If the owner’s prices are too high, customers will go elsewhere

If he goes too low, he cuts into his income

In the same way, no one buyer can affect market price and quantity of gasoline
either
 The price and quantity sold are determined by the combined actions of all buyers and
sellers
22
 Each buyer and seller is a price taker and must accept the price set by the market
 Only a few markets conform to the assumptions of perfect competition
 However many real world markets are characterized by a high degree of competition so the
perfectively competitive model can be useful
 Perfect competition is useful to compare with the outcomes of other types of markets

Demand
 Law of demand
 The quantity demanded for any good is the amount that buyers (consumers) are willing and
able to purchase
 One of the most important factors in deciding quantity demanded is the good’s price
 If the price is low, then consumers will demand more
 If the price is high, then buyers will demand less of the good
 The law of demand refers to the negative relationship between a good’s price and the
quantity demanded of the good
 Alternatively, the two are inversely related
 The law of demand results from the cost-benefit analysis that rational decision-makers use
 As the price of a good increases, the opportunity cost of consuming that good also
increases
 The consumer must cut back on consuming other goods in order to afford the higher price
 Therefore, as price increases, they will want less of that good and more of other goods
This is not explicitly stated in the Power Guide, but might as well be: “Imperfect competition arises because of barriers to entry in
the market” (page 56, right column). Barriers to entry will be discussed later in microeconomics.
21
If no barriers to entry exist, firms can easily enter and leave the market until economic profits fall to zero. In imperfectly
competitive markets, economic profits exist because barriers to entry prevent other firms from entering the market to take them.
22
The term “price taker” is not in the main text, but it is in the glossary, under the description of a competitive market.
20
Economics Power Guide | 16
Because scarcity limits wealth, consumers must decide how much of each good they want
 The consumer’s preference determines the marginal utility of a good

Marginal utility decreases with each increase in quantity consumed
 The ratio of marginal utility to price is like the “bang for the buck” of a good

Consuming more of a good will decrease this bang for the buck, thanks to
diminishing marginal utility (also called diminishing returns)
 The goal of a consumer is to equate all ratios of marginal utility to price

If all bangs for the buck are the same, there is no extra bang for the buck to be
derived from substituting one good for another

If we all got the same benefit from chocolate chip cookies as from spinach, no one
would care which one they ate

More formally, substituting between goods cannot increase the consumer’s utility
 Increasing the price of a good must be accompanied with an increase in the marginal
utility of that good to keep the ratios equal

Marginal utility can be increased by decreasing the amount consumed
 Decreasing the price requires a diminished marginal utility, increasing the amount
consumed

Therefore, an increase in the price of a good will lead to a decrease in the amount
of that good wanted
 Demand curve
 The law of demand relates the price of a good to how much the consumer wants
23
 Applied to a range of prices, this relationship leads to a table called a demand schedule

Demand Schedule for Alfred’s Alpacas
Price per Alpaca
$5
$10
$15
$20
$25
Quantity Demanded
20
15
10
5
0

Plotted on a chart with quantity and price as the axes, the schedule becomes a curve
The Demand Curve
Price
Quantity Demanded



23
The curve slopes downward and to the right
Note that price is on the vertical axis and quantity is on the horizontal axis
 This choice is peculiar because independent variables are usually on the horizontal axis
 The independent variable is the variable you manipulate

In our case, price is the independent variable
The dependent variable is the variable that responds
Occasionally, the demand function (curve) is referred to as a demand schedule, but USAD uses the different terms.
Economics Power Guide | 17
Quantity is the dependent variable
 Quantity demanded is the number demanded by a consumer at any given point
24
 Demand is the curve itself
 Demand is a relationship between price and quantity demanded
 When price changes, move along the curve and change quantity demanded
25
 Whenever something shifts the demand curve, move the curve itself
 Adding up the demand curves of individuals forms a market demand curve
 The market demand curve relates price to quantity for the whole market
 This process is a simple summation of all the individual demand curves

Note that this assumes an individual’s purchasing patterns do not affect other’s
 To create a market demand curve, add up the quantity that every consumer demands
at each possible price
 The result is adding the demand curves horizontally to obtain the market demand
 Shifts in the demand curve
 The law of demand only accounts for price as a variable that alters quantity demanded
 Many other things can influence the quantity demanded
 If one of these factors changes, the demand curve shifts
 A shift represents a change in the quantity demanded at all prices, or a whole new
demand curve
 An inward shift (to the left, or toward the origin) means that the quantity demanded at
all prices has decreased
 An outward shift (to the right, or away from the origin) means that the quantity
demanded at all prices has increased
 A change in price will lead to movement along the demand curve

Movement along the Demand Curve
Price
Shift in the Demand Curve
Price
Quantity Demanded
Quantity Demanded
 Five factors can shift the demand curve 26

24
(1) A change in the income of consumers will cause a shift
 The direction of the shift depends on the type of good in question
 Most goods fall under two categories: normal goods and inferior goods
Never forget this distinction! – Cat
Shifts of the demand curve are covered in the next section. Remember price  quantity demanded. Anything else  shift the
curve. I don’t recall an Economics test that didn’t test on the distinction, so be sure to learn it.
26
Six, if you split up “prices of related goods” into substitutes and complements like my team did, but if USAD asks “what are some
of the most important factors affecting the quantity demanded,” then the answer is five.
25
Economics Power Guide | 18
As a consumer’s income increases, he will buy more normal goods and fewer
inferior goods

Consumers prefer to buy normal goods over inferior goods if they have the income
to do so
27
 For normal goods, an increase in consumer income will lead to an increase in
demand

Demand is positively related to income

The demand curve will shift to the right
 For inferior goods, an increase in income will lead to a decrease in demand

Demand is inversely related to income

The demand curve will shift to the left
28
 Example: New cars are normal goods, and used cars are inferior goods

If Car-Crazy Carmen doesn’t have much money and decides to buy a car, she’ll
probably get a used car rather than a new one

If Carmen gets a raise and starts doing better financially, she’ll be more likely to
buy a new car
(2) The prices of related goods also affect demand for a good
 Demand for a good can change due to a change in the price of a substitute good

Substitute goods serve the same purpose another good

Utility functions for substitute goods are the sum of the individual goods

Since the consumer can use both goods equally, the utilities just add up

A consumer can switch from one good to the other without a decrease in utility

Two substitute goods are usually the same quality

Example: Pepsi and Coca-Cola are widely considered substitutes

If the price of Pepsi increases, the quantity demanded of Pepsi will decrease in
accordance with the law of demand

To avoid the higher price of Pepsi, many consumers will switch to Coca-Cola
because Coca-Cola is just as satisfying
• As a result, the demand of Coca-Cola increases; its demand curve shifts to
the right

A decrease in the price of Pepsi will result in a decrease in the demand of CocaCola; the demand curve for Coca-Cola shifts to the left

A rise in the price of one good leads to a decrease in demand for its substitute

A fall in the price of a good leads to an increase in demand for its substitute
 Demand for a good can change because of a change in the price of a complement

Complementary goods are goods that are required for each other’s use

Purchasing one requires purchasing the other

Having extra of one good provides no utility

A good example is a mechanical pencil and pencil lead

If the price of mechanical pencils increases, the quantity demanded of
mechanical pencils will decrease

Because people buy mechanical pencils and pencil lead together, fewer people
will buy pencil lead


27
28
Normal goods are sometimes referred to as superior goods. – Christopher
A friend on the Pearland team showed me that children are also in fact inferior goods: http://tinyurl.com/3mbozpn
Economics Power Guide | 19
As a result, the demand for pencil lead will decrease, and the demand curve for
pencil lead will shift to the left

On the other hand, a decrease in the price of mechanical pencils will shift the
demand for pencil lead outward

Note that the market for mechanical pencils moves along the same demand curve,
while the market for pencil lead gets a new demand curve through a shift 29
 (3) Changes in consumer preferences or tastes can affect demand
 Preferences reflect the utility value that consumers assign to goods
 A good that is preferred is popular or “in style”
 If the popularity of electric cars increases it will lead to an increase in demand for
electric cars
 A shift of preferences away from vinyl records, for example, will lead to a decrease in
demand for vinyl records
 (4) Changes in consumer expectations can also affect demand
 If consumers expect a newer, better good to emerge in the near future, the demand for
the current good will decrease 30
 If consumers expect a decrease in the price of a good in the future, the current demand
for that good will decrease

Consumers wait for the lower price
 If consumers expect an increase in the price of a good in the future, they will demand
more now in order to take advantage of the price while it lasts
 (5) Changes in the number of consumers will also affect demand
 If consumer numbers drop, then the demand will decrease
 If consumers increases, the demand will increase
 When testing curves, remember: everything else besides the factor that shifts remains the same

Normal goods
Income
Inferior goods
Substitutes
Factors that shift
the demand curve
Prices of related
goods
Complements
Consumer tastes
Consumer
expectations
Number of
consumers
 Elasticity of demand 31
 The shape of the demand curve is related to its elasticity
29
Changes in price are reflected through movement along the demand curve. Changes in income, related goods, expectations, tastes,
and the number of buyers are reflected through movement of the entire curve.
30
For example, knowing the iPhone 5 is coming out next month might decrease your demand for an iPhone 4 this week. – Cat
31
I split up the “Elasticity” section into the elasticity of demand and elasticity of supply.
Economics Power Guide | 20

Elasticity is a measurement of the percent change of one variable in response to a percent
change in another
Qf -Qi
E=
% ΔQuantity
% Δ Pr ice
≈
Qi
Pf - Pi
Pi
In the equation, “f” stands for final and “i” stands for initial
 Elasticity is one variable’s sensitivity of to changes in another
 Elasticity is inversely related to the slope of a curve

A steep line will have a low elasticity

A shallow line will have a high elasticity

The graph for an inelastic good goes up and down like an inelastic brick wall

The graph for an elastic good, on the other hand, looks like an elastic rubber band
flying sideways through the air
 The price elasticity of demand measures how sensitive quantity demanded is to price changes

QD f - QD i
E denand =
% ΔQuantity demanded
% Δ Pr ice
≈
QD i
Pf - Pi
Pi




32
According to the law of demand, quantity demanded is negatively (inversely) related to
price, so this ratio is always negative
 Convention says we ignore this sign when considering elasticity of demand
 Absolute value signs indicate this convention
Elasticity is useful because it does not rely on units of measurement
 For example, the slope of the demand curve for milk will differ depending on whether
it’s in gallons or liters
 However, in both cases, the elasticity of the demand curve will be the same
If demand elasticity is less than one, the good is said to be price-inelastic (or inelastic with
respect to price)
 A price-inelastic good is not sensitive to changes in price
32
 Goods which are price-inelastic are necessities such as food and clothing
 Consumers must consume these goods regardless of income or price
 These goods do not have many substitutes
 If price increases, consumers keep buyiny anyway
 Graphically, the inelastic curve is very steep
If demand elasticity is equal to zero, the good is perfectly price-inelastic
 Any change in price will not result in any change in quantity demanded
 Graphically, a perfectly inelastic demand curve is vertical
 The perfectly price-inelastic is purely theoretical
 Even for absolute necessities, price will eventually become prohibitively high

Example: Diabetics need insulin but they will eventually be entirely unable to pay
for it
And hair dye in my case. – Cat
Economics Power Guide | 21



If demand elasticity is greater than one, the good is price-elastic (or just elastic)
 An elastic good is sensitive to changes in price
 Increasing the price of a good will lead to a decrease in total revenue
 A price-elastic good is usually a luxury or has readily available substitutes

If its price increases, consumers can stop purchasing the item or switch to a
substitute with a lower price

Example: If the price of Bentleys goes up, consumers can choose to switch to
BMWs or not buy a luxury car at all
 Graphically, an elastic demand curve is very flat
If demand elasticity equals infinity, a good is perfectly price-elastic
 Any change in price will result in an infinite change in the quantity demanded
33
 Consumers will only demand goods at one price
 Like perfectly inelastic goods, perfectly elastic goods are purely theoretical
If elasticity is equal to one, a good is said to be unit elastic
Perfectly Elastic
Perfectly Inelastic
Price
Price
Quantity Demanded
Quantity Demanded
Inelastic
Price
Price
Price
Quantity Demanded
Elastic
Unit Elastic
Quantity Demanded
Quantity Demanded
 Four factors influence the price elasticity of demand


33
(1) The degree to which a good can be substituted affects elasticity
 Goods with substitutes tend to have high elasticities of demand
 Consumers can easily switch from one to another

Elasticity of demand for a particular soda (like Sprite or Pepsi) is high

If the price of Sprite rises, consumers can easily switch to another brand
 Conversely, when close substitutes do not exist, elasticity of demand tends to be lower
(2) A good’s degree of necessity affects its elasticity as well
 Necessities tend to have lower price elasticities of demand than luxuries
 Since people need the good, they will continue to buy it at any price until they cannot
afford it
Perfectly competitive markets have perfectly elastic demand. Consumers only demand the good at the market price.
Economics Power Guide | 22


(3) The price elasticity of a good is also related to time
 In the short run, individuals have less time to look for alternative goods

As a result, goods are generally more inelastic in the short run
 In the long run, individuals can find alternatives or change their lifestyles to adjust

Consequently, goods are generally more elastic in the long run
 Example: Gas is inelastic in the short run because cars cannot run on any other form of
fuel, and consumers do not have any other form of transportation

Even if the price of gas increases, people have no choice but to fill up

They can drive less and carpool more, but their overall demand for gas does not
change dramatically

In the long run, however, consumers can buy electric cars, relocate closer to their
jobs, take public transportation, and so on
(4) The scope of the demand market affects its elasticity
 Scope refers to the size of the market

Example: The market for beverages is bigger in scope than the market for Gatorade
 Markets with a larger scope tend to have lower elasticities

In other words, the broader the good category, the more inelastic the good

Since the market is bigger, there are fewer substitutes available

Example: It is easier to find a substitute for Gatorade than for beverages as a whole. 34
Substitutes
Necessity
Factors influencing
demand elasticity
Scope of market
Time horizon
 Elasticity falls continuously along the demand curve

34
A linear demand naturally has a constant slope
 Let us call this slope “e”
ΔP
ΔQ

e=

The ratio

The elasticity of demand along a linear demand curve is equal to


P and Q in this case are for a specific point along the demand curve
Moving down the demand curve, P is falling and Q is rising

Therefore,

b=

All considered, the elasticity of demand must be falling
ΔQ 1
= = b is naturally also a constant
ΔP
e
P
must be falling
Q
1
is constant, since the demand curve is linear
e
I can’t even imagine what a substitute for beverages would be. – Cat
P
•b
Q
Economics Power Guide | 23
Price Elasticity of Demand
Number Range
Name
Relation to Total
Revenue (TR)
Graphical
Representation
Other Notes
E=0
Perfectly
inelastic
Increase in price leads
to increase in TR;
decrease in price leads
to decrease in TR
Perfectly vertical
line
Purely theoretical
Inelastic
Increase in price leads
to increase in TR;
decrease in price leads
to decrease in TR
Steep line
Applies to goods that
are necessities and
goods that have few
available substitutes;
goods are more
inelastic in the short
run
Unit elastic
Change in price has no
effect on TR
Line with
a slope of -1
Changes in quantity
demanded are
exactly proportional
to changes in price
Relatively flat line
Applies to goods that
are luxuries and
goods that have
many available
substitutes; goods
are more elastic in
the long run
Perfectly
horizontal line
Purely theoretical
E<1
E=1
E>1
Elastic
Increase in price leads
to decrease in TR;
decrease in price leads
to increase in TR
E=∞
Perfectly elastic
Change in price leads
to loss of all TR
Supply
 Law of supply
 The quantity supplied of any good is the amount sellers are willing and able to produce
 The most important factor affecting quantity supplied is the price suppliers receive
 The higher the price received, the more suppliers are willing to produce
 The law of supply is the positive relationship between price and quantity supplied
 The law of supply results from the cost-benefit analysis performed by rational suppliers
 Suppliers compare the benefits of the marginal good sold with the opportunity cost of their
time, effort, and expense
 As price rises, it is rational to devote more resources to supply that good
 As long as price received exceeds opportunity cost, they will be willing to supply
 Supply curve
 The law of supply relates the price of a good and how many units a profit-maximizing
producer will be willing to supply
 Supply is the quantity of a good or service that producers are willing and able to produce
at any given price
 The quantity supplied is the amount of a good supplied at a specific price
 Price and quantity supplied are directly or positively related
 “Quantity supplied” is a point on the supply curve
Economics Power Guide | 24
“Supply” refers to the entire supply curve
 The law of supply creates a table called a supply schedule
 The supply schedule lists the number of goods producers can supply at each price
 The prices are unit prices, which represent the price of each good supplied

Supply Schedule for Alejandro’s Alpacas
Price per Alpaca
$5
$10
$15
$20
$25
Quantity Supplied
0
5
10
15
20
 A supply schedule plotted on a plane becomes a supply curve

The curve is a “continuous” relationship because it allows the calculation of quantity
supplied at any price
The Supply Curve
Price
Quantity Supplied
Just as with demand, the vertical axis represents price and the horizontal axis quantity 35
 The supply curve slopes upward: the slope of the curve is positive
 The supply curve slopes upward because producers are more willing to supply a good at
higher prices
 Thus, the quantity supplied increases as price increases
 The market supply curve is obtained by adding all the quantities supplied at each price by all
suppliers within that market
 Like the market demand curve, this is the same as adding the individual supply curves
horizontally
 Shifts in the supply curve
 A movement along the supply curve indicates a change in quantity supplied
 A movement along the curve is from one point to another on the curve
 A shift of the entire supply curve indicates a change in supply
 When the supply curve shifts, the quantity supplied of a good at all prices changes
 An inward shift (left, or toward the origin) means that the quantity supplied at any given
price decreases
 An outward shift (right, or away from the origin) means that the quantity supplied at any
given price increases 36
 Four important factors cause shifts in the supply curve

Anyone else think it odd that we say “supply and demand” but learn about demand first 99% of the time?
Economists often use the terms “left” and “right” to describe decreases and increases in supply. Be careful not to use “up” and
“down”: a shift upward in the supply curve actually represents a decrease in supply. This gets confusing—so stick to left and right.
35
36
Economics Power Guide | 25




(1) If the cost of the factors of production increases or decreases, the supply curve will shift to
the left or right, respectively
 Firms cannot produce as much for a given price, so they must supply less quantity
 If the price of inputs decreases, firms are willing to produce more goods at existing
prices, pushing the supply curve to the right
(2) If technological progress occurs, the supply curve will shift outward 37
 A breakthrough in productive technology will decrease the cost of producing a good,
shifting supply to the right
(3) Expectations of price changes can shift the supply curve
 An expected decrease in the price of a good will lead firms to supply more so they can
sell the good at the current higher price
 An expected increase in prices will lead firms to decrease supply now so they can wait
for the higher prices
(4) A change in the number of firms supplying a good will shift the market’s supply curve
 If the number of firms supplying a good increases, the supply curve shifts to the right
 If the number of firms supplying a good decreases, the supply curve shifts to the left
Cost of
inputs
Technology
Things that
shift the
supply
curve
Expectation
s
Number of
suppliers


A change in the price of a good only leads to a movement along the supply curve for that
good, not a shift in the curve itself
When solving supply shift problems, remember that all other factors will remain the same
Shift in the Supply Curve
Movement Along the Supply Curve
Price
Price
Quantity Supplied
Quantity Supplied
 Elasticity of supply
 The price elasticity of supply describes the shape of the supply curve
37
Technological regression would supply to decrease, but, unless all the electricity in the world stops working, it is unlikely.
Economics Power Guide | 26
Supply elasticity measures how sensitive supply is to changes in price
 Additionally, it reflects how easily suppliers can alter the quantity of production
 Elasticity of supply is defined analogously to elasticity of demand

QS f - QS i
E sup ply =
% ΔQuantity sup plied
% Δ Pr ice
≈
QS i
Pf - Pi
Pi
 Three factors affect elasticity of supply
(1) The difficulty of entry and exit into a market relates to elasticity
 If few barriers to entry exist, supply tends to be more elastic
 (2) Elasticity for supply curves typically has a time factor
 In the short run, firms will have already made their production decisions

Firms cannot change the quantity supplied much, if at all, to respond to price changes

Quantity supplied is thus often inelastic (not very responsive) to changes in price
 In the long run, firms are able to plan all of their production decisions

Firms will enter or leave the market if the market price is different than the price
that yields normal profit

Quantity supplied is elastic, or very responsive to changes in price
 (3) Scarcity of inputs affects supply elasticity
 If inputs are scarce, then the supply will be inelastic
 Like elasticity of demand, supply’s elasticity
has five cases
Factors
affecting
 (1) Perfectly inelastic
Scarcity
elasticity of
of inputs
 Perfectly inelastic demand curves do
supply
not exist
 Only perfectly inelastic supply
Time
curves exist
horizon
 These curves are for goods that are
no longer produced or for which
Presence of
barriers to
the inputs no longer exist 38
entry
 (2) Inelastic
 (3) Unit elastic
 (4) Elastic
 (5) Perfectly elastic

Perfectly Elastic
Perfectly Inelastic
Price
Price
Quantity Supplied
38
Quantity Supplied
For example, suppliers cannot make any more antique cabinets from the year 1850.
Economics Power Guide | 27
 Using elasticity 39
 If a good is inelastic, an increase in price will cause a smaller decrease in either quantity
demanded or quantity supplied
 The firm can increase the price thereby increasing revenue
 Revenue equals price multiplied by quantity
 Revenue is graphically depicted as a rectangle
 The intersection of supply and demand form one corner of this rectangle
 The increased price makes up for the lost quantity
 If a good is unit elastic, an increase in price will cause an equivalent decrease in quantity
Inelastic
Price
Price
Price
Quantity Supplied

Elastic
Unit Elastic
Quantity Supplied
Quantity Supplied
A change in price will not affect revenue
 If a good is elastic, an increase in price will cause a greater decrease in quantity



The firm will lose revenue if they increase prices
The increase in price does not make up for the decrease in quantity
If the firm decreases their prices, revenue will increase
Price Elasticity of Supply
Number
Range
Name
Relation to Total Revenue (TR)
Representation
E=0
Perfectly
inelastic
Increase in price leads to increase in TR; decrease in
price leads to decrease in TR
Perfectly vertical
line
E<1
Inelastic
Increase in price leads to increase in TR; decrease in
price leads to decrease in TR
Steep line
E=1
Unit elastic
Change in price has no effect on TR
Line with
a slope of 1
E>1
Elastic
Increase in price leads to decrease in TR; decrease in
price leads to increase in TR
Relatively flat line
E=∞
Perfectly
elastic
Change in price leads to loss of all TR
Perfectly
horizontal line
Equilibrium
 What is equilibrium?
 Most people first hear of equilibrium in their science classes
39
This is adapted from the “Using Elasticity” section, starting on page 28 of the USAD Resource Guide.
Economics Power Guide | 28
 Equilibrium is used in both the physical and
social sciences
 Equilibrium is the point at which all the
forces in a system are balanced
40
 Something at equilibrium is stable
 For economics, equilibrium is the point where
no participant in the market has any reason to
change their behavior
 The price in a competitive market acts as a
signal between producers and consumers
 If the price is right, consumers will
signal this by purchasing the
equilibrium quantity of product
 On the other hand, if the price is too high, consumers will refuse to buy the product
 Where is equilibrium?
 Market equilibrium occurs where the market supply curves and demand curves meet
 Market equilibrium is when the price and quantity are at the intersection point
 Since the two curves slope in opposite directions, there can only be one point of intersection 41
 Characteristics of competitive market equilibrium
 Consumers and producers interact in markets
 Potential buyers and potential sellers form a market when they come into contact with one
another to exchange goods or services
 Perfectly competitive markets rely on the assumptions discussed earlier
 These four assumptions hold true for all perfectly competitive markets
 (1) The good or service in question is homogenous
 (2) The number of buyers and sellers is large
 (3) Everyone involved is well informed about the market price
 (4) The market has no barriers to entry
 Happily, competitive markets tend to gravitate toward the equilibrium quantity and price
 This tendency has two desirable effects
 (1) Competitive markets effectively allocate resources

The price tells suppliers about the value consumers place on a good

Likewise, prices inform demanders about the opportunity cost of supplying the good

This way, scarce goods and services are produced at the lowest cost and allocated to
those who value them the highest
 (2) Competitive equilibrium maximizes benefits for both buyers and sellers

The available supply goes to those who value the good the highest

The ones who supply the good are those who supply it at the lowest cost
 Buyers receive a number of benefits from participating in the market
 The height of the demand curve at each point reveals the willingness of the marginal
buyer 42 to pay
 Suppose four fans of an extremely popular card game want to buy new booster packs
 Each fan values the booster pack at different prices
However, something that is in equilibrium is not necessarily static.
Sorry, Yoda.
42
The marginal buyer is the buyer, who at a certain price, is indifferent between buying the good or not buying it.
40
41
Economics Power Guide | 29


Buyer
Willingness to Pay
Yugi
$100
Joey
$80
Tristan
$70
Téa
$50
The actual price of the booster pack is $60

Téa will not buy a pack, since she only values it at $50 43

The other three duelists will buy a pack, but each receives a different benefit from
purchasing the booster pack
The consumer surplus is the surplus benefit received by consumers
Buyer
Benefit from Purchase
Yugi
$40
Joey
$20
Tristan
$10
Added all together, the total consumer surplus is $70
 Graphically, a line is drawn horizontally from the market price out to the price axis

The difference between the height of the demand curve and this line is the
consumer surplus

It is triangle shaped
 Suppliers benefit from participating in the market
 The height of the supply curve at each quantity measures the willingness of the marginal
seller 44to supply
 It also measures the opportunity cost to the marginal seller
 If the market price exceeds the opportunity cost, the difference is the producer surplus
 The total producer surplus is found by adding the surplus of all suppliers in the market
 Similar to the consumer surplus, the area above the supply curve and below the market
price graphically illustrates producer surplus
 Supply and demand graphs include consumer and producer surplus between the supply and
demand curves

Consumerand
andProducer
ProducerSurpluses
urpluses
Consumer
Price
Supply
A
B
Demand
Quantity
43
44
How thrifty of her! – Cat
Analogous to the marginal buyer, the marginal seller is the seller who would leave if the price of the good got any lower.
Economics Power Guide | 30
Triangle A is the consumer surplus 45
 The top of the triangle is the section of the demand curve above the market price

This section stands for those who are willing to pay more than the market price
 The vertical difference between the demand curve and the market price is in dollars per
good
 The horizontal base of the triangle is the quantity sold of the product
46
 Therefore, the area of the triangle is in dollars

Triangle B is the producer surplus
 The section of the supply curve used is the part below the market price

This section stands for the sellers who would be willing to sell at cheaper prices
than the market price
 The base of the triangle is the quantity sold in the market
 Just as with consumer surplus, producer surplus is measured in dollars
The sum of triangles A and B is the total market surplus
 Total market surplus measures the total benefits that market participants receive
 One goal of a benevolent social planner is to maximize total market surplus
 In theory, this will produce the greatest good
 Maximizing total surplus satisfies Pareto efficiency

When total market surplus is maximized, no way exists to make anyone better off
without reducing making someone else worse off
To achieve efficiency, a market planner needs to know two things
 (1) The value that each consumer places on the good
 (2) The cost of producing each unit of the good
In addition, the market planner must answer the
three fundamental questions of economics
How
 How much should be produced?
much
to
 Who should produce the good?
produce?
 Who should receive the goods?
Answering these questions and calculating these
values would be difficult
 A competitive market answers these questions
 The self-interested actions of the market’s
participants leads the market to equilibrium
 These participants only respond to changes in
the market price





Applications of the Competitive Market Model
 Basics of market equilibrium
 The demand curve for an individual producer is perfectly elastic
 Consumers are price responsive
 A seller that increases its prices will lose all of its customers
 Since goods exchanged are homogenous, consumers have no preference for one good
over another; they simply buy the cheapest one
45
I remember that consumer surplus is above producer surplus because C comes before P in the alphabet. – Cat
We will use dollars, but any currency would work (as long as it’s used consistently). The assumption is that the United States
Academic Decathlon would most likely use dollars as well.
46
Economics Power Guide | 31
In a perfectly competitive market, firms obey the market price
 If the market price is below the equilibrium point, firms will leave the market
 Supply decreases and price increases until economic profits are nonnegative
 If the market price is above the equilibrium point, economic profits will be made
 More firms will enter the market and drive up supply
47
 Because demand is perfectly elastic, it is always equal to marginal revenue
 Marginal revenue is the additional revenue earned by selling one more of a good
 Firms only sell their good at one price, so every unit purchased (regardless of total
quantity) brings the same revenue
 Furthermore, both marginal revenue and demand are equal to the price of the good
 Perfectly competitive markets include most primary commodity markets
 A classic example is the wheat market
 All wheat is essentially the same, so all prices for wheat are the same

Perfect Competition (Firm)
Perfect Competition (Market)
Price
Supply
MC
Price
Demand = MR = Price
Demand
Quantity
Quantity
 Changes in market equilibrium
 Markets are not always static
 One or both the supply and demand curves for a particular market can shift due to the factors
discussed earlier
 Test questions will usually ask you to identify the curve shift(s) and then deduce how price
and quantity change
 If only one curve shifts, the effects on price and quantity are unambiguous

If supply increases, the price will fall but quantity will increase

If supply decreases, the price will increase and quantity will decrease

If demand increases, both the price and quantity will increase

If demand decreases, both price and quantity will decrease
 A change in supply directly changes quantity and inversely changes price
 A change in demand directly changes both quantity and price
 If both curves shift at the same time, either price or quantity (but not both) will be
ambiguous

If supply and demand shift in the same direction, then the change in exchange
price is ambiguous
47
Marginal revenue will be further discussed in the section on the profit motive and the behavior of firms.
Economics Power Guide | 32
If supply and demand both increase, quantity will increase, but the change in
the price is uncertain

If supply and demand both decrease, exchange quantity will decrease, but the
effect on price is uncertain
If supply and demand shift in opposite directions, the change in exchange quantity
will be ambiguous

If supply increases but demand decreases, then price will decrease, but the
change in quantity is uncertain

If supply decreases but demand increases, then the price will increase, but
quantity is uncertain
These shifts are ambiguous because they contain two opposing forces moving in
opposite directions

For example, if both supply and demand shift outward, the increase in demand
tries to raise the price

The increase in supply, however, tries to bring the price down

We do not know which effect will take over unless we have quantitative data
(which USAD will not expect you to crunch)
Both the supply and demand shifts agree to increase quantity




Market Equilibrium
Price
B
A
2
4
1
C
D
3
Quantity

In the graph above, line A represents the original demand curve, line C the original
supply curve, and point 1 the original market equilibrium

If demand shifts from A to B and supply (line C) remains the same, then the new
market equilibrium is at point 2

Price and quantity have both increased

If supply shifts from C to D while demand (line A) remains the same, then the new
market equilibrium is point 3

Price has decreased while quantity has increased

If both curves shift (demand from A to B and supply from C to D), then the new
market equilibrium is point 4

Quantity has increased, but price is ambiguous

If you are not convinced that the change in price is ambiguous, try shifting the
curves different amounts

If you shift demand more, the price is higher than the original value
Economics Power Guide | 33
Inversely, if you shift demand less than the graph did, the price is lower
 Rather than memorize all the different combinations, break up shifts into their
individual parts

Draw one graph in which you shift only demand and one in which you shift only
supply

Then analyze the effect on quantity and price in each graph

One of the two will change in the same direction in both graphs while the other
will change in the opposite direction
 The one which changes in the opposite direction is indeterminate
 In addition to price and quantity, surplus changes when curves shift
 The effects of curve shifts on surplus are analyzed graphically
 To analyze shifts and their effect, remember that surpluses are triangle-shaped
 Shift the supply and demand curves as needed
 Compare the size of the new triangle-shaped surpluses to the old ones
 Remember that quantitative data will clear ambiguities
 USAD will not expect you to crunch such data

Shifts of Supply and Demand 48, 49
Shift
Result
Supply
Demand
P
Q
Producer
surplus
Consumer
surplus
Total
surplus
↑
No shift
↓
↑
ambiguous
↑
↑
↓
No shift
↑
↓
ambiguous
↓
↓
No shift
↑
↑
↑
↑
ambiguous
↑
No shift
↓
↓
↓
↓
ambiguous
↓
↑
↑
ambiguous
↑
↑
↑
↑
↓
↓
ambiguous
↓
↓
↓
↓
↑
↓
↓
ambiguous
ambiguous
ambiguous
ambiguous
↓
↑
↑
ambiguous
ambiguous
ambiguous
ambiguous
The Profit Motive and the Behavior of Firms50
 All about firms
 Firms are economic actors who are responsible for supplying goods and services
 Firms combine many inputs to produce the products consumers want
 Labor
 Capital equipment
 Raw materials
 Economic and accounting profits
 A firm’s goal is to maximize profits 51
You know, in case you want to memorize the shifts and their effects anyway…
In this chart, an ↑ means increase and ↓ means decrease. Otherwise, shifting supply upwards means supply is decreasing and
shifting supply downwards means supply is increasing. – Jimmy
50
The section “Evaluating Government Policy” was relocated to after this one.
48
49
Economics Power Guide | 34


Total revenue is the amount the firm receives from selling its goods or services
 Mathematically, total revenue is equal to the total quantity of output multiplied by its
price
Total costs are the cost of supplying the good or service
 Accounting costs include actual monetary costs

Accounting profit is the monetary profit earned
 Economic costs include both monetary and opportunity costs of resources used

Economic profit is monetary profit minus opportunity costs

In the long-run, economic profits are always equal to zero (more in the next
section)
Economic Analysis
Accounting Analysis
Economic profit
Accounting profit
Revenue
Revenue
Implicit costs
Total
opportunity
costs
Explicit costs
Explicit costs
 A number of costs are included in economic costs 52
In this graphic, the top, green squircles 53 represent the profits associated with each analysis
 The lower, red ones are the costs subtracted to get revenue
 Explicit costs are costs with direct monetary value, like wages
 Implicit costs are opportunity costs, like what the shop owner could get if he ran a
different business
 Firms evaluate their position by examining their marginal costs
 Marginal costs have two components
 Fixed costs are costs a firm must pay regardless of how many units it produces

The more a firm produces, the lower its average fixed cost for each additional
unit 54

The cost is spread over more units of output

By definition, firms cannot change fixed costs in the short run

This rule excludes non-profit organizations.
USAD will most likely not test on these names, since most are not in the resource guide.
53
Squectangle just doesn’t have the same ring to it. – Cat
54
Maximizing production to lower fixed costs is also called economies of scale.
51
52
Economics Power Guide | 35
A lease on a factory is a fixed cost; the firm must pay the cost regardless of how
many units or even if no units are produced

In the long run, however, the firm considers all costs (including fixed costs)
Variable costs change with the amount produced

A firm only incurs variable costs when it produces something

Variable costs increase as the firm adds more variable inputs (such as labor) to fixed
inputs (such as capital)

Examples of variable costs include wages (firms can hire and fire workers) and
purchases of raw materials

Producing more units of goods requires more laborers and more raw materials

If no units are produced, then a firm will not incur any variable costs but will
still have fixed costs

By definition, firms can alter variable costs in the short run
The marginal cost is the cost incurred by producing one more unit of output

Marginal costs generally increase as production increases

The producer will produce until marginal revenue is equivalent to marginal cost 55

Marginal revenue is the revenue from producing one additional unit
Average cost is the total production cost of each unit of output

Average cost is the sum of fixed costs and total variable costs divided by the total
number of units produced




Average Total Cost =
Total fixed cos ts + Total var iable cos ts
Total number of units produced
Firms spread fixed costs over multiple units of output

The more a firm produces, the lower the average fixed cost (fixed cost per unit
of output)

Variable costs drag average cost upward after a certain point of production

This upward trend is due to diminishing returns

As more and more variable inputs enter the production process, they become
less productive

Adding more workers in a factory, for example, doesn’t help boost production
if there are no machines for them to use

This phenomenon of decreasing then increasing marginal cost is called
diminishing returns to scale

In the long run, all factors are variable, so all costs are variable

A fixed cost in the short run is always a variable cost in the long run
 For all short-run decisions, firms face a mix of fixed costs and variable costs

The marginal cost curve is usually U-shaped and resembles a rounded checkmark

If a firm initially produces more of a good, the marginal cost drops because the
fixed costs of production are spread over more units

This effect was not captured in our model of production above but is a closer
approximation of reality

After a certain point, the marginal cost curve climbs upward as variable costs increase
The graph 56 below features all the different types of costs discussed


55
56
This is the Golden Rule of (Micro)Economics.
USAD will not test on the shapes of curves, but visualizing them helps some people.
Economics Power Guide | 36
Cost Curves
Marginal cost
Average
total cost
Price
Average
variable
cost
AFC
Average
fixed cost
Quantity Produced




Note the U shape of the marginal cost (MC) curve

The MC curve decreases, then increases
Notice how the average fixed cost (AFC) curve continues to decline

This reflects the fact that average fixed costs continue to decline as the firm
produces more and more units
Since average total cost (ATC) is equal to average variable cost (AVC) plus average
fixed costs (AFC), the distance between the ATC and AVC curves is the AFC

This distance decreases as the AFC decreases and more units are produced.
It is important to observe that the MC curve intersects the ATC and AVC curves at
the minimum of each

A marginal increase over the average will increase the average

A marginal decrease below the average will decrease the average

Example: Intelligent Izzy diligently studying for his final in AP Economics

He wants to know the grade he needs on the final to get an A in the class

He knows his average in the class is 90%

Through his calculations, he realizes that any score above 90% on the final will
raise his average

Any score below 90% will lower his average

Izzy’s class grade is the average, and his prospective score on the final is the
marginal increase

On the graph, we can see how minimums and maximums come into play at a firm
Profit Maximization
$
Average
total cost
Marginal
Profit
maximization
Average
variable cost
Average
fixed cost
Quantity
Economics Power Guide | 37
To the left of the intersection of MC and AVC curves, MC is less than AVC at
all points

As a result, AVC decreases until the two intersect

After the two intersect, MC remains above AVC

As a result, AVC continues to rise

The same observations hold true when comparing MC and ATC
 This graph also gives us the profit-maximizing level of output (but only for one input,
unlike our previous approach)

Find the intersection of the marginal cost and marginal revenue curves

Marginal revenue in a competitive market is constant and equal to the market
price 57

The line drawn downward is the profit-maximizing quantity
 As long as diminishing returns to scale applies, marginal costs rise as output increases
 Since opportunity costs are increasing, this firm’s supply curve will slope upwards
 Entry, exit, and the market supply curve
 Suppose that Intelligent Izzy is so intelligent that he opened a store that has now expanded
into a multibillion-dollar franchise
58
 This franchise sells crests as accessories
 At first, as the only seller of crests, Izzy will earn an economic profit
 Recall that economic profit is monetary profit earned minus opportunity costs
 Naturally, others will begin producing crests when they see that Izzy is making substantial
economic profits
59
 Old childhood friends T.K., Yamato, and Sora enter the market for crests as well
 More producers means the market supply curve will shift outwards
 The equilibrium price then falls
 Once economic profits for all producers equal zero, entry by other producers stops
 If economic profits ever went below zero, people would begin leaving

This might happen due to a shift in consumer preferences

Maybe their friends Mimi and Daisuke started making much fancier eggs that have
the same function as these crests
 Friends Tai, Hikari, and Joe have no reason to enter the market, as economic profits
are zero
 Two points are worth bearing in mind
 (1) In a competitive market, in the long run, all owners will earn zero economic profits and
be content with it
 The owners are earning their opportunity wage
 Whatever business they are engaged in remains their best alternative
 (2) Prices not only ration scarce goods but allocate productive resources between different
activities
 Say prices exceed production costs while Mimi and Daisuke are initially making their
egg accessories
 Positive economic profits cause their buddies Yolei and Iori to enter the market
 The positive profits means that additional resources should be deployed to fake-egg
production 6061

This is not the case in a market that doesn’t follow competitive market principles, but we’ll get to that in another section.
Go with it…
59
+10 awesome if you can guess where these and the following names are from.
57
58
Economics Power Guide | 38
Evaluating Government Policy: the Impact of Price Controls and Taxes
 Price controls
 Economists use surplus to explain the effects of government intervention in the market
 The government can implement price controls through price ceilings or price floors
 Price ceilings and floors affect the market, are binding, if they are below or above the
market price, respectively 62
 Price ceilings set a maximum price on a good

A binding price ceiling will create a shortage as the price will be below the marketclearing price

Quantity demanded will increase because consumers are willing to purchase
more at the lower price

Quantity supplied will decrease because firms are not as willing to supply the
good at the lower price

Consumers who would be willing to buy the good at the current price are unable
to do so because firms will not supply enough

Quantity demanded is greater than quantity supplied
Price Ceiling
Price
A
C
Price
Ceiling
B
Quantity
Trapezoid A is consumer surplus

Note that the original triangle of consumer surplus is “choked” by the limited
supply

Triangle B is producer surplus

The triangle is heavily contracted due to the decreased price and quantity

Triangle C is the market’s deadweight loss

Deadweight loss is the surplus that someone would have received if the market
was in equilibrium

No one gets this surplus

It is lost to inefficiency
Price floors set a minimum price on a good

A binding price floor will create a surplus since the price will be above the market
price


And then Ken enters the market and slaughters them all, until Takeru/T.K. punches some sense into him. Oops, spoilers.
Thank goodness this is after the time of those pesky black gears. Imagine those running rampant in this already fragile theoretical
economy. Those poor DigiDestined. :P – Ariel
62
Imagine that you are in a house. Like equilibrium price, you are below the ceiling and above the floor. – Cat
60
61
Economics Power Guide | 39
Quantity demanded will decrease because consumers are not willing to
purchase the good at the higher price

Quantity supplied will increase because firms are willing to supply more at the
higher price
Consumers will not buy all of the goods, and the market will not clear

Quantity demanded is less than quantity supplied


Price Floor
A
Price
Floor
Price
B
C
Quantity
As before, A is consumer surplus

B is producer surplus

C is deadweight loss

Note that any deviation from the competitive market price in a closed economy
leads to a deadweight loss

Therefore, moving toward the market price is a Pareto efficient move

The market “recovers” deadweight loss without hurting anyone
 Some suggest government interventions could set a better price
 Usually, such efforts come with significant social cost
 Consider placing a price ceiling (below the market price) on apartments in Mumbai
 (1) The consumer surplus of some renters increases, while the producer surplus of
landlords decreases

Landlords will supply fewer apartments, so some renters will not be able to find a
place to live

Landlords may stop maintaining their apartments, since they are not worthwhile
investments
 (2) Total surplus is reduced, since the price ceiling prevents some mutually beneficial
transactions from taking place

Landlords would like to rent apartments at a high price

Some consumers would be willing to pay a higher price
 Additionally, rent controls disrupt how apartments are usually allocated
 In the competitive market, apartments are rationed using price

Everyone who wants an apartment at or above the market price can get one

Landlords willing to supply at or below this price can rent them
 With rent controls in place, landlords are in a position to select tenants

Potential renters might be required to pay a finders’ fee

Landlords might rent to their friends

Economics Power Guide | 40
The landlords might discriminate based on characteristics they like or dislike
History points to the negative effects of rent controls
 In the short-run the supply and demand for housing in a city is highly inelastic

Rent controls can lower the price of apartments without creating a large excess of
demand
 Over time, supply and demand become much more elastic

Landlords will cut back on maintenance costs

Apartments will deteriorate

Eventually, landlords will remove those apartments completely, decreasing
supply

Meanwhile, low prices attract more people to the city 63


 Taxes
 All levels of government use taxes to raise revenue to pay for public expenditures
 An important issue is who should bear the burden of a particular tax
 Governments attempt to control the distribution of burdens through legislation, but things
are never that simple
 A marginal tax creates a different price for producers than consumers

Example: A $20 tax on a $600 computer would lead to consumers paying $620
and producers only receiving $600

Therefore, consumers only demand as much quantity as they would at $620,
and producers only supply as much quantity as they would at $600

The government “wedges” 64 itself between consumers and producers by instituting
a tax

The tax sits between the consumer and producer prices

Similarly, tax revenue sits between consumer and producer surplus

Marginal taxation policies have the effect of setting a fixed quantity below market
quantity
Marginal Taxation
Price
A
Tax
Consumer
price
D
C
Producer
price
B
Quantity

As before, A and B are the consumer and producer surpluses, respectively
Ironically, increased demand and decreased supply increase the price and has an ambiguous effect on quantity. Even here, the
market tries to get to equilibrium.
64
I’m mad craving an orange right now. – Sophy
63
Economics Power Guide | 41
C is the deadweight loss associated with the tax

Deadweight loss occurs because both consumers and producers move less
quantity than they would without the tax

Deadweight loss indicates a reduction in social welfare

D is tax revenue

Tax revenue is the tax per unit multiplied by the number of units—the area of
box D

Any area measurement on a supply demand graph is in terms of dollars. 65
 To draw taxes and determine their effect, one can do three things, depending on who
the tax is applied to

(1) Shift the market demand curve down by the amount of the tax

(2) Shift the market supply curve up by the amount of the tax

(3) Find the point where the distance between the curves is equal to the amount of
the tax
 Therefore, taxes have two main effects
 (1) Taxes reduce social welfare
 (2) The government collects revenue

The government usually does not, however, collect as much revenue as expected

By introducing a tax, price naturally increases and people will demand less
 If either the supply or demand curves “flatten out,” or become more elastic, tax revenue
decreases
 The right hand side of the tax revenue box gets pushed to the left, decreasing the area
 The deadweight loss triangle increases in area as it becomes longer
 Therefore, goods with elastic demands and/or supplies are not very effective to tax
66
 On the other hand, the government can tax inelastic goods effectively
 Notice that even though the government levied the tax on consumers (only their price
went up), both consumers and producers paid for the tax in lost surplus
 In a competitive market, a marginal tax cannot target only consumers or producers
 The elasticities of supply and demand distribute the burden of taxation between producers and
consumers
 The more inelastic party will bear more of the tax
 If the elasticities are the same, the tax splits equally between consumers and producers
 Note that market elasticities are typically outside of the direct influence of government
 The political economy of trade 67
 We can extend the perfectly competitive market model to situations with international trade
 We will assume the domestic economy is small and does not greatly influence the world
economy
 The domestic economy acts as a price taker
 The world price for a good is taken as a given
 The domestic economy cannot affect the world price of the good
 Therefore, international trade is equivalent to the price controls discussed before
 The difference is that the international market buys up the surplus or provides goods
for the shortage
 If the world price is higher than the domestic equilibrium price, the economy exports

Or yen, or euros, or pounds, or rupees…
Taxes on cigarettes are a good example.
67
This section and the “Comparative Advantage” section in Section I are united in the resource guide under “International Trade”
65
66
Economics Power Guide | 42
Exporting Economy
A
C
Price
World
Price
B
D
Quantity
Triangle A is consumer surplus, as usual

Note that consumers generally lose surplus when an economy opens up to
trade and exports

Consumers have to compete with other consumers in the world

The big triangle B is producer surplus

Producer surplus includes domestic surplus plus the gains from international trade

Triangle C represents the gains from trade

Producers receive all of this surplus

Total social welfare increases

Rectangle D is the value of the goods exported (quantity times price)

This situation is analogous to a price floor, which would usually leave a surplus of
goods

The surplus is sold to the world market

Note that there is no deadweight loss
If the world price is lower than domestic equilibrium price, the economy imports


Importing Economy
Price
A
C
B
D
World
Price
Quantity


The big triangle A is consumer surplus

Consumers gain surplus because they have access to the lower world price
Triangle B is producer surplus

Producers lose customers to imports and have to produce at the lower world
price
Economics Power Guide | 43


Triangle C represents the gains from trade, which all go to the consumer, who gets
to enjoy lower prices

Total social welfare increases
Triangle D is the value of the goods imported
Failures of the Perfectly Competitive Model
 Market failures
 A market failure is when competitive markets fail to produce socially desirable outcomes
 Two types of market failures exist
 (1) Externalities
 (2) Public goods
 Addressing these market failures is one of the most prominent roles of government in our
economy
 No externalities
 Externalities are costs or benefits that affect a third party uninvolved in the activity or
transaction in question
 Individuals usually do not factor externalities into their decision-making because they do
not pay the costs or receive the benefits
 Externalities take two forms
 Negative externalities occur when an individual’s (or firm’s) decision imposes some harm
on others
 The individual does not have to pay for this harm and, consequently, does not factor it
into his or her decision
 Negative externalities thus lead to situations that are not socially optimal
 Example: Jon’s Wall of Sound may produce noise pollution (a negative externality) as a
byproduct of its being loud

When Lame Lucius walks by, he incurs a cost in the form of hearing damage

Ideally, Jon would factor the social cost of noise pollution into his decision-making
and turn his volume down

Since Jon does not factor in this cost, however, Jon is louder than is optimal for
society
 Positive externalities result when an individual’s (or firm’s) decision results in positive
effects for society or other individuals
 Since the individual does not benefit from these effects,
he does not factor them into his decision
 Positive externalities also lead to suboptimal situations

They do not provide enough of an incentive to
encourage decision-makers to repeat their behavior
resulting in the positive externality
 Example: Gardener Gary might plant a large patch of
fresh roses on his front lawn

Though Gary was the only person involved in
planting them, neighbors and passers-by enjoy the
roses’ sweet fragrance

The strangers’ olfactory pleasure is a positive externality 68
68
Assuming the strangers don’t have allergies to roses or overzealous shōnen stereotypes.
Economics Power Guide | 44
Gary’s neighbors, Ash and Misty, of course, want him to plant more roses so they
can enjoy even more of the scent

The positive externality (their happiness) does not, however, encourage Gary to
plant more roses

Consequently, Gary plants fewer roses in his lawn than is socially optimal
 Externalities enter the competitive market model when agents internalize costs or benefits
 An individual internalizes a cost when he pays it directly (building it into the market)

An individual internalizes a benefit when he enjoys it

An individual takes costs or benefits into account only when he internalizes it
 Taxes, fines, and regulations can internalize the costs of negative externalities

These measures discourage an activity by increasing its cost

In our example, a loudness tax may encourage Jon to turn down his Wall of Sound
 Subsidies, tax incentives, and other inducements can internalize some of the benefits
from positive externalities

These measures encourage an activity by increasing its benefit

Gardener Gary would be more likely to plant more roses in his garden if Ash and
Misty chipped in to help cover the cost of the flowers
 Internalizing externalities help move the individual (or firm) toward the socially
optimal level of activity
 Even for a negative externality, the optimal level is not zero
 The activity that generates the externality still has a positive value
 The cost of reducing this activity too much outweighs the additional benefits of reducing
the externality
 We can depict the true social cost of production by shifting the supply curve left (for
negative externalities) or right (for positive) by the cost of the externality
 Market participants have incentives to attempt solving problems that externalities create
 Often, the two parties pay off one another to prevent or encourage the externality
 Another approach is to internalize the externality
 According to the Coase Theorem developed by Ronald Coase, private parties should be
able to resolve inefficiencies created by externalities
 But the parties need to be able to negotiate with each other
 And property rights need to be clearly defined
 Despite these simple conditions, externalities are a major problem

In many cases, property rights are poorly defined

The costs of negotiation may be too high
 Pollution is a good example

Many people suffer mininal harm from pollution, so the total effect is large

But because the individual effects are small no one has any incentive to negotiate,
and a lawsuit would be long and drawn out
 Where private negotiations fail, governments step in
 Some use taxes or subsidies to correct externalities
 Using taxes is most effective when the externality’s value is easily estimated
 Otherwise, using a quota works as well

A quota is a numerical limit on how much of something is allowed

One problem with using a quota is that the people who value the good or service
the most may not get it

Economics Power Guide | 45
This can be resolved by creating a market where people buy and sell the permit for
that good or service
 Property rights and public goods
 One of the most prominent institutions is property
69
 Even though property is a very familiar concept, it is incredibly nuanced
 For most of us reading this, the property rights seem natural
 Property rights are not natural, however, but are a social innovation
 Goods in general fall under one of four categories

Four Types of Goods
Rival
Non-Rival



69
70
Excludable
Non-excludable
Private Goods
Common Resources
(food, clothes, cars)
(crowded free roads, fishing ponds)
Collective Goods
Public Goods
(uncrowded toll roads, electricity)
(national defense, air)
Each category is characterized by rivalry and excludability
 One person’s consumption of a rival good prevents others from using that same good

Example: If Colin is using the floor microwave to heat up his lunch, his suitemate
Creevey cannot use the microwave

The microwave is a rival good
 If a good is non-rival, one person’s consumption of the good does not limit other
individuals’ use of the good

National defense is a common example of a non-rival good

Everyone in the United States enjoys the protection of the government

No one’s enjoyment of this protection inhibits anyone else’s safety 70
 Access to an excludable good can be limited

Example: Suppose Rincewind loves orange juice—he buys five gallons of it per week

Rincewind can prevent Twoflower, who also loves orange juice, from buying his OJ

Rincewind’s orange juice is an excludable good
 No one can prevent other individuals from consuming non-excludable goods

A common example is air
Property rights ensure the security of private goods
 Owners of private goods can exclude other persons from using their goods

Owners of private goods have the right to dispense, rent out, or lease their own
private property to others

Slices of pizza, computers, and toy alpacas are private goods
Common goods or resources are rival and non-excludable
 The tragedy of the commons plagues these types of goods

Individual users may exploit or overuse a common resource, thus degrading (or
even destroying) that resource

Environmental situations like excessive fishing and overgrazing of communal
farmland, are examples of the tragedy of the commons
Property law is unfathomable. – Sujay
In theory; “Anyone” in this case, only refers to Americans.
Economics Power Guide | 46
People do better when they decide collectively what to do with these goods, since
externalities are internalized

Usually, these goods are the sources of externalities
 Society at large holds public goods
 These goods are non-rival and non-excludable

Since public goods are non-rival, the marginal cost of providing them is near zero
 Public goods include publicly funded transportation systems (like highways), public
education, public parks, clean water, and the global environment

When public goods are provided, the quantity supplied will be too low
 Since public goods are available to consumers at no marginal cost, there is a rational
incentive to overuse or abuse them 71
 Collective goods are non-rival but highly excludable
72
 Collective goods are easily privatized and tend to be natural monopolies
 Since these goods are non-rival in consumption, the marginal cost of producing them
is nearly zero

Monopolies can profitably supply these goods, but have the tendency to set prices
too high and supply too little

For this reason, governments like to regulate or directly provide collective goods
 Good examples are satellite radio and pay-per-view television
 As mentioned before, public goods are a major source of externalities 73
 Government intervention usually helps negate the effects of the externalities

Imperfect Competition
 Market power
 Perfect competition is an approximation for the economy
 At the same time, the markets for some very important products are dominated by a few very
large firms
 Computer operating systems
 Commercial airplanes
 Automobiles
 Air travel
 Mobile phones
 Other times, only one supplier of a good exists
 Electricity
 Water
 Cable television
 Markets with only one or a few suppliers are imperfectly competitive
 Just like firms in perfectively competitive markets, firms in imperfectly competitive
markets want to maximize profits
 Unlike perfectly competitive firms, however, these other firms face a downward sloping
demand curve
 Their decisions about how much to supply affect the price they get
 Firms with a downward sloping demand curve possess market power
71
Because clean air is totally overrated. I was never a huge fan of breathing anyway. –Christina
These are discussed in the next section on imperfect competition.
73
Public goods cause the free-rider problem. Consider roads, which are neither rival nor excludable. Who would pay for the
construction and maintenance of roads? The answer is no one. Everyone would just wait for someone else to pay for it and then use it
for free. Government solves this by forcing everyone to pay taxes to fund the roads.
72
Economics Power Guide | 47


Instead of taking prices as given, they choose their price
The price and quantity available for firms to choose from are determined by the
market demand
 Monopoly
 If the number of firms decrease to one, we are left with a monopoly
 Monopolies can purposefully create scarcity, called contrived scarcity
 Under contrived scarcity, the monopolist produces less than what consumers demand
at the given market price
 Contrived scarcity drives up profits while simultaneously leaving some consumer
demand unmet (thus decreasing the general welfare)
 In other words, monopolies produce less and charge more than is socially optimal
 Monopolies impose a welfare loss on society primarily through contrived scarcity

By producing less and charging more, monopolies are able to capture some of the
consumer surplus as producer surplus

Even more of the consumer surplus disappears and no one benefits

This lost surplus is called a deadweight loss

It is surplus lost by consumers but not regained by producers
 Monopolies can be inefficient due to lack of competition
 While monopolies are profit-maximizers, they can produce inefficiently due to laziness,
incompetence, or lack of having competitors around to “keep them on their toes”

In competitive markets, efficient firms run inefficient firms out of business

Monopolies can remain inefficient, which results in wasted resources, higher
production costs, and higher prices for consumers
 One can distinguish between monopolies that have “earned” their position and those
which have not
 Microsoft is a monopoly that has arguably earned its position in the market for PC
operating systems

It provides products that consumers demand and maintains a level of innovation
 Economic profits can reward such successes
 Long-term monopoly can give a firm a stable position that facilitates innovation to
maintain economic profits
 Monopolies arise from barriers that prevent competitors from entering the market
 (1) Ownership of a key resource
 Most residential electricity is a monopoly since one company owns the retail electricity
distribution system
 The diamond industry also tends towards monopolies

Until early this millennium, the DeBeers company owned 80% of the world’s
diamond mines
 (2) Government-created
 These barriers to entry include patents, copyrights, and other property protections

If the government gives someone a patent, the inventor gets the exclusive right to
use the technology for 20 years in exchange for revealing the details

An author is a monopolist over their book under copyright laws
 These barriers allow a firm to operate exclusively in a given market for a period of time
 Government licensing or similar regulations can create artificial monopolies if the
government authorizes only one firm to provide a good in a given region
 (3) Natural monopolies
Economics Power Guide | 48

Natural monopolies emerge when economic conditions make it practical for one seller
to operate in a given market

Natural monopolies emerge through economies of scale

If a natural monopoly exists, it is economically preferable for only one firm to
operate

Usually, there are large fixed costs that cause the firm’s average costs to fall as
more goods are produced

In this case, the government usually works to regulate the natural monopolist to
ensure public welfare

Natural monopolies often result from market forces or the nature of producing
certain goods

Example: Train services and utility companies (electricity, gas, water, etc.) are
typically natural monopolies
Three most important
barriers to entry for
monopoly
Ownership of a
key resource
Government
intervention
Natural
monopolies
 Monopoly supply is very similar to supply for a perfectly competitive firm
Like a firm in a perfectively competitive market, a monopoly will set their price and
quantity supplied where marginal revenue equals marginal cost
 Unlike a perfectively competitive firm, increasing supply until marginal revenue equals
marginal cost increases economic profits
 No other firms can enter the market and drive economic profits to zero
 The presence of monopolies has two effects
 (1) Consumer surplus is transferred to the monopolist
 Demanders still buy the good at the monopoly’s price
 These same demanders, however, would have been able to purchase the same product
at a lower price in a perfectly competitive market
 (2) Overall social well-being decreases
 In a monopoly, supply is restricted to be less than the competitive quantity
 The additional quantity would cost less to supply than the amount that consumers
value it
 The monopolist will not supply that amount, since doing that would reduce the
revenue it gets from those willing to pay the monopoly price
 Governments have devised their own methods for dealing with monopolies
 (1) Use of legislation
 In 1890, the Sherman Anti-Trust Act was passed in the United States
 Large mergers and acquisitions are reviewed to ensure they do not reduce competition
in certain markets

Economics Power Guide | 49
Additionally, large companies can be broken up or other steps taken

In 1984, AT&T was broken up

Recently, Microsoft was required to unbundle Internet Explorer from Windows
 (2) Regulation
 Many natural monopolies are allowed to exist but are closely regulated
 Public utilities are not allowed to set prices independently
 Public oversight agencies often approve their rates
 (3) Public ownership
 Municipal governments often local services

Water

Sewer

Sanitation
 Firms separate their customers into different groups
 This strategy is called perfect price discrimination
 Price discrimination is the act of charging different consumers different prices
 Obviously, each consumer values certain goods at different prices
 Ideally, a firm could choose to charge different prices to customers based on how much
they valued that good
 The firm could avoid negative effects of expanding sales

Normally, to expand sales a firm would have to lower its prices

With price discrimination, a firm will not suffer such effects
 Such a firm’s marginal revenue curve would be identical to the market demand curve
 Price discrimination allows monopolies to capture more profits

The monopoly captures more of the benefits produced by each transaction

Complete, perfect price discrimination transfers all consumer surplus to the
producer as profit
 Fortunately, price discrimination increases social welfare

The market moves closer to the socially efficient quantity
 For price discrimination to be successful, a firm must be able to meet two requirements
 (1) It must separate the market into two or more groups based on their demand
elasticity
 (2) The firm must prevent the resale of its products

In other words, those who are buying the good for less than others must not be
able to resell the good to those who would otherwise pay more
 Example: Assume Farsighted Farah plans to vacation in San Francisco on April 10

She books her flight a month in advance with Generic Airlines and pays $150 for
her round-trip ticket

On April 7, Businessman Brandon’s boss tells him he needs to go to San Francisco
on April 10 to meet with some clients

Brandon also books his round-trip ticket with Generic Airlines

His round-trip ticket costs $325

This scenario is an example of price discrimination

Brandon and Farah are purchasing the same good, but Brandon is paying more

Brandon’s demand for the flight is relatively inelastic

He has to go on a specific day, and there are not many days left before the flight by
the time he buys his seat

Farah’s demand, on the other hand, is relatively elastic

Economics Power Guide | 50
She has plenty of time to choose the airline she wants

Her schedule is, presumably, somewhat flexible

Because of their differing demand elasticity, Brandon is willing to pay more for
a ticket than Farah is

The airline price discriminates by charging these two customers different amounts
in attempting to capture each consumer’s surplus
 Price discrimination restores some efficiency lost when firms with market power increase
the price above the market price
 Price discrimination allows consumers who would not be able to afford the higher
price to purchase the product
 It is not as efficient as pricing in a perfectly competitive market

Of course, companies rarely discriminate perfectly between customers
 However, they can split consumers into different groups

Cable companies offer differently priced packages of channels

Movie theatres often have discounts for children and for seniors

Airlines discount those willing to stay over a Saturday night

Colleges offer need-based financial aid, effectively reducing tuition for needy
students
 Oligopoly
 Few industries are truly monopolies
 In most cases, a small number of producers supplies most of the market
 Tennis balls
 Breakfast cereals
 Aircraft
 Electric light bulbs
 Washing machines
 Cigarettes
 A market with a few interdependent firms is an oligopoly
 Firms in an oligopoly feature highly differentiated products or homogenous products
 In either case, oligopolistic markets have long periods of price stability
 There is almost no price competition, only non-price competition
 Oligopolies are common in the real world
 The car market is an oligopoly of highly differentiated products
 The market for steel is an oligopoly of homogenous products
 The most notable oligopoly is OPEC

OPEC (Organization of Petroleum Exporting Countries) is an oil cartel that
manipulates crude oil prices

In 1972, oil was $11 a barrel

OPEC played a major role in raising prices to $35 a barrel in 1981
 Collusion is a common characteristic of many oligopolies
 Collusion occurs when firms cooperate to artificially raise market prices by restricting
supply
 Producers must consider both the downward sloping demand curve in a certain market, as
well as the choices of other producers
 A group of firms that colludes to control prices is called a cartel

Economics Power Guide | 51
Cartels are illegal under U.S. anti-trust law 74
 A cartel essentially acts as a monopoly because all the firms work together
 The main problem with collusion is the high incentive to “cheat”
 Since the market price is artificially high and the quantity supplied is artificially low, a
firm could make a lot of profit by supplying more than the other firms

Doing so, however, would drive up the market supply and, in turn, decrease the
market price

The other firms in the oligopoly would have to follow suit and lower their prices,
resulting in price competition

Thus, the collusive agreement effectively self-destructs

In 1986, oil prices collapsed back to $13 a barrel when the OPEC countries
ceased limiting production
 Due to the threats of a price war and the incentive to maintain profits, oligopolies
generally work together (outside the United States)
 Firms in an oligopoly benefit from working together, making them interdependent
 Each firm relies on other firms to maintain the same prices
 But given incentives to “cheat,” oligopolies become very unstable
 Oligopolies become more stable when members have a way to sanction cheaters such as
imposing costs or punishments
 Oligopolies, like all other firms, maximize profits by equating marginal revenue and
marginal cost
 For an oligopoly, the outcome will be between the extremes of monopoly and perfect
competition
 Without numbers or knowing the specifics of each market, we cannot say exactly
where
 We can say that an oligopolistic market results in some reduction to social welfare, but
the degree of reduction depends on the market
 Monopolistic competition
 The most common type of market is the monopolistically competitive model
 Book publishing
 Restaurants
 Clothing
75
 Breakfast cereals
 Local service industries
 Markets with a large number of firms and product differentiation are in monopolistic
competition
 Product differentiation is the difference between similar goods in the market
 Example: Computers all do the same thing, but consumers differentiate between Apple
computers, HP computers, and so on
 Many competing sellers exist in the market, so firms do not have absolute market power
 Some barriers to entry exist, giving monopolistic firms some control over price (some
market power)
 Firms in a monopolistically competitive market still produce at a point that maximizes profits
 In a monopolistically competitive market, a firm can charge a price above the market price

But not any international laws.
My team had an argument about whether cereal belonged to an oligopoly or a monopolistically competitive market, since it’s listed
under both. Our conclusion was that USAD needed more proofreaders. Seriously, if it does come up, dispute it. - Sophy
74
75
Economics Power Guide | 52
Like all other firms, they will produce where marginal revenue equals marginal cost
 Since the firm’s demand curve slopes downward, marginal revenue is less than price

At this point (where marginal revenue equals marginal cost), market price is greater
than marginal cost of production
 A firm in a monopolistically competitive market will not earn economic profits
 Barriers to entry in a monopolistically competitive market are at most low
 Firms can easily enter and start supplying similar goods and services
 Existing firms will see their demand curves shift left, and profits fall
 Product differentiation causes firms to engage in non-price competition
 Advertising, branding, and other activities allow a firm to make its product stand out
from alternatives

Doing so allows a firm to charge consumers a high price for its differentiated product
 Monopolistic firms use advertising and marketing to gain market power so they can
imitate monopolist pricing techniques

Advertising does not make sense in a perfectly competitive market because all
goods are the same

Advertising is also not necessary for a monopolist because there are no other sellers

Advertising may play other roles, however, such as boosting demand for the
product among consumers who may not otherwise demand it
 Differentiated products present a barrier to entry for new firms because they must be able
to differentiate their product successfully before they can compete
 Product differentiation is an extremely expensive advertising process
 The fashion industry is a great example of monopolistic competition
 Brands spend huge sums on advertising to differentiate their products from the rest
 Several points must be noted about monopolistically competitive markets
 (1) Since price is greater than marginal cost, some social inefficiencies exist
 Some consumers value a product at more than the marginal cost of more production
 The failure to take advantage of this is a failure to exploit mutually beneficial exchanges
 Monopolistically competitive firms have an incentive to restrain production
 (2) Diversification of products in a monopolistically competitive market gives consumers
more choices

Types of Markets
Monopoly
Oligopoly
Less competitive
Less efficient
Monopolistic Competition
Perfect Competition
More competitive
More efficient
Creative Destruction: the Profit Motive and the Sources of Economic Change76
 Economic profits
 Economic profits, as seen, are a payment above and beyond the opportunity wage
 Self-interested economic agents want to identify opportunities to earn economic profits
 Economic agents can achieve economic profits by escaping the constraints of competitive
markets
76
Long title, one of the shortest sections in the packet…
Economics Power Guide | 53
Producers create barriers to entry that in turn create imperfect competition
 Entrepreneurship
 To establish market power, firms can innovate
 Entrepreneurs are individuals who take on the risk
of creating new products or services, new markets,
or new methods of production
 Although risk is high, entrepreneurs can earn
significant economic profits by being the first to
market a new product
 For scientific innovations, entrepreneurs can
obtain a legal monopoly through patents
 In other cases, market power arises because
entrepreneurs can differentiate their goods from
others in the market

(1) Defining the desirable characteristics of
their product

(2) Possession of trade secrets
 While innovation create barriers to entry, it can also
break down existing market imperfections
 Profits encourages efforts to invent around existing
barriers to entry
 Creative destruction
 Economist Joseph Schumpeter described the impact of entrepreneurs as creative destruction
 Continuing to develop new and improved products is one of the key sources of long-run
improvements in well-being
 The opportunity to earn economic profits is the catalyst of creative destruction
 Many economists think the inefficiency of market transition is a small price to pay for innovation

Institutions, Organizations, and Governments
 Collective decision-making
 Collective decision-making institutions are used to overcome the effects of departures from
perfect competition
 Analyzing how collective decision-making processes emerged in modern economies is
extremely complex
 But, analyzing them is important
 Economists believe that worldwide variations in standards of living and how to deal with
such differences stem from challenges in collective decision-making
 Institutions and organizations
 So far, we have analyzed human interaction and decision making in a vacuum
 We state that markets organize buyers and sellers together
 However, we have not really given a good description of how they do so
 Markets rely upon institutions to ensure that they function properly
 Institutions are formal or informal rules that structure human interaction
 Institutions set the “rules of the game”
 They ensure functioning of markets by facilitating exchange
 Institutions can include government institutions, private institutions, laws, regulations,
and even general codes of conduct or social norms
Economics Power Guide | 54
Most markets are also institutions
 Like institutions, organizations also organize human interactions
 Unlike institutions, the rules and structures of organizations are more formal
 Examples include commodity and stock exchanges
 Corporations and organized religions are organizations as well
 Institutions and organizations require voluntary cooperation to be effective
 Self-interested individuals only conform to the rules of organizations and institutions as
long as such cooperation makes them better off
 As we have seen, there are powerful incentives to cheat on voluntary agreements
 Government
 Compared to institutions and organizations, governments possess two distinctive powers
 (1) Ability to tax its citizens
 Businesses only earn revenue through selling products, and only if consumers are
willing to buy
 Government’s ability to compel payment of tax is not absolute

Citizens are free to move between cities, counties, and states

If they do not like the level of taxation in one area, they can move elsewhere

European Union members are free to move from one country to another
 Usually though, international mobility is limited

The United States imposes significant restrictions on legal immigration
 (2) Legal monopoly on the legitimate use of force
 Government uses force for three purposes

(1) To restrain criminals

(2) To compel military service 77

(3) To protect national security
 Clearly, government’s ability to use force underlies its ability to collect taxes

In most cases, this ability compels citizens to act in ways that are not in the
individual’s immediate self-interest

Things such as taxes are essential to support a system of private property

The whole system of voluntary exchange rests on the assumptions of private
property rights
 Government supports a broader range of voluntary cooperation than otherwise possible
 Governments enforce contractual obligations
 Contracts are agreements entered into voluntarily because both parties anticipate that
they will gain from the agreement
 If circumstances change, one party might regret entering into the contract
 Without the court system, individuals would be more reluctant to enter into them
 Government is not all good deeds 78
 Governments can also be a source of inefficiency and corruption
 Remember that elected officials and government employees are self-interested individuals
 Their interests may diverge from the majority
 Economics identifies these conflicting forces more clearly

77
78
Even in the United States, men over 18 register for Selective Service. It’s not a draft, but it could become one if needed.
It’s our wonderful, condescending economics resource guide. Of course it isn’t.
Economics Power Guide | 55
 Pork barrel politics
 Pork barrel politics refers to the tendency for elected officials to steer money to their
constituents by introducing projects
 Naturally, that legislator’s constituents are happy with the projects
 Together, these pet projects increase the cost of government
 Suppose a member of the House introduces an amendment to a bill that will bring $10
million in benefits to his district—building a new high-tech highway overpass
 The cost of the program to the federal government would be $15 million
 To the community in question, however, the cost would be a tiny fraction of that
 By supporting a fellow colleague’s pet project, the other voting legislators can get votes for
their own pet projects
 Vote trading among elected officials is termed logrolling
 Such vote trading accounts for some degree of “wasteful” government spending
 In 2010, pork barrel projects consumed 0.45% of the federal budget
 Rent seeking
 Inefficiencies arise when gains from government programs are concentrated while their costs
are spread widely
 Currently, the United States provides price supports for domestic sugar growers
 Additionally, the United States restricts importing cheaper sugar
 Overall, U.S. sugar prices are almost twice world levels
 The cost to U.S. consumers exceeds $1 billion a year
 Spread across 300 million people, however, the cost per person is small
 Sugar growers can hire lobbyists to influence legislators to continue price supports
 Most voters are unaware of these policies
 Even if they were, most would find the effort to counter them not worth it
 Even projects with more benefit than cost can generate wasteful resource allocation
 Lobbyists compete to influence the location of expensive federally supported activities
 These lobbyists spend a lot of money
 Rent seeking refers to activities that redirect, rather than create, economic benefits
 Most lobbying and petitioning of government is rent seeking to a certain degree
 The public does not gain from constant lobbying
 What is the proper role for government?
 Deciding the proper role for government lies in the realm of normative economics
 People differ in their opinions on size of government and the extent of its influence
 Economics illuminates the issues at hand and frames the choices of citizens more clearly
 Government is not essential to a market economy
 However, since governments enforce the law, more exchanges occur with than without them
 Most of us accept losing some autonomy in exchange for individual and property protection
 Unconstrained government can become intrusive and reduce individual freedoms
Economics Power Guide | 56
MACROECONOMICS
POWER PREVIEW
This section covers the basics of
macroeconomics. We will construct two
different models in the process of
understanding the economy better. These
models will then be applied to government
policy and international trade.
POWER NOTES
 30% of the exam (15 questions) will focus on
macroeconomics
 18 questions from the USAD practice test are on topics
from this section
 This section loosely covers pgs. 57-103 of the USAD
Economics Resource Guide
Macroeconomic Basics
 Economics on the national level
 Different perspectives often exist within the same field
 Biologists who study proteins use different approaches than those who study ecosystems
 Both sets of biologists, however, rely on the same set of fundamental principles
 Economics is much the same way
 Macroeconomics is the study of national economies
 The models and data that economists use to study entire economies differ from those used
to study markets within these economies (such as in microeconomics)
 Long- and short-run issues
 Macroeconomics is concerned with two questions
 (1) The factors that affect things in the long-run
 Size of economies
 Standard of living
Two
 Price level
questions
 (2) The causes and consequences of short-run
fluctuations
 Level of economic activity
 Unemployment
Long-run
Short-run
 Inflation
 Additionally, economists have developed aggregate
Level of
economic indicators to describe the performance of
Size of
economic
economies
national economies
activity
 Gross Domestic Product (GDP)
 Cost of living
Standard of
79
Unemployment
 Unemployment rate
living
Macroeconomic Issues
Price level
Inflation
 Economic growth and living standards
 Real Gross Domestic Product (Real GDP)
measures the total quantity of goods and services
produced in an economy in a given year, adjusted to remove inflation 80
 Since 1900, real GDP for the United States has increased by a factor of nearly 32
79
80
Unemployment is a state of being, unemployment rate is a number (glossary). These will be touched on later.
GDP and its variations will be studied more in-depth later.
Economics Power Guide | 57
Naturally, there are some ups and downs
81
 The Great Depression , from 1929 to 1933, featured a decline in output
 Output expanded from 1941 to 1945, during World War II
 Overall, the impact of individual events is dwarfed by expansion of the total economy
 At the national level, the amount people consume is limited by the amount produced
 Since population has been increasing, it follows that production has risen as well
 Output has grown much faster than population since 1900

The United States population has only increased by a factor of four since 1900

This data implies average output per person since 1900 has risen by a factor of eight
 Output (or GDP) per person is also termed output per capita
 The phrase “per capita” comes from Latin
 Literally, it means “per head”
 Per capita is commonly used to denote averages for entire populations
 Average output per capita naturally indicates what the typical person can consume
 Average labor productivity is a measure of how much the typical worker can produce
 Mathematically, average labor productivity is equivalent to the economy’s total output
divided by the total number of workers employed 82

Average labor productivity =
Economy' s total output (national GDP )
Total number of wor ker s
 Variations in production per person can be very large
In 2008, the average output per person in the United States was $43,000
 China’s population is five times that of the United States
 China’s total output is only a fraction of the United States’
 Production per person is about one-fifth (20%) of the United States’

This is about 5% of the United States’ output per capita 83
 The countries with the lowest level of production per capita are located in Africa
 In Ghana, output per person averages $458

This value is just over 1% of output per capita in the United States

This is less than $2 per day
 Even the poorest citizens of industrialized nations enjoy many things that the average citizen in
a poorer country cannot
 Human happiness depends on more than just material levels of consumption
 (1) Living a long and healthy life
 (2) Access to education
 (3) A clean environment
 Still, the material resources that higher levels of production create make these things possible
 The business cycle
 The economy alternates between periods of growth and decline

81
PSA to all my 2011 Decathletes: Grapes of Wrath. The New Deal. Ella Fitzgerald. Artesian wells. Okay, I’m done. – Cat
Output per capita would be total output divided by the entire population. After all, not everyone works.
83
On a multiple choice test, I guess it’d be smart to rule out any options that don’t have a 5 in them.
82
Economics Power Guide | 58
 The business cycle represents the cyclical
fluctuations in total output, or real GDP, that
most economies experience
 Though the business cycle features periods of
growth and decline, the general trend of the
cycle is upwards
 An expansion (or upturn) occurs when the
economy shows an increase in real GDP
 Expansion continues until the economy
reaches a peak
 By definition, a downturn occurs after a peak
 Real GDP begins to decline
 A recession occurs when the economy
experiences a persistent downturn
 An extremely severe recession is called a
depression
 The Great Depression from 1929 to 1933 is the most severe episode of economic decline
observed to date 84
 Recessions continue until the economy reaches a trough, after which the economy begins
to expand again
 The National Bureau of Economic Research defines a recession as “a significant decline in
economic activity spread across the economy, lasting more than a few months, normally visible
in real GDP, real income, employment, industrial production, and wholesale-retail sales”
 Most governments work to moderate the business cycle through policy
 Expansions are dampened to prevent inflation and to ease future downturns
 Recessions are dampened to relieve social problems (such as unemployment)
 The United States’ economy has experienced business cycles, just like any other economy
 Business cycle fluctuations are one of the fundamental features of the economy that
macroeconomics attempts to explain
 One central focus of macroeconomic policy is to reduce the severity and durations of
periods of recession
 Unemployment
 Apart from output, macroeconomists are concerned with employment, a measurement of what
fraction of the labor force has a job
 Unemployment is the state of actively seeking paid work and not finding it
 The labor force of a given economy includes all members of the population who are employed
or actively looking for work (unemployed)
 In other words, the size of the labor force is equal to the number of people employed plus
the number of people unemployed
 Only adults (ages 16 and over) who are not incarcerated (in jail) can count as part of the
labor force
 The percent of the eligible population of an economy which is in the labor force is known
as the labor force participation rate
 An individual is only counted as participating in the labor force if he is either
employed or actively looking for work
84
As opposed to the Pretty Bad Depression, Mediocre Depression, and That Wasn’t Bad At All Depression – Cat
Economics Power Guide | 59
Stay-at-home moms and dads, retired persons, children, those serving in the armed
forces, and other individuals not looking for work are not counted as part of the labor
force
A critical factor impacting the participation rate is the number of women in the workforce
 The entry of more women into the workforce over the last half-century has significantly
increased the participation rate in the United States
The employment rate is the number of persons employed divided by the number of persons in
the labor force
The unemployment rate is the number of persons unemployed (but still in the labor force)
divided by the number of persons in the labor force, 85 usually expressed as a percentage
 The number of unemployed persons in a given economy is equal to the number of people
in the labor force minus the number of people who are employed
 Adding the employment rate and the unemployment rate should always yield 100%
(barring statistical discrepancies)
 With a high unemployment rate, finding work is difficult
 People who do have jobs find it harder to get promoted or to get a pay raise
 This phenomenon goes hand-in-hand with the fact that the unemployment rate goes
up during recessions and down during expansions
 Keep in mind two important things
 (1) Unemployment is never zero

Somewhere out there, someone is looking for a job

New job-seekers are always entering the market 86

Within industries or regions, fortunes are always changing

Even during the Great Depression, some companies were hiring
 (2) The American unemployment rate has not increased in the long-run
 The Bureau of Labor Statistics (BLS) is responsible for measuring the unemployment rate
each month
 The BLS surveys about 60,000 households a month
Everyone in the population aged 16 and over belongs to one of three categories set by the BLS
 Employed
 An employed person worked for pay (full- or part-time) during the past week
 Otherwise, the person is on vacation or sick leave from a job
 Unemployed
 The person in question did not work during the past week
 The person, however, made an effort to find paid work during the past four weeks
 Out of the labor force
 The person did not work in the past week or try to find work in the past four weeks
 The person could also be a member of one of the groups mentioned above
(incarcerated, military, too young, retired, homemaker, etc.)
Each month, the BLS collects data on the U.S. labor force






85
86
The labor force, NOT the total population.
I double entered the job market this June. Doing DemiDec and working a retail job is beyond exhausting. – Cat
Economics Power Guide | 60
Group
Number of people (in 1000s 87, 88)
Adult, non-incarcerated population
236,086
154,577
Labor force
Employed
139,649
Not in labor force


Unemployed
14,928
81,509
In 2009, the labor force participation rate was about 66%
Overall unemployment was 9.7%
 Among sub-groups, this statistic differed
Group
Unemployment
All workers
9.7%
Teenagers
25.5%
Black / African American
15.1%
Hispanic or Latino
13%
Adult men
10.1%
White
8.9%
Adult women
7.6%
 Unemployment is generally categorized in three ways


87
88
Structural unemployment is unemployment which results from changes in the goods that
consumers demand or changes in technology
 For workers experiencing structural unemployment, the rest of the economy may be in
perfect health while they are out of work
 Not enough jobs exist in a specific market for the number of workers who want jobs
 Structural unemployment ultimately results from a mismatch between the skills a
worker possesses and the skills demanded by the market

In the 1980s, the U.S. steel industry contracted while the computer industry expanded

Unfortunately, laid-off steel workers were mostly located in the industrial northeast

Most of the newly expanding industries were located in the Sunbelt

Many of these workers lacked the skills to pursue jobs in the new industries
 Structural unemployment can only be reduced by retraining workers for new jobs
 Structural unemployment is persistent unless the labor force catches up with demand
Cyclical unemployment is unemployment which results from changes in the business cycle
 If the economy is in recession, unemployment will be above normal
 If the economy is growing, then unemployment should be lower than normal
 Example: Unlucky Ulysses works at United Steel

Faced with a severe recession, United Steel’s sales fall drastically, and fires hundreds
of workers, including Unlucky Ulysses

Unlucky Ulysses is cyclically unemployed
So just stick three zeros onto the end of each number and you’re good.
This data is from August 2009.
Economics Power Guide | 61
Frictional unemployment is unemployment which results from looking for work
 Frictional unemployment results from the time-lag between when a worker is fired or
quits his or her job and when he finds a new job
 Relocation, as well as searching, applying, and interviewing for jobs, contribute to
frictional unemployment
 Frictional unemployment can never be eliminated because some time lag will always
exist between leaving one job and finding another
 Time lags can be reduced, though, by ensuring that a dynamic and flexible labor
market exists so that new jobs are readily available 89
 All economies have a natural rate of unemployment
 The natural rate of unemployment is the unemployment rate which exists in an economy
at full employment
 Full employment is NOT 100% of all adult people have paid jobs
 Unemployment can never drop below its natural rate (at least, not for long)
 When unemployment drops below its natural rate, firms compete fiercely for workers

To attract new workers, firms have to increase wages (or other benefits), which
increases labor costs

As labor costs increase, the price of goods will also increase, increasing inflation

The natural rate of unemployment can thus be described as the level of
unemployment that corresponds to no inflation
 Even when the economy is at full employment, some types of unemployment are
inevitable

Frictional unemployment will always exist to some degree as workers switch jobs

Frictional unemployment is a majority of natural unemployment

Structural unemployment is also a part of natural unemployment

Cyclical unemployment should be negligible in a healthy economy
 The natural rate of unemployment for any economy is the overall unemployment rate
minus cyclical unemployment
 An economy at full employment has only natural unemployment
 The natural rate of unemployment itself can fluctuate due to changes in the market

During the 1970s and 1980s, women entered the labor force and subsequently
raised the natural rate of unemployment

More recently, the natural rate of unemployment has fallen
 Inflation in brief 90
 Inflation occurs when all prices rise together
 It means that the goods people consume are becoming more expensive
 Inflation reduces purchasing power, the number of goods and services that a person can
purchase with one unit of currency
 The rate of inflation in the United States has varied considerably over time
 Prior to 1940, prices actually decreased during certain periods
 During the World Wars and the 1970s, inflation was quite high
 Since World War II, prices have risen consistently
 Since the early 1980s, inflation has been low

Seasonal unemployment is not covered in the USAD resource guide—but it is relatively intuitive. The job market for men who
look like Santa Claus dies in January and revives in November; some jobs only exist, in other words, seasonally. People who rely on
these jobs are seasonally unemployed when their job is out of season.
90
We will return to inflation when discussing CPI/GDP Deflator and money.
89
Economics Power Guide | 62
Macroeconomic Measurement—GDP
 Aggregation
 Aggregation is the process of combining different things into one variable
 Well-constructed aggregates allow us to see the big picture
 Aggregation often obscures other important details
 Developing economic aggregates is an important branch of macroeconomics
 To understand these aggregates and what they tell us, we need to take them apart
 Measuring total output: GDP
 Economists developed Gross Domestic
Product (GDP) as a way to measure the
“The market value of all final goods and
services
produced within a country during a
total output in an economy
specified period of time”
 While this seems simple, there are several
The formal definition of GDP
important points to note
 Market value
 In the United States, most goods and services are priced in dollars
 It follows that to combine all the different types of things the U.S. produces, we just add up
their dollar values
 We have to multiply by the quantity of each good before adding them all up
 Since we use market prices, more expensive goods contribute more to GDP
91
 Market prices reflect the value the marginal consumer places on that good or service
 Goods that have a higher value to consumers have higher prices
 These goods contribute more to total output
 Final goods and services
 Everything we consume results from a complex chain of production activities
 Only end products count toward GDP
 Intermediate goods are those goods used up in the production of a final good
 Intermediate goods are not counted
 Excluding intermediate goods ensures GDP is not affected by vertical integration
 Vertical integration occurs when industries that manufacture different aspects or parts of a
product are combined
 For example, Toyota may own both car assembly factories and steel refineries
 The steel is used to make cars
 The value of the steel is included in the final price of the cars

Even if another company sold steel to Toyota, the value of the steel would still be
counted in the cars’ value

By excluding whatever transactions surround intermediate goods, we get the same
contribution to GDP, regardless of industry ownership
 Some goods can be either final goods or intermediate goods
 Only the portion of production that is sold to final users counts toward GDP directly
 The portion that serves as an intermediate good is reflected in the cost of the final products
that it is used for
 Capital goods are goods that are produced so they can produce other goods and services
 Capital goods are not used up in production
 Examples include machinery or factory buildings
 Capital goods are counted once in the year they were produced
91
Marginal consumers value a certain good or service the least and will leave the market if the price rises by any amount.
Economics Power Guide | 63
Building capital goods invests in the future
 If capital goods were not counted, a country that produced more capital goods would
appear to have a lower GDP than one that made all consumer goods
 Within a country
 GDP is Gross Domestic Product
 Domestic means only goods produced within the borders of the relevant country are counted
 Toyota and Honda are Japanese car makers, but cars they produce within the U.S. country
count toward the United States’ GDP
 A McDonald’s restaurant in South Korea contributes to South Korean GDP, not U.S. GDP
 During a specified period of time
 GDP includes items produced within a specific period of time
 Usually, economists consider annual or quarterly (three-month) periods
 Goods produced in earlier periods are not included
 Suppose Intelligent Izzy buys up his fellow crest-makers’ companies
 He then sells one crest-making factory to young upstarts Henry and Takato
 The cost of the transaction does not count toward GDP, since the cost of the factory was
counted when it was produced
 The 6% commission of real estate agent Ruki does count toward GDP, since her services
were provided in the current year
 What GDP measures
 Interest in measuring economic output stems back to the mid-17th century
th
 In the mid-17 century, Sir William Petty was assigned by the British government to
assess the ability of the Irish to pay taxes to the crown 92
 The basis for measuring GDP was developed in the 1930s
 To fight the Great Depression the government needed information on economic activity
 In 1932, the U.S. Department of Commerce commissioned Simon Kuznets to
develop a system to measure national output

Kuznets presented his findings to the U.S. Senate in 1934
 The U.S. perfected techniques for measuring output and collecting data in World War II
 In 1971, Kuznets received the Nobel Prize in Economic Science
 Despite their usefulness, Kuznets’ concepts have a number of limitations
 (1) It is not always easy to determine what good or service is final
 Conventionally, spending on national defense (the military) falls within GDP
 Kuznets noted that military spending could be viewed as an intermediate good, since it
enables a country’s citizens to enjoy final goods and services
 (2) GDP excludes goods that are not bought and sold in markets
 Housekeeping and childcare performed by those in a family do not count toward GDP
 But these same services are included when purchased through a market
 Over the past 60 years, women have increasingly entered the paid labor force

Some purchased commercially provided childcare and housecleaning

GDP has risen twofold as a result, but the childcare would have taken place anyway
 Anything sold on the black market will not be counted in GDP
 (3) Measuring GDP ignores activities that deplete natural resources or pollute
 Measuring the value of natural resources and the environment is difficult
 Only normative economics provides a way to judge what goes into GDP

92
He did a petty good job. – Amanda
Economics Power Guide | 64
Ways to Measure GDP
 Expenditures equal production
 GDP is supposed to measure the quantity of goods and services produced
93
 However, goods that are produced are also purchased
 Therefore, we can think of GDP as a measure of the total expenditures within a country
 There are four categories of purchasers
 (1) Households
 (2) Firms
 (3) Government
 (4) Foreign sector—foreign purchasers of domestic goods
 For each of these categories, there is a separate category of spending
 (1) Consumption expenditures
 (2) Investment spending
 (3) Government purchases
 (4) Net exports
 Household purchases are called consumption expenditures or consumption
 Consumption is subdivided into multiple areas
 Consumer durables are long-lived consumer goods

Automobiles

Washing machines

Furniture
 Consumer nondurables are used more quickly

Food

Clothing
 Services are intangible

Education

Legal services
 Purchase of houses falls under investment, not consumption
 Spending by firms on final goods and household purchase of houses are termed investment
 Investment is also subdivided
 Business fixed investment includes the purchase of capital equipment by firms

Factories

Offices

Machinery
 Residential fixed investment is the purchase of new homes and apartment buildings
 Inventories are the addition of unsold goods to company inventories
94
 Investment does not include purely financial assets (stocks, bonds)
 Purchase of these transfers ownership, but does not create new assets
 Purchases by federal, state, or local governments are government purchases
 These include wages and expenditures on goods
 Military spending falls under government purchases
 Transfer payments do not fall under government purchases
 Transfer payments are the transfer of money from one party to another
 Nothing is created during the transfer
93
94
…eventually. :P – Sophy
This can be confusing, because in common conversation/understanding, we refer to stocks and bonds as investments.
Economics Power Guide | 65
Social security benefits are transfer payments
 The interest paid on government debt does not factor into government purchases either
 The purchases conducted in the foreign sector are net exports
 Mathematically, net exports is the difference between the value of locally produced goods
sold to foreigners and the value of foreign-produced goods bought by domestic buyers
 More simply, net exports are exports minus imports

NX = exports – imports
When exports exceed imports, the nation is running a trade surplus and GDP increases
 When imports exceed exports, the nation is running a trade deficit and GDP decreases
95
 The United States is slightly less dependent on trade than other countries due to its size
 But trade has been increasing in recent years
96
 In the long run, the levels of imports and exports move in similar ways

There have been shifts in levels of imports and exports relative to each other

Up until the late 1950s, the U.S. exported more than it imported

Since the 1970s, imports have exceeded exports
 The expenditures method of calculating GDP can be summarized by one equation

GDP = expenditures = C + I + G + NX




Services
C is consumption
I is investment
G is government purchases
NX is net exports 97,98
Consumer
nondurables
Consumer
durables
Household
consumption
Net exports
Government
purchases
Firm
investment
Inventories
Residential
fixed
investment
Business
fixed
investment
This is from the extremely brief section on page 62.
Meaning that imports and exports will either both increase or both decrease in the long run.
97
One of our varsities thought that “cigarettes” would be a good mnemonic for this (stands for CIGX). Since he was a varsity, we
visibly shunned the idea on principle, but it’s good for those just starting out.
98
So I had this great idea to use CIG-er-X (Or cigarettes) to remember CIGNX, but the honors on our team shunned it based
on principle. Oh… – Tad
95
96
Economics Power Guide | 66
 Income equals production (which equals expenditures)
 We have seen that GDP can be measured with production (output) or spending (expenditures)
 GDP can also be thought of as income
 When a good is sold, the revenue received is split between workers and owners of the
capital used to produce the good
 When technical adjustments are made, the combined income of labor and capital equals
expenditures
 Expenditures in turn equal production
GDP = production = expenditures = income
 These terms are used interchangeably by economists when discussing the concept of GDP
Real GDP
 The problems with GDP and price
 The size of GDP depends on the quantity and price of goods produced
 Economists need a way to separate the effects of changes in price from changes in quantity
produced
 One of the purposes of GDP is to track changes in economic activity over time
 In most cases, the quantities of some goods are increasing, while others are decreasing
 Prices do not change consistently
 Economists construct real GDP by using prices from a single year and converting the current
prices (and consumption) to that year
 Real and nominal
 Nominal GDP is GDP in prices from the current year
 Normally, nominal anything means that it is measured with regard to the current year
 Anything measured in real terms is measured with regard to a base year
Measuring Inflation
 The CPI
 The Consumer Price Index (CPI) is the method governments use to measure inflation
 In the U.S., it is calculated each month by the Bureau of Labor Statistics
 The CPI compares the prices of a basket of goods between the current year and a base year
 The CPI basket includes the goods which an average household would buy on a
regular basis
 The main component is housing
 For the CPI to work, the variety and quantity of individual items in the basket must be
the same
 Changing the make-up of the basket of goods from year to year would make
comparing prices impossible because the comparisons would be between different
goods 99
 The baskets vary by income and geographic region, to show differences in
consumption patterns
 Every month, the BLS employees visit stores and websites for the items in each basket
 The Consumer Expenditure Survey dictates what will be in each basket
 The CPI in the base year is always 100
99
Like comparing apples and oranges. Or Star Wars and Star Trek. -Christina
Economics Power Guide | 67
The number represents a percentage
 A CPI of 150 would mean that prices are 50% higher than in the base year
 A CPI of 90 would mean that prices are 90% of what they were in the base year

In other words, prices have gone down by 10%
To calculate the CPI in a given year (here, “t”), use the following formula


CPI year =
cos t of bundle year t
cos t of bundle base year
× 100
The CPI holds practical importance
 Social Security benefits are adjusted to reflect changes in the cost of living, which are
determined by changes in the CPI
 Many union employment contracts tie wage increases to the CPI
 Informally, employers and employees consider CPI changes when thinking about wage
rate adjustments
 The CPI has advantages
 It captures changes in price for basic consumer goods, which form one of the largest
(and most important) parts of aggregate demand
 With CPIs, the inflation rate is easy to calculate
 The goal of the CPI is to measure how changes in price affect the ability to maintain the
same level of well-being as in the base year
 In actuality, the CPI measures how changes in price affect the cost of a fixed bundle
 The CPI tends to overstate the true increase in cost of living
 The CPI has shortcomings
 New goods and services are introduced all of the time

Over time, changing consumer demands, technology, or other factors may render
the fixed CPI basket inaccurate or irrelevant

For example, VCRs were a significant consumer good ten years ago but are not
important today due to the emergence of DVD players

Goods are not added to the CPI until they gain wide market penetration
 The CPI does not account for substitution biases

If one good in the basket becomes too expensive, consumers may switch to a
substitute good

The fixed nature of the CPI does not account for this
 The CPI does not account for changes in quality

While the price of cars is certainly more today than it was 15 years ago, part of this
increase is due to the use of more expensive (improved) technology
 In 1996, economist Michael Boskin headed the Boskin Commission
 This commission reviewed the methods used to calculate CPI
 They found that the CPI overstated the rate of price inflation by 1.3% a year
 The GDP deflator
 An alternative to the CPI is the GDP deflator
 The GDP deflator is a broad price index used to correct for price increases in nominal
GDP
 The GDP deflator allows us to convert nominal GDP to real GDP

No min al GDP =
GDP deflator
100
× Re al GDP
Economics Power Guide | 68
Alternatively,
GDP deflator =
No min al GDP
Re al GDP
× 100
A GDP deflator of 100 indicates that there is no inflation
A GDP deflator less than 100 tells us the economy is experiencing deflation
 A GDP deflator greater than 100 tells us that there is currently inflation
 Compared to the CPI, the GDP deflator is less volatile
 The GDP deflator rises less at peaks and decelerates less at troughs
 Over its entire course, the GDP deflator has risen less than the CPI
 The GDP deflator has two main differences compared to the CPI
 (1) The GDP deflator only reflects prices of domestically produced goods

The CPI market basket can include imports
 In the beginning and end of the 1970s, the CPI rose much faster than the deflator

Rising oil prices pushed the CPI upward

Since oil was mainly produced overseas, the GDP deflator was not affected
 (2) The GDP deflator and CPI weight goods and services differently
 The CPI uses a fixed basket of goods, while the GDP deflator weights prices by
production level
 Therefore, the GDP deflator adjusts to changing consumption patterns over time
 The GDP deflator has some shortcomings
 This value is difficult to accurately calculate
 As a result, it is only published once each year
 Consequently, it can’t track inflation very quickly
 Like CPI, the GDP deflator fails to account for changes in quality
 Though the GDP deflator presents a more accurate picture of inflation across the economy, it
is not suitable for guiding government policy—it takes too long and is too difficult to calculate


Money100
 What is money?
 Money is anything with the following three functions
 (1) A medium of exchange used by buyers to purchase goods and services
 Sellers need to be confident they can use the money they earn selling things to buy things
 Therefore, people are willing to hold onto money even if it accrues no interest, because
they gain the ability to complete transactions quickly
 (2) A unit of account is a yardstick to establish the values of goods
 Unit of account allows us to make comparisons.
 Money as a medium of exchange is closely linked to money as a unit of account

Money is used to buy things

Prices are expressed in money terms
 Suppose a Pokéball is worth 37 vintage records and a Digivice is worth 12 of
Intelligent Izzy’s crests

If we had a common unit of account, the prices of the Pokéball and the Digivice
would be easier to express and compare
100
This section was moved from after financial markets.
Economics Power Guide | 69
(3) A store of value is just what it sounds like, something that keeps its purchasing power
into the future
 Sellers can hold onto money for weeks, months, or years before becoming a buyer
 Money pays no interest
 Wealth is all the value in an economy
 To distinguish what makes wealth, economists use liquidity
 Liquidity measures how an asset can be converted into that economy’s particular medium
of exchange
 Currency is the most liquid asset
 Checking accounts, most stocks and bonds, and shares of mutual funds are highly
liquid
 Real estate and antiques are more difficult to sell and therefore less liquid
 Commodity and fiat money
 Commodity money is money with intrinsic value
 The money’s component material has worth
 Money made of gold or silver is considered commodity money
 During World War II, prisoners of war used cigarettes as money
 Fiat money is money with no inherent worth
 A fiat is an order or decree
 Likewise, fiat money is money by government decree

Most money in the world today is fiat money 101

Medium
of
exchange
Unit of
account
Store of
value
Commodity
money
Money
Fiat money
 Measuring money
 To analyze the effects of money on the economy, we must know how much there is
 In the United States, the stock of money is made up of several things
 The money supply is the stock of liquid assets in an economy that can be exchanged for goods
 Currency is money in the form of paper or coins and is used in everyday transactions
 We are most familiar with currency
 Currency can be made of something valuable (a commodity), backed by a commodity,
or based purely on fiat (or faith)
 In early America, the government exchanged currency for silver

In other words, American currency was backed by the commodity of silver
 Currency is the most liquid form of money
 Demand deposits consist of money stored in accounts at banks
101
Fiat money. Dolla dolla bills y’all.
Economics Power Guide | 70
Demand deposits can be withdrawn at any time without prior notice
 Typically, demand deposits are checking accounts
 Demand deposits are more commonly known as savings deposits
 Time deposits also consist of money stored in accounts, typically at banks
 Time deposits differ from demand deposits in that time deposits cannot be withdrawn
at any time
 Time deposits cannot be withdrawn for a predetermined period of time
 Examples of time deposits are certain savings accounts and certificates of deposit (CDs)
 Money market accounts are another form of deposits that have a variety of restrictions
 Money market accounts require a larger initial deposit in exchange for higher returns
on that deposit
 Money market accounts limit the number of transactions their owners can make in a
given time period (usually a month)
 Money markets also require owners to keep larger balances to maintain higher interest
payments on deposits
 Other forms of money include traveler’s checks, types of liabilities, and Eurodollars
 Eurodollars include dollar accounts held outside of the United States
 These accounts can be located anywhere
 Credit cards and similar devices are NOT considered money
 Think of credit cards as a convenient form of an I.O.U., to be paid back later
 Credit cards reduce the economy’s need for money

Credit cards are convenient
 There are several different definitions of the money supply 102
 Definitions of money supply usually differ from one another based on liquidity
 The monetary base, or M0, is the narrowest possible definition of the money supply,
including only coins and paper currency
 These are the most liquid forms of money
 It includes all currency in bank vaults and held by the general (non-bank) public
 M1 is restricted to very liquid forms of money; it is more inclusive than the monetary base
 It includes currency in the hands of the public, traveler’s checks, demand deposits, and
other deposits against which checks can be written
 This definition of the money supply emphasizes transactions
 M2 is a broader definition of the money supply and includes less liquid forms of money
 M2 includes everything in M1 plus savings accounts, time deposits of under $100,000,
and balances in money market funds/retail money funds
 Time deposits under $100,000 are considered “small”
 M2 is less liquid than M1 but includes forms of money which are still useful for
everyday transactions
 Many economists consider M2 the best definition of the money supply

When trying to memorize things like what is in M1 and M2(explained on the next page), a really good trick is thinking of a scene,
or a story, that involves elements from whatever you’re memorizing. Like for M1, I think about a traveler at a bank, who is currently
demanding that he check his deposits. – Tad
102
Economics Power Guide | 71
Example Money Supply in a
Recent Year
M1
M2
Dollar amount
(in billions)
Currency
758.7
Nonbank travelers
checks
6.3
Demand/checking
deposits
294.8
Other checkable deposits
306.8
M1
1366.6
Savings deposits
3033.7
Small denomination time
deposits
1218.9
Retail money funds
959.9
Total
6579.1
The Financial System 103
 Saving and investment
 To an economist, saving happens when someone has more income than he wants to spend
 Investment describes the purchase of new capital equipment
 Financial institutions coordinate the saving and investment decisions within the economy
 Financial markets
 Financial markets are institutions where people who wish to save can supply their funds to
those who wish to borrow for investment
 A bond is a certificate of indebtedness that specifies the obligations of the borrowers to the
bond holder
104
 The sale of bonds is called debt finance
 A bond details the date of maturity and the interest rate to be paid until the loan is repaid
 The date of maturity is the date when the loan will be repaid
 The original amount of the bond is called the principal
 The bond purchaser will receive both the principal and periodic interest payments
 Usually, large corporations sell bonds to the public to finance their investments
 The purchaser of the bond can hold the bond until maturity or sell the bond to
someone else
 Market interest rates fluctuate with the fortunes of the marketplace
 Subsequently, the price at which a bond can be sold will change to equate the
promised bond payments with the new interest rate
 The bond purchaser assumes the risk of this price fluctuation

The longer the maturity of the bond, the greater the risk of changes in price

Borrowers must pay more to the buyers of the bond
 The bond purchaser risks that the borrower may default on their obligation by
declaring bankruptcy
103
104
This section was before the money stuff in the resource guide.
Both bond and debt have the letter b in them! 
Economics Power Guide | 72
To compensate for this, a borrower must offer high enough rates of interest to their
bond buyers

The United States government is a safe credit risk 105, so it can borrow at lower rates
than private companies

Financially insecure companies must pay high interest rates to attract bond
purchasers
 A stock represents a share in ownership for a firm
 The sale of stock shares is termed equity finance
 A company will sell stocks to make money
 Shareholders enjoy benefits if the company succeeds through the payment of dividends
or an increase in the value of their shares
 The company will only make money on the initial sell of the stock, not any subsequent
resellings
 These new transactions do not contribute to the nation’s investment
 Stocks can be sold on an organized stock exchange, such as NASDAQ (National
Association of Securities Dealers Automated Quotation System) or New York Stock
Exchange (NYSE)
 The prices of these shares depend on the supply and demand for shares in the company
 The supply and demand for shares of stock respond to the current profits and future
prospects of the company
 The ease with which shareholders can buy and sell stock on organized exchanges
contribute to the shareholders’ willingness to hold assets
 Most companies use equity and debt finance
 Shareholders receive dividends or more valuable shares if a company does well
 The bondholders only get interest payments
 If the company runs into trouble, bondholders are paid before shareholders
 Financial intermediaries
 An intermediary is a third party, acting as a link between two others
 Two important intermediaries are banks and mutual funds
 Small businesses are likely to turn to banks in order to get the funds they need
 Banks get their funds from people who wish to save their money in deposits
 Banks give their depositors interest and charge borrowers more than they pay to depositors
 Deposits have little risk, since most banks deposits are fully insured and can fund can be
withdrawn whenever the account holder wishes
 Banks facilitate purchases of goods and services with checking accounts
 Mutual funds allow savers with little money to purchase stocks and bonds
 Mutual funds purchase portfolios of stocks and bonds, and then sell the shares to savers
 The shareholders of mutual funds assume the risks of decline in the value of the stocks and
bonds in the portfolio
 Savers like mutual funds for two reasons
 (1) Mutual funds make a high degree of diversification possible

When someone holds the stock or bonds of just one company, that person takes on
a high degree of risk 106

Diversification reduces potential ups and downs

105
Even with all the current concern about the national debt, it remains just about the world’s safest currency for investors. That may
change someday, of course.
106
Putting all of your eggs in one basket.
Economics Power Guide | 73

(2) Mutual funds provide their savers access to the knowledge and insight of
professional money managers

Individuals do not have to closely follow developments in the market
The Federal Reserve System and Financial Markets107
 The Federal Reserve
 The amount of money in the economy of the United States is determined by the interaction
between three groups
 (1) The public
 (2) The commercial bank system
 (3) The Federal Reserve system
 The Federal Reserve System is often called the Fed and serves as the central bank of the
United States
 A central bank is created to oversee the banking system of a country and regulate the
money supply
 The Federal Reserve was created in 1913
 It features 12 regional banks owned by the commercial banks in their respective regions
 The Federal Reserve is run by a seven member board of governors
 The members of the board are appointed by the President and confirmed by the Senate
 The term of each governor lasts for 14 years, to ensure the actions of the Fed are
immune to political pressure
 The 12 regional banks oversee commercial banks in their regions and facilitate transactions
by clearing checks
 These regional banks act as a bankers’ bank, allowing them to borrow funds
 Whenever a member bank is unable to get funds from other sources, the Fed banks
maintain the stability as a lender of last resort
 The task of controlling the money supply belongs to the Federal Open Market Committee
(FOMC)
 The FOMC is seven Fed governors and five regional bank presidents
 The president of the New York Federal Reserve bank is always a member, but the other
four places on the FOMC rotate
 The FOMC meets every six weeks in Washington, D.C.
 They assesses the state of the economy and determine if changes in monetary policy are
necessary
 Monetary policy are policies instituted by the Fed affecting the money supply, which
influences aggregate demand 108
 Changing the money supply
 The FOMC can alter money supply with three activities
 (1) Open-market operations are the usual means through which the Federal Reserve,
through the FOMC, conducts monetary policy
 Open-market operations are the buying and selling of government securities (treasury
bonds)
 To increase the money supply, the FOMC buys bonds from bondholders

Buying bonds takes securities out of the economy and injects money into it
107
108
This stuff was located after the money.
This will be discussed later.
Economics Power Guide | 74
To reduce the money supply, the FOMC sells bonds

Selling bonds takes money out of the economy and replaces it with securities 109
(2) Adjustments to the discount rate and the federal funds rate by the Board of Governors
are the next most-utilized ways of conducting monetary policy
 The discount rate is the rate of interest which the Federal Reserve charges commercial
banks for loans

Commercial banks will seek loans to meet cash shortfalls or to maintain reserve
requirements

As the lender of last resort, the Federal Reserve acts as the bank for commercial
banks

Commercial banks use the Federal Reserve as a last-resort source of short-term
credit

Lowering the discount rate encourages commercial banks to make loans because
borrowing from the Federal Reserve in case of a shortfall will be less costly

Increasing the discount rate increases the cost of borrowing from the Fed, which
will discourage commercial banks from making loans

The more banks loan, the more money is injected into the economy

Raising the discount rate decreases the money supply

Lowering the discount rate increases the money supply

The Federal Reserve exercises direct control over the discount rate and can set the
rate as it wishes

Commercial banks, can, however, seek other sources of credit

If a bank is forced to borrow from the Federal Reserve, others will think that
bank is experiencing financial difficulty
 The federal funds rate is the overnight rate of interest charged on loans between banks

As with the discount rate, banks will loan more at a lower rate, less at a higher rate

More loans means more money in the economy

The Federal Reserve does not set the federal funds rate directly

It can only influence it through market operations

Buying and selling government securities impacts the interest rate as well as directly
influencing how much money is in the economy
(3) The final way the Federal Reserve can conduct monetary policy is by changing the
reserve requirement
 The reserve requirement (also known as the reserve-deposit ratio) is the percentage of
deposits which a bank must have on hand at any given time

When banks loan money, the money is taken from deposits given to them by
customers

If all deposits are loaned out, depositors will be unable to withdraw their money
when they want to do so

Reserves are the extra money that banks keep on hand to be able to pay
depositors

If banks run out of deposits, they can collapse and savers may lose their money

This situation happened to many savers during the Great Depression

Ensuring that banks always have a certain amount of money on hand means that
depositors will always be able to withdraw their deposits



109
A nice mnemonic for you: Buy Bonds = Bigger Bucks, and Sell Bonds = Smaller Bucks – Lawrence
Economics Power Guide | 75
Making reserve requirements legally binding means that banks will always have to
meet these requirements

If reserves dip below the required amount, banks have to borrow money from
other banks or Federal Reserve to restore required levels

This is one way changes in discount and federal funds rates affect money supply
The impact of changes in the reserve ratio on the money supply can be measured
through the money multiplier (MM)

The money multiplier is the inverse of the reserve requirement (RR)


MM =
For example, if the reserve requirement is 20% of total deposits, then the money
multiplier will be 5: 1 ÷ .2 = 5

To calculate the impact of a new deposit in a bank on the money supply, multiply
the amount of the deposit by the money multiplier

If the reserve ratio is 20% and someone deposits $1 million in a bank, the net
result will be a $5 million increase in the money supply:
$1 million x 5 = $5 million

Theoretically, the bank will loan out $800,000 (80%) of the initial $1 million deposit

Eventually, this $800,000 will all be re-deposited, either by the borrower or by
others (such as firms that receive the money as payment for goods)

Of this $800,000 that is re-deposited, 80% ($640,000) will be loaned out again

The cycle continues

Eventually, the impact on the money supply will be an increase of $5 million
If the reserve ratio is decreased, banks have to keep less money on hand

Consequently, they can loan out more funds, increasing the money supply
If the reserve ratio is increased, banks have to keep more money on hand

They can’t loan out as much money, and the money supply decreases
Unlike open-market operations and changes in interest rates, changes in the reserve
requirement are initiated by the Federal Reserve’s Board of Governors, not the FOMC

The reserve requirement is not usually utilized as a policy tool because it alters the
banking system, which creates difficulties for banks

Banks can hold reserves beyond what is required, so as to more easily pay depositors
The reserve requirement is enabled by fractional reserve banking

In a system of fractional reserve banking, banks keep a fraction of their deposits

Depositors still own the money they have deposited in the bank, but banks can
loan this money to borrowers

These loans create additional money, increasing the money supply

Changes in the reserve requirement accelerate or hinder this activity

A bank’s reserves and the loans it makes are called assets

Likewise, the deposits in the bank are called liabilities
Economists have an equation that shows the effects of changing reserve requirements
on the money supply

The Fed provides M dollars of currency

The public holds C dollars of currency

Therefore, the banking sector holds M – C in reserves

The monetary base (“M”) is the total of currency and reserves






1
RR
Economics Power Guide | 76

R is the fraction of each dollar that banks hold in reserve
Money supply = deposits + C =

M-C
R
+C=
R ×C+M-C
R
=
M + (R - 1) × C
R
The smaller C or R are, the larger the money supply
Tools Of Monetary Policy
Policy Tool
Who
Acts?
What Happens?
Expansionary/
Contractionary
How Does It Work?
Used How
Often?
Open-Market
Operations
FOMC
The Federal Reserve
buys and sells
American securities
E: Buy securities
C: Sell securities
Injects or removes money
from the economy
Daily
Discount Rate
(DR)
Board of
Governors
The Federal Reserve
changes the interest
rate for loans from
the Federal Reserve
to member banks
E: ↓DR
C: ↑DR
Changes the cost of
borrowing from the Fed
Rarely
Federal Funds
Rate (FFR)
Board of
Governors
The Federal Reserve
changes bank-tobank lending rates
E: ↓FFR
C: ↑FFR
Changes the cost of
loans between all banks
About once
per quarter
Reserve
Requirements
(RR)
Board of
Governors
The Federal Reserve
changes the reserve
requirements for
banks
E: ↓RR
C: ↑RR
Changes the amount of
reserves banks must
maintain
Very rarely
 Note that the Federal Reserve does NOT change the money supply by actually creating new
currency (printing new bills and minting new coins)
 The printing of new currency requires special Congressional legislation
 Instead, the Federal Reserve changes the effective supply of money
 This is the “M” in the above equation
 The graphs below illustrate how monetary policy functions
Monetary Policy
Real
Interest
Rate
Investment Rates
Interest
Rate
Money
Supply
Money
Demand
Quantity of Money


Investment
Demand
Quantity of Investment
All of the monetary policy tools serve to increase or decrease the effective money supply
The money supply curve shifts to the left or right if the policy tool is contractionary or
expansionary, respectively
 Contractionary monetary policy decreases the money supply
 Expansionary monetary policy increases the money supply
Economics Power Guide | 77
A change in the interest rate through monetary policy influences the amount of investment
in an economy
 Expansionary monetary policy leads to lower interest rates, which encourages investment
 Remember that investment is a component of GDP
 Expansionary monetary policy, therefore, increases GDP through increases in investment
 Contractionary monetary policy decreases GDP through decreases in investment
 Think of the curves as the market for money and the market for investment, respectively
 Do not forget that monetary policy refers to changes in the money supply which can only be
done by the Federal Reserve
 Bank runs
 Fractional reserves are problematic when the public decides it wants to hold more currency
 A bank run is a rush of depositors to a bank in order to withdraw their deposits prior to other
depositors
 Banks only hold reserves equal to a fraction of their liabilities
 Even the solvent banks will be unable to pay all of their depositors
 A solvent bank’s assets exceed its liabilities
 Banks will be forced to shut their doors until loans are repaid or borrow more funds
 At points like this, the Fed must act as a lender of last resort to prevent disruptions
 In the past, bank runs were a frequent source of financial disruption
 Saving and investment in aggregate 110
 Remember that GDP equals production, income, and expenditures
 This equality is an identity
 By virtue of being an identity, it is always true
 Let us assume that the economy in question is closed to trade
 Therefore, GDP = Y = C + I + G
 Naturally, I = Y – C – G
 The right side (Y – C – G) is national savings
 This implies another identity, that savings equals investment (S = I)
 We can subtract net taxes (T) from each side
 S = (Y – C – T) + (T – G) = I
 This means that savings is equal to the sum of private savings and government saving
 Private savings is the amount of money that households have left over after taxes and
consumption spending
 For households, taxes are an expense, but they are income for the government
 If government savings (T – G) is positive, the government is running a budget surplus
 Otherwise, the government is running a budget deficit
 Note that whenever the government runs a deficit, it reduces investment, which in turn
reduces the growth of living standards
 International capital flows in an open economy
 In an open economy, domestic savings no longer have to equal domestic investment
 There are two types of international capital flows
 (1) Foreign direct investment describes when a company or individual acquires assets in a
foreign country that they will actively manage
 Mitsubishi bought Rockefeller Center in 1989

110
The next few sections are actually from after everything on the Fed.
Economics Power Guide | 78
(2) Portfolio investment occurs when an individual or company purchases stocks or bonds
issued by a foreign corporation
 Similar to net exports, we now must consider net capital outflow
 Net capital outflow (NCO) equals the purchase of foreign capital or financial assets by
domestic residents minus foreign purchase of domestic assets
 In an open economy, NCO always equals NX
 This holds true because it is an identity
 Recall that Y = C + I + G + NX
 Rearrange so that Y – C – G = S = I + NX
 Since NCO and NX are the same, S = I + NCO
 This means that in an open economy, savings can differ from investment only to the extent
by which the difference is offset by net capital outflow
 How financial markets coordinate saving and investment
 We will consider a closed economy, the situation will be quite similar
 Even though there is a large number of financial markets, they are all closely linked
111
 Individuals with excess savings
can easily move their funds between markets to get
the most return
 Borrowers have many different markets to choose from
 Therefore, we can merge these markets into a single financial market when analyzing them
 The financial market features the supply of savings and the demand for savings
 The demand for savings is equivalent to investment
 The supply and demand for savings are equalized through adjustments of the interest rate
 We graph quantity on the horizontal axis and the real interest rate on the vertical axis
 In the financial market, the real interest rate acts as the price of a loan
 The real interest rate is how much borrowers pay for the loan and how much savers
receive for making the loan
 For a lender (saver), saving is a decision to postpone consumption until the future

Lenders do this because they know that by receiving interest, they can consume
more in the future
 We graph the real interest rate because that is
Financial Market
what lenders and borrowers consider
Real
Supply of
 The real interest rate is the nominal
Interest
Savings
Rate
interest rate minus the rate of inflation
 The higher the real interest, the greater
the amount that people will save
 This is why the supply of savings is
upward sloping
Savings
 The lower the real interest, the more
Demand
investment projects businesses will pursue
 Businesses only borrow and invest if
Quantity of Money
they believe the new revenues they can
earn will exceed the cost of borrowing
 This is why the demand for savings is downward sloping
 Consider three possible changes 112 in market equilibrium

111
112
I don’t think I would ever have excess savings, but this is probably a personal failing on my part. – Jessica
There are more, but these are the only three USAD mentions.
Economics Power Guide | 79



(1) New, more productive technology shifts the money demand curve out
 Interest rates rise and more people save and invest
(2) The government increases its deficit and causes the supply of savings to shift left
 Interest rates are higher, but the total amount of saving and investment decreases
(3) The government gives a tax credit that ends up encouraging savings
 Interest rates fall, while saving and investment increase
Money and Inflation in the Long Run
 Price level and inflation
 Over the last 50 years, the CPI has increased more than seven times
 In 1960, the CPI was 29.6
 In 2008, this number rose to 215.3
 Prices have risen since 1960
 In the long-term, prices have actually fallen during some years
 Between 1929 and 1933, the aggregate price level fell almost 25%
 Between 1920 and 1922, the aggregate price level dropped a little over 16%
 The price level measures prices relative to a base
 The aggregate price level is the level that prices are at for the entire economy
 The price level, as demonstrated by the numbers above, rises and falls over time
 For example, the price of many goods has risen over time
 This does not mean that people enjoy these goods more
 More likely, the money they used to purchase these goods has lost value
 Inflation focuses on the changes in the value of money, rather than the value of goods
 When an economy’s price level rises, it takes more money to buy a fixed basket of goods
 Alternatively, the value of money relative to goods has gone down
 Suppose “P” is the price level as measured by the CPI and GDP deflator
 Therefore, P also measures the cost of a basket of goods
 The amount of goods and services that can be bought with $1 is 1/P
 This means that 1/P is also the value of money, measured in goods and services
 The money market in the long run
 In the long run, the value of money is determined by the interaction of supply and demand
 The supply of money depends on the decisions of the Fed and the banking system
 The demand for money depends on how much people want to hold their money rather
than have it in other forms
 People mainly hold money because it is useful as a medium of exchange
 An increased number of ATMs or credit cards will reduce the demand for money
 The two most important determinants of how much money people demand are associated
with the transactions that take place
 (1) Volume of transactions
 (2) Prices at which the transactions take place
 Assuming the real level of activity in the economy remains the same, doubling prices
should double the demand for money
 The long run is the time period for the price level to adjust and equate the demand for money
with the money supply

At this point, the value of money (1/P) and the quantity of money in the market will settle
where the money supply and money demand intersect
 1/P (the value of money) belongs on the vertical axis
Economics Power Guide | 80
Quantity, as always, goes on the horizontal axis
Money demand slopes downward to reflect the that people need less money to purchase
goods as the value of money rises (the price level falls)
The money supply is inelastic, as it is set by the Fed



Money Market
Value of
money
(1/P)
Money
Supply
Money
Demand
Quantity of Money
 Suppose the Fed decides to double the money supply
People will find they have more money than they want 113
114
 Many people will put their extra money into a bank, increasing the supply of savings
 Increasing the supply of savings will cause interest rates to fall
 In turn, businesses and consumers will increase spending
 Therefore, demand for goods and services in the economy will increase
 Since the supply of goods and services remains unchanged, higher demand will cause the
price level to increase
 Prices will continue rising until they have risen enough for money demand to equal money
supply
 At this new point, the value of money has fallen by half (the price level doubled)
 In short, the change in the money supply initiated by the Fed, in the long run, is equal to
the increase in the price level
 The long-run neutrality of money means that changes in the quantity of money have no effect
on real quantities in the nation’s economy
 Monetary changes will only affect real quantities
 Real quantities, measured in physical units, will not be affected by monetary changes
 The money supply multiplied by the number of times money is used should be equal to the
output in the economy at current prices
115
 The quantity theory of money states that M x V = P x Y
 This equation is also known as the equation of exchange
 M is the stock of money or money supply (how much money exists)

M is determined independently of the other variables

In other words, it is an independent variable in the equation
 V is the velocity of money, or how often money circulates through the economy

Velocity is how often a dollar bill is spent or changes hands in a given period

V is considered to have a constant equilibrium value

113
Yea, right. – Cat
This is a different graph, discussed just one section earlier.
115
Also, Q can be replaced with Y (meaning real GDP) to make VM = PY. I always remembered it as “vampy.” – Cat
114
Economics Power Guide | 81
It varies over time but will always average out to its equilibrium value
 Y (or T or Q) is the output of goods and services

Y is said to be given: real output at a given point in time is fixed

Note that P × Y = nominal GDP = M × V
 P is the average current price level

P is the dependent variable in the equation

It is influenced by the other three

Since V and Y are typically assumed to be fixed, changes in P are directly
dependent upon changes in M
 The equation states that the amount of money spent equals the amount of money used
 Increasing the money supply will have one of three effects
 (1) Velocity of money will fall
 (2) Real GDP will increase
 (3) Price level will increase
 This equation shows that, given V and Y as constants, increases in M (the money supply)
will result in increases in P (inflation)
 A key foundation of macroeconomics is the long term neutrality of money
 As we saw, changing monetary variables can only change the price level, not “real” variables
 Example: Increasing the money supply cannot increase long run real output
 Increasing long run real output would require increasing labor productivity, capital
investment, and so on
 Inflation
 Inflation is a sustained rise in the general price level
 The rate of inflation is the rise in the price level per unit of time
 In the United States, most official measurements of inflation are by quarter
 A quarter is equal to three months (a quarter of a year)
 Inflation decreases the value (purchasing power) of money
 Inflation weakens money’s ability to serve as a “store of value” because it erodes money’s
value over time
 As inflation continues, more and more money is needed to buy the same goods
 Inflation is unpopular
 Inflation rates reached the double digits in the 1970s
 During this time, many consumers saw inflation as the country’s number one problem
 Even though money is neutral in the long run, inflation can have powerful short-term effects
 (1) Inflation reduces the value of money
 Inflation acts as a tax on those that choose to hold money
 People will have to go to the bank or ATM more often
 Firms will have to adjust the prices of their products more frequently
 (2) Inflation distorts prices
 Not all firms adjust prices at the same time

Relative prices will not always accurately reflect the costs of production

The information conveyed to consumers by market prices becomes less valuable
 (3) Inflation introduces confusion about the value of goods in the future
 When someone lends their savings, they are postponing consumption

If that person cannot predict the rate of inflation, they will not be able to calculate
future purchasing power

This increases the risks that borrowers and lenders face

Economics Power Guide | 82


Subsequently, the supply of savings and demand for investment decrease
Investment is crucial to economic growth, so inflation serves to reduce economic
growth
Economic Growth, Productivity, and Living Standards
 Economic growth
 Sustained economic growth began over 200 years ago in the United States and Western
Europe
 During the 19th and 20th centuries, economic growth spread to Japan and portions of Latin
America
 The 1950s brought economic growth to many more countries around the world
 The circular flow model
 The circular flow model shows the relationship between different sectors of the economy
 (1) Households
 (2) Firms
116
 (3) Government
 The circular flow model goes two ways, and we will separate the different flows for simplicity
 Goods and services move clockwise, while money moves counter-clockwise
Factor
Markets
Land, capital
labor
Households
Factors of
production
Transfer
payments
Government
Firms
Goods and
services
Goods and
services
116
The foreign sector is not included. 
Goods and
Services
Markets
Goods and
services
Economics Power Guide | 83
Income (GDP)
Households
Factor
Markets
Wages and
rent
Government
Firms
Taxes
Government
purchases
Consumption
Goods and
Services
Markets
Revenue
 The model has three main components
(1) Households provide resources, such as labor
 These resources are used to make goods and purchase goods in the market
117
 The “goods” that households “produce” are factors of production,
such as labor,
land, and capital
 Households use the income they receive to buy goods and services, pay taxes, and save
in financial markets

Both households and firms borrow from financial markets, to pay for consumer
durables and capital equipment
(2) Firms (also referred to as the business sector) consume resources to produce goods to sell to
households in the market
 Firms use income to pay for the factors of production they purchase from households
 (3) The government sits between consumers and the goods market
 The government taxes households, earning income
 The government borrows from financial markets
 It uses both of these sources of income to purchase goods and services
 The circular flow model has two basic markets, both of which are governed by the forces of
supply and demand
 The market in which firms buy factors of production from households is the factor market
 The market in which households buy final goods and services from firms is the market for
goods and services
 The only places at which new wealth enters the cycle are households
 Households provide human labor that can be used to work
 This model assigns ownership of inputs such as land to individuals in households, who
rent it out to businesses

I remember using the mnemonic “CELL” to remember the factors of production: capital, entrepreneurship, land, and labor.
USAD does not emphasize this as much as in previous years, but I do recall seeing a couple of questions on which one was NOT a
factor of production (money would be the answer).
117
Economics Power Guide | 84
In general, all factors of production are originally owned by households
 Differences in GDP per capita
 Closely examining the circular flow model, we see that the economy’s output depends on the
total quantity of goods and services that firms can produce
 This in turn depends on the quantity of factor inputs that households can supply to the
firms and the ability of the firms to turn the inputs into outputs that others will buy
 Everything else being equal, larger economies should produce more than smaller economies
 None of this explains differences in GDP per capita
 Real GDP per capita is equal to real GDP per worker multiplied by the fraction of the
population employed

Real GDP per capita = real GDP per worker x fraction of population employed
GDP GDP
N
×
=
POP
POP
N



POP is the country’s total population
N is the labor force
real GDP
POP
is real GDP per capita or the amount of goods and services available to be
consumed by each person
 When you cancel out N in the two fractions on the right, the right side equals the left, so
this equation is always true
 The quantity of goods and services that can be consumed by each person depends on
average labor productivity and the part of the populace engaged in production
 Average labor productivity is the average amount each worker can produce
 Most differences in GDP per capita are explained by differences in average labor productivity
 The proportion of the population engaged in production has been remarkably consistent
 In the United States, labor force participation increased as women entered the market
and had less children (increasing the relative size of the working-class)
 Earlier retirement and longer education have served to negate this steady increase
 In other countries, this trend holds as well
 Average labor productivity and standard of living
 Five factors affect average labor productivity
 (1) Physical capital
 Workers with better tools, machinery, and up-to-date factories will be more productive
than those without them (or less of them)
 Capital equipment is produced

Increasing future capital stock means giving up consumption in the present
 (2) Human capital
 Human capital refers to the skills and experience acquired through education, training,
and on-the-job experience
 Human capital, unlike physical capital, is not tangible
 Like physical capital, creating human capital usually requires sacrificing current
consumption

The time spent learning and training could be used in productive activities
 (3) Natural resources
 The wealth of many countries depends on their vast natural resources

Saudi Arabia and Kuwait gain much wealth from their oil fields
Economics Power Guide | 85
Other natural resources like iron ore and petroleum contribute to a country’s wealth
 In a global world, domestic natural resources are not essential to a high standard of
living or maintaining a high average labor productivity

For example, Japan imports raw materials produced elsewhere
(4) Technological knowledge
 Technological knowledge is the knowledge about techniques that transform inputs
into the goods and services households desire
 Historically, advances in technological knowledge are the single most important factor in
raising average labor productivity
 Progress in technological knowledge comes in two main categories

(1) Inventing new products

Semiconductors

Integrated circuits

Lasers

Genetic engineering

(2) Developing better methods of organization

Example: the moving assembly line by Henry Ford
(5) Political and legal environment
 Some technological knowledge is kept as trade secrets or is patented
 Most technological knowledge is available to be learned and copied

The growth of living standards in countries like Japan, South Korea, and China
illustrates that countries can advance rapidly if they borrow and adapt

The fact that some countries are persistently poor indicates that significant barriers
to successfully borrowing and creating new ideas still exist
 Dysfunctional political and legal systems prevent many countries from exploiting the
potential of modern manufacturing techniques

After World War II, North and South Korea had similar resources, populations,
and standards of living

Today, South Korea enjoys a standard of living like that in other developed nations

Poverty and starvation are widespread in communist North Korea 118



 Creating appropriate incentives is essential to achieving a high standard of living

118
Governments should encourage investment in physical and human capital
I recommend a documentary called Inside North Korea if you want an inside look at how the North Korean government operates.
It’s moving and disturbing. National Geographic has it on their YouTube channel: http://tinyurl.com/37atf8q – Cat
Economics Power Guide | 86
Beyond a certain point, however, declining return would kick in
 If all current output were directed toward investing, we would have no goods and
services to consume (the Soviet Union came close to this in their early Five Year Plans)
New technological knowledge should also be encouraged through research and
development (R&D)
 New knowledge is a public good
 Private incentive to create new knowledge can lead to underinvestment
 Government can encourage R&D in various ways

Tax credits

Subsidies

Direct expenditures (paying for research directly)

Legal protections, such as patents


Short-Run Economic Fluctuations
 Economic fluctuations
 Business cycles and their accompanying fluctuations have been a characteristic of industrial
societies since at least the late 18th century
 Recessions occur when real GDP declines for two consecutive quarters (six months)
 The National Bureau of Economic Research (NBER) is responsible for researching these
short-run fluctuations
 The Great Depression lasted for 43 months, starting in August 1929
 The nation’s real GDP fell by more than 25%
 Since World War II, recessions have generally been short
 Only three have lasted longer than twelve months
119
 Recessions since World War II have been mild in terms of drop in real GDP
 Expansions lasted longer than most recessions
 Most lasted more than two years
 Real GDP has trended upward
 Characteristics of short-run fluctuations
 The two most important correlates of fluctuations in the economy’s aggregate growth are
unemployment and inflation
 Recessions are characterized by increased unemployment
 Businesses are slow to increase hiring in the early phases of an expansion
 Increased employment tends to lag behind the next stage of economic growth
 Periods of expansion feature accelerating inflation
 Between 1960 and 1979, the rate of inflation trended upward with the business cycle
 Periods of recession are linked to slowing inflation 120
Potential Output, the Output Gap, and the Natural Rate of Unemployment
 Output gap
 Think of the actual level of GDP as having two parts
 (1) The potential output of the economy
119
The USAD guide (except the Russia portion) predates the recent “Great Recession”.
If inflation occurs during a recession, an economy is experiencing stagflation—high inflation and unemployment. A stagflation
crisis plagued the United States in the late 1970s, when the rising price of oil knocked the economy off-kilter.
120
Economics Power Guide | 87
Potential output is the quantity of goods and services that the economy could produce
when using all its resources at normal rates
 The level of potential output can increase over time as technology improves and the
country obtains more resources
 The variable “Y*” will be used to denote potential output

Actual output will be symbolized with “Y”
 (2) The output gap
 The output gap is the difference between actual output and potential output
 In equation form, output gap = Y – Y*
 When an output gap exists, the economy’s resources are not being fully utilized
 Unemployment rises when the economy is below its potential output, or in recession
 More specifically, the cyclical component of unemployment rises when the economy is
in recession
 If this cyclical component were zero, only the natural rate of unemployment would
prevail, 121 composed of only frictional and structural unemployment
 In the 1960s, Arthur Okun noted that there was a relationship between the output gap
and the level of cyclical unemployment
 Okun was one of President Kennedy’s chief economic advisors
 Okun’s Law states that for every 1% the unemployment rate differs from the natural
rate of unemployment, the output gap deviates by 2%

If cyclical unemployment increases from 1% to 2%, the output gap would increase
from 2% to 4%
 Explaining short-run fluctuations
 Variations in the growth of output over time can be caused by two things
 (1) Changes in the growth rate of potential output
 (2) Actual output falling above or below potential output
 Changes in the growth rate of potential output depend on three factors
 (1) Growth rate of the population
 (2) Rate at which the capital stock increases
 (3) Changes in the pace of technological advances
 In the long run, changes in the growth rate of potential output can affect economic growth
 In the short-run, variation is mostly due to divergence between actual and potential output
 In a magical world where prices adjust immediately to balance supply and demand, the
economy’s actual output wouldn’t deviate from potential output
 Firms do not constantly adjust their prices to respond to changes in market demand
 Instead, most firms set their prices and sell what is demanded
 Only after a sustained period of imbalance between demand and desired supply do firms
change their prices
 Since firms respond to variations in demand by changing production rather than prices in the
short-run, output in the economy in the short-run is determined by the level of aggregate
demand
 Aggregate demand is the total desired spending on final goods and services by all of the
people in the economy
 Mathematically, like GDP, aggregate demand equals the sum of consumption, investment,
government purchases, and net exports

121
This was discussed in the earlier section on unemployment, toward the beginning of macro.
Economics Power Guide | 88
 Over the long run, firms will adjust prices to move back to the normal level of production


These price changes eliminate the gap between actual and potential output
Since adjustments take time, government policies can eliminate output gaps more quickly
Variations in rate of growth of output
LONG RUN
Changes in growth rate of potential output
Growth rate
of population
Rate of
increase of
capital stock
Changes in
pace of
technological
advances
SHORT RUN
Actual output
relative to
potential
output
 British economist John Maynard Keynes (1883-1946) developed a model to explain short-run
economic fluctuations
 He first established his theory in his 1936 book, The General Theory of Employment,
Interest, and Money
 Keynes believed current microeconomic models were inadequate to account for the events
of the Great Depression
 This is called the Keynesian model
The Keynesian Model
 Similarities to microeconomics
 The intersection of supply and demand in microeconomics gave us an equilibrium price and
quantity
 The intersection of aggregate supply and aggregate demand in the macroeconomic AD/AS
model yields an equilibrium price level and level of real output (GDP)
 Curves and axes
 According to Keynes, short-run fluctuations in the level of activity in an economy can be
summarized with the interaction of two curves
 Aggregate demand (AD) curve
SR
 Short-run aggregate supply (SRAS or AS )
 Additionally, there is a long-run aggregate supply (LRAS) curve that is perfectly inelastic,
drawn at the point where Y = Y* (where output equals potential output)
 The horizontal axis measures real GDP
 The vertical axis measures the aggregate price level
 While the Keynesian model looks very similar to the supply and demand diagrams that analyze
individual markets, the reasons for the shapes of the curves are different
Economics Power Guide | 89
An Economy in Long-Run Equilibrium
LRAS
Price Level
SRAS
AD
Full Employment
Output
Aggregate Demand
Real Level of
Output
 The aggregate demand curve
 Adding these four components yields aggregate demand
 Consumer spending on goods
 Investment spending (usually by firms) on capital equipment and inventories
 Government spending on goods for the state or public welfare
 Net exports, or total value of goods exported minus total value of goods imported
 Summing these four components recalls the expenditure approach for calculating GDP
 Unlike microeconomics, aggregate demand maps the price level, not price, to real output
 We built the microeconomic demand curve from substitution and income effects
 These effects do not directly apply on the economy’s level
 At the level of the economy, a decline in the aggregate price level means the prices of
all goods decreased
 The substitution and income effects will not apply
 To derive the demand curve, we must rely on three different effects
 (1) The first is the wealth effect, analogous to the income effect

As the price level decreases, incomes increase, allowing consumers to buy more goods

Remember that real incomes are adjusted for the price level

If the price level goes down but nominal wages stay constant, the real value of the
nominal wages increase

This increase in purchasing power leads consumers to an increase in the level of
output demanded

This follows from the quantity equations, M x V = P x Y 122

If V and M remain the same, a lower P will leader to a higher Y
 (2) The second is the interest effect

As the price level increases, more money is needed for transactions

As a result, more people try to borrow money

This competition is essentially an increase in the demand for money, so real
interest rates (the “price” of money) increase
122
Oh there’s the vampy equation! – Cat
Economics Power Guide | 90
This increase makes borrowing more expensive, discouraging consumption and
(primarily) investment

Aggregate demand decreases as price level increases

When people have more money than they want, they will save in financial markets

Increased savings cause interest rates to fall and encourages households and
firms to borrow more
 (3) The third is the foreign exchange effect, analogous to the substitution effect

When domestically-produced goods grow cheaper at home, they are also cheaper abroad

The result is more consumption and exports, increasing the level of output demanded
The end result is a downward sloping curve that relates real output to price level


The Aggregate Demand Curve
Price
Level
Real Level of Output
 Shifts of the aggregate demand curve
 The aggregate demand curve can shift due to certain changes in the economy 123
 (1) Changing consumption decisions can shift the AD curve
 This can alter the values for consumption and net exports, respectively
 (2) Firms altering investment levels shift the AD curve
 To increase investment spending, a firm spends more on capital goods, which will shift
aggregate demand to the right

In this situation, investment (one of the components of aggregate demand) rises

Firms increase planned investment spending because they expect to do well in the
future or see future opportunities for which to prepare
 If firms expect rough times ahead, they will decrease planned investment, which shifts
aggregate demand to the left
 During the dot.com boom of the 1990s, many of the companies made substantial
investments, which shifted the AD curve right temporarily
 (3) Consumer sentiment can change
 Consumer sentiment affects consumption spending and shifts the AD curve left or right
 In the wake of the 9/11 attacks, consumer confidence and stock prices dropped

Wealth was reduced and consumers reduced their spending at each price level
 (4) Governments can spend directly or impose taxes
 By increasing or decreasing spending, the government directly changes one of the
elements of aggregate demand, shifting the curve itself
 Many state governments cut spending during the 2008-2009 recession, which shifted
the AD curve left
123
USAD only lists some of these changes, so don’t worry about learning everything you would in AP Macro.
Economics Power Guide | 91
When the government cuts taxes, consumers have more income to spend, which shifts
the AD curve right
 Remember that a shift in the aggregate demand curve represents a change in the level of
output demanded at all price levels
 A change in the price level itself only causes a movement along the aggregate demand curve

Aggregate Supply
 The aggregate supply curves
 Economists use different supply curves for different time frames
 Short-run aggregate supply (SRAS) is the potential supply of all goods in the short-run 124
 The short run aggregate supply curve slopes upwards, like the microeconomic supply curve
 There is a connections between level of output and price level
 As price levels increase, suppliers across the economy increase production
 In the microeconomic model, the supply curve sloped upward because higher prices
attracted firms producing other products
 As the price of Duke’s Dice increases, people who were producing Seto’s Playing Cards
will switch to the Dice
 At the aggregate level, resources cannot be shifted from other activities
 The aggregate supply curve slopes upward to reflect the relationship between price
adjustments and anticipated sales
 Firms fix prices and sell as much as consumers demand
 Only over time do firms adjust prices
 The position of the aggregate supply curve depends on the economy’s long-run potential
output and expectations for the price level
 When an output gap does not exist, the SRAS will pass through the LRAS at a price level
equal to the expectation about aggregate prices at Y*
 Shift in the aggregate supply curves
 Shifts in the short-run aggregate supply curve occur for two reasons
 (1) Changes in the aggregate price level are the most common cause of shifts in the
position of SRAS
 At the expected aggregate price level, SRAS is equal to Y*
 An increase in the expected price level will cause SRAS to shift upward

A decrease in the expected price level will cause SRAS to shift down
125
 (2) Aggregate supply shocks also shift the aggregate supply curve
 Positive weather and climate conditions affect agricultural production

A good harvest means that more agricultural commodities are available at each
price, which shifts SRAS rightward 126
 In 1973, OPEC initiated an oil embargo

The shortage of imported oil caused a reduction in quantities produced in the
United States at every price

SRAS subsequently shifted leftward
When economists (or USAD, for that matter) say “aggregate supply,” they are generally referring to short-run aggregate supply.
The resource guide apparently decided to combine a bunch of shifts under this generic cause.
126
If the climate and weather are permanently beneficial to agricultural production, then LRAS would eventually shift right.
124
125
Economics Power Guide | 92
Short-Run Aggregate Supply
Price Level
Level of Output
 Over time, technological progress can cause the LRAS to shift rightward

This increase in potential output accounts for the long-run growth of real GDP
 Remember that changes in the price level cause a movement along the aggregate supply curve
 Only the factors listed above cause the curve itself to shift
The Keynesian Model and Short-Run Fluctuations
 Intersection point
 The LRAS is drawn where Y = Y*
 The long-run aggregate supply curve is determined by the availability and productivity of
the factors of production
 Supply is independent of the price level and fixed at the full employment level of output
 The long-run aggregate supply curve as a whole is perfectly inelastic, or vertical
 Changes in the aggregate supply curve can only come from real changes in the productivity
of an economy
 The perfect inelasticity of the long run aggregate supply curve is really a statement
about monetary neutrality
An Economy in Long-Run Equilibrium
LRAS
Price Level
SRAS
AD
Full Employment
Output
Real Level of
Output
 The output level of the long-run aggregate supply curve is at the point of full employment
Economics Power Guide | 93


If the LRAS curve passes through the intersection of the SRAS curve and the aggregate
demand curve, the economy is in long-run equilibrium (see graph above)
If the LRAS curve does not pass through this point, the economy is either experiencing
inflation or recession
 A recession occurs when the production level of long-run aggregate supply is greater
than the current level of production

The economy’s production potential is not being realized

According to classical economic theory, prices will fall, consumption and production
will increase, and the economy will move back toward long-run equilibrium

In March 2001, the United States economy went into a recession

Firms, pessimistic about future sales, decreased investment spending

Interest rates were also rising

Declining investment, along with the events of 9/11, decreased aggregate demand

Some businesses will lower prices, causing the aggregate price level to decrease

Falling prices shift SRAS downward
An Economy in Recession
Price Level
SRAS
LRAS
SRAS
New equilibrium
AD2
AD1
Real Level of
Output
Eventually, the economy returns to equilibrium at a lower price level (but the
same potential output)
Recessions can also occur when SRAS decreases

In 1973, OPEC significantly reduced the supply of oil to the United States

SRAS decreased


Economics Power Guide | 94
An Economy in Recession
Price Level
LRAS
SRAS1
SRAS2
AD
Real Level of
Output


Firms found that actual sales were not meeting expectations
Eventually, firms cut prices, causing SRAS to shift down
An Economy in Recession
Price Level
LRAS
SRAS1 / SRAS3
SRAS2
New equilibrium
(that happens to be
the same as the old)
AD
Real Level of
Output
An economy returns to equilibrium at the same price level and potential output 127
Inflation occurs when the production level of long-run aggregate supply is less than the
current level of production

Factors are being over-utilized and the economy is “overheated”

According to classical economic theory, prices will rise, consumption and production
will drop, and the economy will move back toward long-run equilibrium

Suppose excessive government spending (in an attempt to mitigate a recession)
causes the aggregate demand curve to shift too far right

The new equilibrium is now right of potential output


This is because all the SRAS is doing is shifting. Note the direction of the arrows. Graphically, shifting left is the same as shifting
down, and shifting right is the same as shifting up.
127
Economics Power Guide | 95
An Overheated Economy
SRAS
Price Level
AD2
LRAS
AD1
Real Level of
Output




The economy cannot stay in such a state for long
Firms will cut back on production once they see the higher aggregate price level
At a higher price level, sales will not meet the expectations of firms
The economy will return to equilibrium at a higher aggregate price level and
the same potential output 128
An Overheated Economy
SRAS2
Price Level
SRAS1
New
equilibrium
AD2
LRAS
AD1
Real Level of
Output
 Recessions and expansions
 Recessions and expansions occur because of unpredictable shocks to the economy
 These shocks become recessions or expansions due to short-run inflexibility of prices
 If prices everywhere adjusted instantly, then output would never differ from potential
 The short run itself is the period in which the performance of the economy deviates from the
long-run predictions
129
 Recessions and expansions are short run phenomena, lasting from one to three years
I won’t treat how economies overheat and return with regard to shifts of SRAS since it’s a good exercise and just like for a
recession, but backwards. Not that I can’t come up with a scenario or anything…
129
How long is the short run? Economists disagree, but, for our purposes, USAD writes, “You will notice that up until now, we have
been somewhat vague about the period of time that is represented by the “short run.” That is because the definition of the short run is
128
Economics Power Guide | 96
 Inflation in the Keynesian model
 So far, we have assumed the level of inflation is zero
 In the long run, the aggregate price level will rise only if the money supply grows faster than
the economy’s potential output
 This conclusion directly follows from the quantity equation, MV = PY
 In the Keynesian model, increasing the money supply shifts the AD curve right
 If people are accustomed to the price rise, the SRAS will shift upward
 The AD and SRAS curves will intersect at the economy’s potential output
 Full employment equilibrium can exist with any level of inflation
 Unexpected shocks that are not anticipated are the only thing that can cause employment
not to follow equilibrium levels
 In the 1960s, President Johnson financed a military build-up through borrowing
 His actions were unexpected, so inflation increased
 In the long run, no policy will maintain output at a level different from potential output
Influencing the Economy—The Effect of Government
 Fiscal policy
 Fiscal policy allows the government to impact overall economic activity
 Fiscal policy is government spending and taxation used to influence the economy
 Increased government spending results in increased aggregate demand and, thus, higher GDP
 Remember: C + I + G + NX = production = GDP = AD
 C = consumption spending
 I = investment spending
 G = government spending
 NX = net exports = Exports – Imports = X – M
 Expansionary fiscal policy (increased government spending and/or lowered taxes) offsets
recessions and restores full employment
 Contractionary fiscal policy (decreased government spending and/or increased taxes) cools
down expansions and brings employment back down to the natural rate
 The two types of fiscal policy are direct or indirect spending through taxes
 Cutting taxes increases income, which increases spending
 Increased spending, in turn, shifts AD to the right
 Arguments 130 for and against government intervention
 Supporters of intervention argue that deviations of actual output from potential output are costly
 When resources are not fully employed, the economy loses what could have been produced
 Unemployment causes significant hardships
 Whenever resources are overemployed, inflation results
 Detractors have two arguments against government intervention
 (1) It is difficult to identify what the potential output is and what interventions are needed
 It takes time to collect information about the aggregate economy

The first estimates of GDP for a given year take three months to calculate

These estimates are subject to revision
effectively the period of time in which the performance of the economy deviates from the predictions of the long-run model. Judging
from the length of typical economic cycles, this is usually from one to three years.”
130
Normative economic statements ahead! – Cat
Economics Power Guide | 97
Most information about the economy lags,
so policymakers must act on incomplete data
Pros
(2) It may not be practical to carry out fiscal and
monetary policy
 Once policies are enacted, the effects of
actions take time
Deviations
 Businesses will not invest right away, as
from longrun
investments must be planned and funded
equilibrium
 When Congress approves a spending bill, it
are costly
can take six months or a year to implement

Some fiscal policy may not take effect
until the economy is already recovering

As a result, the economy may overshoot
full employment—resulting in inflation
Activist policies might turn out to be counterproductive



Cons
May not be
practical to
carry out
economic
policy
Hard to
identify when
and what
interventions
are needed
Economics Power Guide | 98
COMMUNIST ECONOMIC SYSTEMS
POWER PREVIEW
After the Russian Civil War, the path of Russia’s economy
changed drastically to embody the Marxist-Leninist ideology
of its new leaders. As the Russian Empire became the Soviet
Union, the nation experienced rapid collectivization and
industrialization under the leadership of Joseph Stalin. This
section will focus on the principles and mechanics behind the
socialist system in the context of Russia’s transition into a
new economic system.
POWER NOTES
 According to the USAD outline, 10
questions should come from Section IV.
 10 questions (20%) come from Section IV
on the USAD Economics Practice Test
 This subsection covers pgs. 104-107 of the
USAD Economics Resource Guide
Planned Economy
 Russia’s transition to planned economics
 In a planned economy, the state regulates or “plans” production and price
 Planned economies are also called command economies
 From the late 1920s to 1991, the Soviet Union operated under a planned economy
 The ideology of Marxism-Leninism inspired the use of this system
 Marxism-Leninism encourages public ownership of means of production
 Conversion to a planned economy began after the end of the Russian Civil War in 1920
 The Bolsheviks seized control of Russia after this war
 Vladimir Lenin (1870-1924) led the Bolsheviks during the war
 The Soviet government collectivized agriculture in the late 1920s and 1930s
 Collectivization formed communities in which property is shared

Property was owned by the community, not individuals
 Joseph Stalin (1878-1953) spearheaded collectivization
 Stalin succeeded Lenin as leader of the Bolshevik Party
 The Bolshevik Party became the Communist Party of
the Soviet Union
 Stalin aimed to transform Russia into a socialist economy 131
 In this economy, property and society belonged collectively
to all workers
 Stalin eliminated the class of people who owned
property without contributing labor

This class is referred to as the “capitalists”
 To achieve this goal, the government attempted to
nationalize all private property
 This included all factories and equipment, which were known as “capital”
 Russia’s transition to market-based economics
 Russia now operates under a market-based economy
 Transitioning from a planned to market-based economy took 20 years (1991-2011)
 Most of the transformation occurred in the 1990s
131
According to Marxist theory, socialism is a state that exists between the overthrow of capitalism and establishment of communism.
Both socialism and communism emphasize public ownership of property and means of production. The Soviet Union could be
described as both socialist and communist. http://tinyurl.com/7oj9xgm
Economics Power Guide | 99
Russia no longer operates under communism
 Russia experienced rapid growth from 1999 to 2008
 Growth ended abruptly with the global economic crisis in 2008
 Russia faces significant challenges
 Several problems stall Russia’s development in the global economy

Forms of Property
 The “classical” socialist system
 Three forms of property comprise the “classical” socialist system
132
 These forms are state-owned firms , budgetary institutions, and cooperatives
 State-owned firms
 There were both national firms and regional firms
 National firms fell under the jurisdiction of national-level ministries
 Regional firms fell under the jurisdiction of provincial and local governments
 Subnational governments were controlled by the national government
 Economist Janos Kornai stated that categorizing firms as state-owned was meaningless
 All income from production contributed to state coffers
 Firms could not be bought or sold
 These firms provided employment and housing on a massive scale
 State-owned firms encompassed most heavy industry
 Heavy industry includes auto plants and defense factories
 The Soviet model emphasized economies of scale in every industry
133
 Economies of scale describes the gains a firm achieves from expanding production
 Individual plants commonly employed over 100,000 workers
 The place of employment included all essential social services
 Workers had access to apartments, daycare, schools, and other social services
 This system gave rise to the communist cradle to grave system of social services
 Due to this living and working situation, laborers lacked mobility
 In order to move, workers had to acquire a new job, residence, and housing permit
 A housing permit was called a propiska
 The process of moving took years
 Low worker mobility simplified the process of devising production plans
 Government planners needed to keep track of labor at every individual firm
 Privatization of state-owned firms started in 1992
 Budgetary institutions
 Budgetary institutions included universities, research and educational institutions, training
centers, trade schools, hospitals, and museums
 National or regional government budgets funded budgetary institutions
 Budgetary institutions had no obligation to make income cover expenditures
 Cooperatives
 Cooperatives operate similarly to state-owned firms but were mostly located in agriculture
 The cooperative, or collective farm, was called a kolkhoz
 Like state-owned firms, cooperative farms operated on a massive scale
 Farms included social services such as housing
132
133
For simplicity’s sake, all “enterprises”, “companies”, “corporations”, and “businesses” will be referred to as “firms” in this guide.
For example, economies of scale can be achieved by increasing production to take the most advantage of fixed overhead costs.
Economics Power Guide | 100
 In the 1930s, Stalin collectivized agriculture by stripping all citizens of property
The state assumed ownership of all output
 The government had several motives for collectivizing agriculture
 First, collective farms intended to provide a steady supply of grain for cities
134
 The state believed larger farms would produce more efficiently than smaller farms
 Politically, bureaucratic control of farmers prevented them from fighting back
 Farmers could not become a social, political, or economic force
 They fit seamlessly into the body of the Soviet system
 They could not leave the farm or outsource labor
 Essentially, farmers always remained members of the “collective”
 Summary of socialism
 Socialism replaces private ownership with public ownership
 The state owns all property
 Capitalists could no longer exploit workers

All members of society collectively worked and owned property
 Public ownership of production transferred the responsibility of allocating resources from
market mechanisms to bureaucratic economic planning

State
Committee/Ministry
of Planning (Gosplan)
writes plans
Central Committee of
the Communist Party
approves plans
Council of Ministers
and its respective
ministries execute
plans
The Planning System
 The role of bureaucracy
 The bureaucracy planned all economic activity in a top-down fashion
 Plans originated in the bureaucracy and traveled down through all levels of the economy
 Fulfilling plans was compulsory for all members of the economy
 The planned economy sought to eliminate the anarchy of the market
 The state would organize the economy on a national scale
135
 The bureaucracy, not the market forces , controlled the vitality of a firm
 Bureaucratic planning sought to distribute goods more equitably
 This goal followed the ideals of Marxism
 Five-year plans dictated the Soviet economy
 Each five year plan was split into annual plans
 Five-year plans functioned as statements of policy intent rather than specific plans
 The first plan began in 1928
 The last plan deteriorated in the late 1980s
 Planning involved determining inputs and estimating outputs for each individual factory
136
 This task was enormous, especially since the Soviet Union spanned 13
time zones
134
Everything’s bigger in Soviet Russia! – Cat
In a market economy, firms succeed or fail depending on their ability to remain profitable. In a planned economy, firms are only
expected to follow a specific plan. The government decides if or when to terminate each firm.
136
Unlucky number for an unlucky state. – Cat
135
Economics Power Guide | 101
Number of cars to
produce
Steel required for
cars
Iron required for
steel
Machines
required to mine
iron ore
Labor required to
work machines
Flawed estimations often resulted in shortages
 A lack of inputs caused a lack of outputs
 Plans determined each firm’s level of technical development, capital investment, and trade
 A system of bureaucracy-controlled price lists designated prices of all goods
 Gosplan manually calculated every aspect of the entire Soviet economy
 For most of this period, planners lacked access to computers
 The role of managers 137 and labor
 Plans required coordination of the Communist Party, state
Gosplan
ministries, and individual firms
 Gosplan used the following strategies to break these
Individual ministries
systems down into manageable parts
138
 Planners disaggregated
the plan in a downward
Directorates/sectors
flow of information
 Higher levels sent directions to lower levels
 State plans did not recommend or suggest actions
Individual firms
 The term “command” economy derives from this
process
 Planners received an upward flow of information
 While drafting a plan, planners received information from lower levels

Lower levels contributed nonbinding recommendations about target output levels
 The bureaucracy chose managers at every level of the economy
 Each manager held a specific and mandatory role in each plan
 Plans specified the amount of labor allocated to each sector and factory
 Incentives and attitudes
 Plans required firms to produce exactly the amount stated in the plan
 As a result, managers lacked motivation to innovate
 Managers were not rewarded for producing a surplus
 But the state punished managers for failing to meet plan targets
 Managers could be removed from office, sent to a labor camp, or accused of sabotage

An accusation of sabotage could lead to a death sentence
 The Soviet economy operated under central planning and central management
 Managers found motivation in an ideological sense of duty to the Communist Party
 Managers received bonuses for good work
 Bonuses included awards and privileges
 But the penalties of taking risks outweighed the potential rewards
 Without ownership, managers lacked incentive to exceed the bare minimum
 Kornai states that, among managers, “servility and a heads down mentality prevailed”
 Political and moral convictions toward socialism motivated the bureaucracy
 In addition, political power and prestige provided sources of motivation
 For some, material benefit and fear were motivators

137
138
For simplicity’s sake, “directors” will be referred to as “managers” in this guide.
Disaggregating a plan involves breaking it into smaller parts.
Economics Power Guide | 102
 Economic distortions
 A chronic “shortage” economy emerged in almost every sector
 The planning system misestimated the supply and demand for goods
 In a free market economy, changes in price eliminate excess demand and supply
 This shortage condition affected consumer goods
 Managers had built-in incentives to underreport production
 This ensured that plan targets for the next year would not exceed the firm’s capabilities
 A firm that could produce 150% of the target plan might produce only 101%
 This signaled improvement but not enough to cause expectations of it to increase
 Managers hid extra output and sold it on the black market
 Outputs differed in proportion to inputs
 Target plans only specified that firms meet a goal, not fully utilize the allocated inputs
 As a result, excess inputs existed in some sectors while shortage existed in others
 This caused poor allocation of resources and waste
 Socialism overemphasized rapid growth
 Quantity of production took precedence over quality
 Inferior quality of goods still impedes Russia’s ability to compete in world markets
 The state prioritized industrial production over consumer production
 A black market emerged in response to the chronic “shortage” state
 A black market is called a shadow economy
 It consists of economic activity that lacks official state approval
 In the socialist system, private property and private means of production do not exist
 Black market participants circumvented price lists and other restrictions of the system
 Some analysts believed the black market kept the system alive
 The black market remedied some of the failures of the planning system
 It also fueled corruption at every level of the economy
 Russia still feels the effects of the black market today
Economics Power Guide | 103
REFORM UNDER MIKHAIL GORBACHEV
POWER PREVIEW
Mikhail Gorbachev rose to power in 1985 as the General
Secretary of the Communist Party of the Soviet Union. This
section will cover Gorbachev’s successes and failures in
reform. In many ways, he provided an impetus for change by
encouraging open communication and re-introducing private
property rights. However, his inability to improve the Soviet
Union’s troubled economy ultimately resulted in the system’s
collapse in 1991.
POWER NOTES
 According to the USAD outline, 10
questions should come from Section IV.
 10 questions (20%) come from Section IV
on the USAD Economics Practice Test
 This subsection covers pgs. 107-111 of the
USAD Economics Resource Guide
Mikhail Gorbachev’s Rise To Power
 Mikhail Gorbachev
 Mikhail Gorbachev (b. 1931) became the General
Secretary of the Communist Party in March 1985
139
 A coup was attempted against him coup in 1991
 The Soviet Union collapsed later that year
 Problems facing Gorbachev upon entering office
 Soviet Russia’s stagnating economy was the greatest
challenge
 Its planning system lacked flexibility
 The complexity of calculating economic needs
exceeded the capabilities of state planners
 Tim Colton believed planners could not
anticipate the need for computerization
 As the economy’s size and complexity increased, so did planning failures
 Values and motivation suffered under the overbearing state
 Reform and reconstruction
 Gorbachev immediately recognized a need for an overhaul of the economy
 This goal was referred to as perestroika, literally translating to “reconstruction”
 He did not intend to establish a market-based liberal system
 He sought to reform the existing communist system
 Criticism
 Many critics argued that Gorbachev ignored the Soviet economy
 They compared his actions to Chinese leader Deng Xiaoping’s actions in the 1980s
 They accused him of “sequencing” reform
 This practice involves favoring “easier” political reforms
 In contrast, Gorbachev began his reforms with the economic challenge
 Gorbachev’s economic policies between 1985 and 1991 followed four phases 140
139
In August 1991, parts of the Soviet government and military trapped Mikhail Gorbachev in his house and demanded he resign.
Boris Yeltsin and thousands of Russians demanded he be restored to office. The coup failed. Gorbachev returned, but the coup
damaged his reputation and his authority over the Soviet Union soon dissolved. He resigned in December 1991.
140
Gorbachev doesn’t actually execute policies in all of the phases, but it may be helpful to learn his term in four parts.
Economics Power Guide | 104
Phase 1: 1985-86: Recovering Worker Productivity and Infrastructure
 Anti-alcohol campaign
 First, Gorbachev tackled worker absenteeism and low labor productivity
 He initiated an anti-alcohol campaign to reduce chronic alcoholism among workers
 The campaign closed down some alcohol factories
 Some Russians resorted to producing bootleg liquor

This created the unintended sugar shortage

The consumption of bootleg liquor also meant that productivity remained low
 Uskorenie
 Gorbachev attempted to invest in old infrastructure
 He launched a project called uskorenie, literally meaning “acceleration”
 Uskorenie referred to the acceleration of investment in old plants and factories
 The Soviet Union lagged behind the West’s technological progress
 Poor infrastructure impeded labor productivity
 Failure of both reforms
 Both initiatives failed socially and economically
 The anti-alcohol campaign worked against the investment project
 Closed alcohol factories reduced state revenue
 Decreased revenue hindered increases in investment
 Neither initiative improved worker discipline, economic productivity, or infrastructure
 Workers still consumed bootleg liquor
 The budget deficit increased 141
Phase II: 1987-88: Glasnost and Demokratizatsiia
 Glasnost
 Glasnost142 refers to a policy that allowed greater public discussion
 Gorbachev initiated it at the Central Committee of the Communist Party plenum in
1987
 A plenum is a planning meeting
 Glasnost allowed citizens to openly discuss the merits of the communist and market systems
 The Soviet Union had never allowed this level of free speech
 Glasnost enabled the Soviet media and politicians to discuss issues freely
143
 Politicians of this time comprised a new super parliament
in 1989
 More importantly, glasnost jumpstarted discussion on private property
 The subject had always remained taboo
 Demokratizatsiia
 Demokratizatsiia introduced limited accountability into Soviet politics
 The term demokratizatsiia translates to “democratization”
 It enabled greater participation of interest groups in the political process
 Introduction of private property rights
 “Cooperative” enterprises represented the introduction of quasi-property rights
 These firms operated in the commercial and service sectors
141
Mikhail Gorbachev gets a gold star for trying. And by gold star I mean an attempted coup by his own Politburo. – Cat
I remember glasnost because it kind of has “glass” in it, which is transparent like discussion was intended to be. Also, you make
windows out of glass, and you can “open” windows. Whatever works! – Cat
143
Mikhail Gorbachev’s democratization reforms allowed non-Communist candidates to compete against Communist Party
candidates in the March 1989 election for positions in the new Parliament Congress of Peoples’ Deputies.
142
Economics Power Guide | 105
“Cooperative” enterprises lacked clear governance or ownership structure
 They offered business initiative among a small group of entrepreneurs
 Gorbachev granted managers more autonomy on what to produce
 Managers still had limited opportunities to explore new markets
 Gorbachev maintained the collective farming system
 He refused to reinstate private farming
 Intermittent food shortages persisted
 Miscommunications caused by privatization
 Loosening the planning system caused errors 144 in information between planners and managers
 Sometimes, managers privatized their firms while planners remained unaware
 Some exploited loose oversight by hording inputs and excess outputs
 Managers then sold them on the black market
 These managers acquired the means required to participate in privatization later on
 Laws failed to define cooperatives as private or public
 The relationship of cooperatives to the overall economy was also unclear
 These partial reforms worsened the overall economic situation
 No sweeping economic reform
 Gorbachev tended to compromise with conservative members of his Politburo
 The Politburo consisted of a cabinet of elite communist party officials
 Compromising stalled implementing far-reaching economic reforms
 He missed the chance to initiate reforms before the onset of stagflation
 Stagflation describes inflation with zero or negative economic growth

This presents the worst possible situation for an economy

Normally high growth accompanies inflation

This concern still plagues China’s economy
 Gorbachev may have lacked the means to initiate widespread economic reform
 He may have lacked enough control within the Communist Party
 He also may have lacked desire for change
 He believed in the communist system, not liberal capitalism

Phase III: 1989: Stagflation and the Fall of Communism in Eastern Europe
 Collapse of communism in Eastern Europe
 Gorbachev’s reforms met a receptive audience in Eastern Europe
 The Berlin Wall 145 fell in November 1989
 Several satellite communist governments 146 in Eastern Europe followed suit
 The collapse destroyed guaranteed markets for inferior Soviet goods
 This loss further damaged the Soviet economy
 Gorbachev’s indecision
 Gorbachev attempted to please both radical reformers and conservatives
 As a result, his inconsistent policies deepened the economic crisis
 Reform efforts created larger budget deficits
 Sustained subsidies to industry drained the state’s funds
 Inflation plagued the economy even as growth declined
144
Because the system of imperfect information wasn’t bad enough already! – Marin Young
The Soviet Union built the Berlin Wall in 1961 to separate Soviet-controlled East Berlin from democratic West Berlin.
146
Satellite states refer to countries heavily influenced by another country. Soviet Russia’s satellite states included Poland, Bulgaria,
Czechoslovakia, Romania, Hungary, and East Germany. Discuss: what are American satellite states?
145
Economics Power Guide | 106
The economy experienced stagflation
 Too much currency was circulating
 High wages also caused inflation
The state lacked a mechanism to collect taxes
Restrictions on the development of cooperative movements prevailed
The practice of barter grew
 Barter involves trade without currency
Agriculture experienced limited reform
The Soviet Union faced widespread food shortages
 This problem had not plagued Russia since World War II
The economy experienced negative growth rates
 Production fell by about 10% per year until 1991
The Soviet Union collapsed in 1991








Phase IV: 1990-91: Boris Yeltsin and Reform Alternatives
 The Five Hundred Day Plan
 In the summer of 1990 147, a group of young Russian economists devised a plan
 They dubbed it the Five Hundred Day Plan
 Gorbachev adviser and economist Stanislav Shatalin led the project
 Economist Grigori Yavlinsky also helped produce the plan
 They sought to imitate a recently successful example of economic “shock therapy”
 They borrowed this idea from Poland
 The plan sought to transform the Soviet Union into a market system
 The Five Hundred Day Plan entailed several immediate reforms
 Elimination of price controls
148
 Establishment of the convertibility
of the ruble 149
 Privatization of property
 Stabilization of the economy
 Liberalization of trade
 The group of economists presented the Five Hundred Day Plan to Mikhail Gorbachev
 Gorbachev considered the plan
 He rejected the proposal by the fall of 1990
 He favored a slower and more conservative approach to change

He wanted to retain price controls for another two to three years
 Gorbachev appointed a likeminded conservative prime minister
 Elections across the Soviet Union
 The Soviet Union began to lose legitimacy as an economic and political union
 Its 15 constituent republics, including Russia, started electing new leaders
 Gorbachev authorized these elections
 Boris Yeltsin
 Boris N. Yeltsin (1931-2007) became Russia’s first popularly elected president in June 1991
 This fact gave him greater political legitimacy than Mikhail Gorbachev
 Gorbachev remained the unelected President of the Soviet Union
147
The Five Hundred Days Plan reminds me of 500 Days of Summer. It was written in the summer of 1990 too! – Cat
Convertibility describes the ability of a currency to be exchanged for another currency (or gold).
149
The ruble is the currency used in Russia. Several other countries in Eastern Europe influenced by the Soviet Union also used
currencies called the ruble, though they were all different. http://tinyurl.com/8hkvs7q
148
Economics Power Guide | 107
He also remained the unelected General Secretary of the Communist Party
 Yeltsin held various positions before becoming president
 Member of the Politburo
 Provincial Communist Party boss
 Elected speaker of a new Russian parliament in 1990
 Yeltsin disagreed with Gorbachev’s lagging rate of reform
 He initiated much more rapid reform, leaving
Gorbachev behind
 Gorbachev’s last days
 Boris Yeltsin gained popularity and power to rival
Gorbachev’s position
 This challenge pressured Gorbachev to pursue radical
market solutions—but it was too late
 Gorbachev’s Politburo attempted a coup in August 1991
 This betrayal effectively removed Gorbachev from office
 By December 1991, the Soviet Union completely collapsed
 The union dissolved into 15 new and separate countries
 Russia was the largest of these new countries
 It adopted the title of the Russian Federation
 Boris Yeltsin remained president
 Gorbachev’s legacy
 Gorbachev’s half-measures and indecisive reforms deepened the Soviet Union’s economic crisis
 By the end of 1990, political motives diverted reform efforts from economic needs
 By the end of 1991, shortage and inflation persisted
 The inflation rate loomed at over 100%

The Economy Before the Collapse
 Pre-existing problems
 Although Gorbachev may have fallen short, the Soviet Union’s system deteriorated on its own
 Production levels declined throughout the late 1970s
 They hit a free fall in the late 1980s under Gorbachev
 The growing state sector presented problems for future policymakers
 The state controlled almost every economic activity
 By 1991, most people were on the state payroll
 Although the economy appeared fully employed, many people did nothing

“We pretend to work and you pretend to pay us” became a popular saying 150
 Post-Soviet policymakers feared increasing unemployment
 Minimal pensions and wages necessitated that people work after retirement
 Chronic shortages caused by sub-optimal planning was an enduring problem
 Industrial production far outstripped consumer production
 This imbalance contributed to the low standard of living
 Economic growth under the planning system carried high costs
 The system created inefficiency
 Because of the system’s emphasis on economies of scale, monopolies dominated the economy
 Massive firms operated efficiently as monopolies
150
“I’m hungry” was another popular saying. - Cat
Economics Power Guide | 108
 The Soviet economic system discouraged technological innovation
Meanwhile, the West developed computer hardware and telecommunications
 Even with a strong post-secondary education system, Soviet Russia fell far behind
 The lack of incentive to improve production yielded poor-quality goods
 Soviet Russia’s manufacturing sector could not compete globally
 Instead, the Soviet economy relied on natural resource exports, especially oil and gas
 But global oil and gas prices were falling
 The Soviet economy could no longer protect itself from world competition

Before 1989 151, the Soviet Union rarely traded with non-communist countries
152
 These conditions exposed the Soviet Union to the “resource curse”
 Flaws of the Soviet system
 Money had no real value since prices did not reflect supply and demand
 Price lists determined prices for everything sold in the Soviet Union
 Additionally, the ruble could not be converted in international markets
 About 3,000 different exchange rates existed for almost every item in foreign trade
 The state controlled conversion rates
 Two types of rubles with different values existed in the economy
 Enterprise accounts used one type
 Consumers used the other
 The Soviet economy lacked important financial institutions and markets
 These missing essentials included a private banking system, a real estate market, a stock
market, and private companies
 Negative growth rates
 Exacerbated by Gorbachev’s reforms, these conditions 153 stunted growth
 By the collapse of the Soviet Union on December 25, 1991 154, growth rates hit -17%
 Growth rates had declined from +3% in 1989

Legacy of the Communist System
 Successes of the Communist system
 The system industrialized a predominantly agricultural economy in 70 years
 This process took Western European countries centuries
 The system produced a population with a 99% literacy rate 155
 The Soviet Union became a superpower that rivaled America in land, air, sea, and space
 Failures of the Communist system
 Millions of people died in the industrialization and collectivization process
 The peoples’ demands outpaced the system’s capabilities
 Lack of incentives to innovate caused the economy to fall behind global economic progress
151
Remember, this is when the Berlin Wall and the communist governments of Eastern Europe fell. The Soviet Union pretty much
lost all its guaranteed markets that year. They lost their training wheels but didn’t know how to ride the bike! – Cat
152
The resource curse doesn’t become a huge problem for Russia until the early 2000s. I’ll elaborate more then.
153
A beta tester would also like to add that the dismal state of the economy of the USSR wasn’t solely due to their policies; they were
also busy building weapons, lending aid to other possible Communist countries, and researching science that could be used in
warfare, during this period, known as the Cold War. http://tinyurl.com/8uzg3
154
Merry Christmas, Russia! – Jared
155
Now if only we could manage that in our Decathlon team. – Jared
Economics Power Guide | 109
REFORM UNDER BORIS YELTSIN
POWER PREVIEW
The fifteen newly independent states of the former Soviet
Union diverged in their methods of economic reform. This
section will focus on Russia’s reform process as implemented
by president Boris Yeltsin. Between the fall of the Soviet
Union in 1991 and the end of Yeltsin’s presidency in 2000,
Russia made great strides in breaking down the planning
system and opening the door to privatization.
POWER NOTES
 According to the USAD outline, 10
questions should come from Section IV.
 10 questions (20%) come from Section IV
on the USAD Economics Practice Test
 This subsection covers pgs. 111-117 of the
USAD Economics Resource Guide
Shock Therapy in Theory
 The return of shock therapy
 In the fall of 1991, Boris Yeltsin surveyed reform options proposed by groups of economists
 He settled on the plan put forth by a group of young economists led by Yegor Gaidar
 Yeltsin appointed Gaidar prime minister
 Gaidar advocated rapid transition to a market economy through “shock therapy”
 The approach demanded three immediate and simultaneous reforms 156
Stabilization
End of subsidies to
unprofitable industries
Control of budget
deficit
Liberalization
Elimination of price controls
Exposure of domestic markets to
competition (both foreign and
domestic)
Establishment of convertibility of
the ruble
Privatization
Separation of ownership and
management
Introduction of new profitmotivated practices
 These three key policies 157158 inflicted a short-term “shock” on the population
Prices increased suddenly
Inflation quickly reached high levels
 Unemployment rose as the state allowed unprofitable industries to fail
 Market mechanisms would eventually kick in
 Gaidar expected the economy to grow within three years
 The economy would stabilize well before Yeltsin was up for re-election


Shock Therapy in Practice
 Elimination of price controls
 Shock therapy began with the sudden freeing of prices on January 2, 1992
 Average prices increased by 245% overnight
 Production dropped as expected
 With relaxed import controls, foreign goods filled the market
156
The main tenets closely match the Five Hundred Day Plan, but there are extra details to remember.
Stabilization. Liberalization. Privatization. “Slap?” “Single Ladies Party?” Find a way to remember this! – Cat
158
How about SLIP (Stabilization LIberalization Privatization)? – Adeolu
157
Economics Power Guide | 110
Larger cities imported the most foreign goods
 Freed price controls and relaxed import controls solved the chronic shortage state
 But prices mostly surpassed the average Russian’s budget
 Gaidar assured Yeltsin that market mechanisms would push prices down
 He believed Russian manufacturers would try to match the quality of foreign goods

He also believed they would offer lower prices to Russian consumers
 Backlash
 By April 1992, industrial enterprise managers opposed shock therapy
 They were referred to as “red managers”
 They opposed the end of subsidies to their firms
 Some refused to restructure to accommodate market mechanisms
 Others lacked the means to restructure even if they wanted to
 Debt accumulated as managers traded for industrial inputs without money

In the early 1990s, barter economies existed in both agriculture and industry
 The end of shock therapy
 To assuage opposition, the state issued Central Bank credits to firms in the spring of 1992
 They also increased printing of the ruble
 This compromise caused spikes in the budget deficit and inflation
 These effects especially hurt consumers
 This violation of fiscal austerity and deficit control signaled the end of shock therapy 159
 All other areas of the reform plan receded as well
 Russia opted for more gradual reforms after 1992
 This path necessitated abandoning several aspects of liberal market reform

Privatization in Theory
 Main goals of privatization
 The Russian government pursued three 160 main goals in privatization
 First, creation of socioeconomic stratification, particularly a middle class
 Private property rights and ownership would allow classes to form
 Economically, middle classes provide a reliable source of taxation
161
 Politically, they represent varied interests that support political pluralism

Political pluralism contributes to the creation of a democracy
 Second, creation of a market economy
 Yeltsin’s main political legacy is destroying the communist economic system
 The introduction of private property prevented an easy return to the old system
 Economist Anders Aslund believes two thirds of an efficient market economy must be
private

No more than one third of national employment can exist in the public sector
 Third, separation of ownership from management
 In the planned economy, managers did not legally own their firms

They only controlled them because of their access to information about the firm

This system of ministerial control declined under Gorbachev in the late 1980s
159
In essence, firms could not survive the initial shock. The lack of anticipation for this problem spelled the end of shock therapy.
Gaidar was a little too ambitious and optimistic, in my opinion, but it was a start. – Cat
160
USAD doesn’t list a fourth goal.
161
Political pluralism is the view that power should be spread among a variety of groups representing different interests as opposed to
concentrating power among one group of elites.
Economics Power Guide | 111
Newly empowered managers lacked oversight from a board of directors

They pocketed extra money from selling excess products on the black market
Yeltsin hoped to introduce managerial accountability to a board of directors
 This principle was referred to as corporatization
 He intended to incentivize managers with the principles of supply and demand
 Directors would assess managers on profit and loss, instead of political criteria

Competitive managers would replace poor-quality, command-era managers


Privatization in Practice
 Classification of privatization
 Gaidar and Yeltsin passed the privatization legislation in June 1992
 They initiated the program a month later, in July 1992
 The program attempted to satisfy conflicting ownership claims between managers, local
governments, and workers
 It created the State Committee on Property to oversee the process
162
 This committee was also called the Goskomimushchestvo
 They classified firms eligible for privatization as small, medium, or large

Small firms employed less than 200 employees

Medium firms employed 200-1,000 employees

Large firms employed over 1,000 employees
 The committee divided firms into federal, provincial, and municipal property
 They forced specific firms to privatize

Wholesale trade

Retail trade

Food services

Construction

Consumer services
 Privatization options
 Firms could choose between three different paths of privatization
 These options differed in the percentage of shares owned by insiders
 Insiders include managers and workers of the firm
 The firm auctioned off their remaining shares or traded them for vouchers
 All three options granted insiders favored access to shares
 They allowed for over 25% insider ownership
 Gaidar made this sacrifice to incentivize managers to participate in privatization

This decision was political, not economic
 Critics called this a “giveaway”

They believed this concession prevented separation of ownership and management
 First stage of privatization: voucher program
 As previously stated, firms had the option of auctioning off shares
 Share auctions began in December 1992
 Thousands of auctions occurred every month between December 1993 and June 1994
 Firms traded shares for vouchers through the voucher program
 The voucher program began in August 1992
 This phase of privatization was brief
162
In other words, the really long one. – Cat
Economics Power Guide | 112
Vouchers had to be claimed by the end of January 1993 and invested by July 1, 1994
 The state distributed privatization vouchers to every man, woman, and child 163
 The effort hoped to involve public sector workers in the process of privatization
 Doctors and teachers did not privatize their firms but could still participate
 Citizens could trade their vouchers for shares of privatizing firms
 This feature aimed to create a vibrant stock market
 Initially, each voucher held a value of 10,000 rubles in shares
 When the first privatization legislation passed in June 1992, vouchers were worth $84
 Russians received an average of $50 a month in wage

Vouchers held considerable value
 Russians could use their vouchers in various ways
 Buy shares of the firm they worked for (as long as it underwent privatization)
 Buy shares of other privatizing firms
 Buy shares through mutual funds
 This diversified their portfolio and spread risk across different firms
 Buy shares in a voucher fund
 Sell them
164
 Give them away
 Firms resisted the voucher program because they did not receive money from it
 In May 1993, Yeltsin stated that firms must sell 29% of all shares for vouchers
 This proved moderately successful as the average came closer to 20%
 Citizens invested most vouchers by 1994
 The first stage of privatization finished that year
 Second stage of privatization: auctions of state holdings
 In July 1994, Yeltsin initiated the second stage of privatization
 This stage involved auctioning off remaining state holdings for cash
 Firms received part of the proceeds as capital for restructuring
 The government received the rest of the proceeds
 The government aimed to finance its budget deficit without increasing inflation
 They anticipated billions of dollars of revenues
 The government also intended to create larger blocks of shares for foreign investors
 Foreign investors could then increase their role in corporate governance
 During the second stage of privatization, the benefits to insiders decreased
 The second stage of privatization failed in many ways
165
 Vladimir Polevanov, the more conservative Minister of Privatization, froze privatization
 Nationalists and communists in parliament influenced this decision
 Polevanov advocated the re-nationalization of many firms
 This prospect scared off foreign investors
 “Loans for shares” scheme 166
 The failure of the second stage of privatization made the government desperate for revenue
 In 1995, the Russian government settled on the “loans for shares” scheme
167
 They auctioned off 12 blue-chip
companies to a group of commercial banks

163
No matter what I tell him, little Boris only seems to want to invest in candy! – Cat
This is an example of leakage, the failure to make a rational decision. – Marin
165
Makes you wonder why he chose to be the Minister of Privatization… - Cat
166
This can be thought of as the third stage of privatization, though USAD doesn’t explicitly say so. – Cat
167
A blue-chip company refers is a nationally known, well-established company with reliable earnings and dividends.
164
Economics Power Guide | 113
All interested bidders, foreign and domestic, could participate
 The bank offering the largest loan to the government won a block of shares
 Banks could not sell the shares until September 1, 1996
 They could only keep a third of the capital gains after they sold the shares
 The government made 1 billion dollars
 Corruption in the “loans for shares” scheme
 On the surface, bidders appeared to support the
government
 However, banks mainly wanted to control Russia’s
largest companies
 Ultimately, the Russian government could not repay the
loans
 The banks assumed ownership of the companies
 The “loans for shares” scheme spawned a backlash
 Few banks had the strength to participate
 Participating banks organized auctions themselves
 This system presented a conflict of interest
between auction participants
 By the end of the process, banks openly quarreled
 The process tainted the reputation of privatization
 It transferred a large portion of the economy to a
small group of wealthy business people
168
 This group became known as “the oligarchs”
 Other corruption
 Organized crime groups often purchased shares from failing firms at little cost
 This practice stripped the firm of value
 Purchasing shares this way did nothing for capital stock or the economy in general
 The effects of the privatization program
 By 1996, 75% of large and mid-sized firms successfully underwent privatization
 Almost 90% of industrial output also privatized
 Conservatives called privatization a “crime against the nation”
 Privatization succeeded in redistributing assets
 They did not reach the middle class as originally intended
 The efforts did not provoke major social revolt
 However, many people took issue with the speed of its implementation
 Privatization also occurred at the same time as other pervasive negative changes 169
 As a result, the public linked privatization and negative changes

Causes of the 1998 Economic Crisis
 Non-inflationary measures
 By 1996, inflation and the ruble exchange rate stabilized
 The years 1996 and 1997 were characterized by stabilization and low inflation
 The ruble reached a semi-convertible state
 Russia achieved stabilization by stopping the Central Bank from printing money
168
169
“The powerful few” – Marin
The resource doesn’t specify the negative changes, but I believe it is alluding to rising prices and unemployment. – Cat
Economics Power Guide | 114
Reducing the money supply decreased inflation
 The government borrowed money to handle the growing deficit
 They issued short-term treasury bills and some longer-term treasury bills
170
 They received loans from the International Monetary Fund
 Federal revenues decreased and the state reduced spending
 Federal and regional governments failed to collect taxes
 This setback benefited large oil and electrical firms

They provided energy to firms who could not afford it

In return, the state allowed them to export without paying taxes and tariffs

Over time, these firms accrued tax debts to the government
 The state also withheld wages from state-sector employees

In 1996 and 1997, the state fell behind on payment of wages and pensions
 Russians worked for no pay
 Growing debt
 By late spring and summer of 1998, the state started borrowing foreign currency
 These loans financed their troubling domestic short-term debt
 In the first eight months of 1998, Russia’s foreign debt increased by 18.5 million dollars
 This reduced the foreign currency reserves required to support the ruble
 On July 20, 1998, the International Monetary Fund offered Russia aid
 The package they offered aimed to finance wages and domestic short-term debt
 Instead, Russia used the package to attempt to save the ruble and failed

Effects of the 1998 Financial Crisis
 Effects
 The financial crisis occurred on August 17, 1998
 On this day, Russia devalued the ruble
 It defaulted on its domestic and international debts
 The crisis eliminated all savings in Russia
 Devaluation of the ruble made imported goods too expensive
 Russians returned to purchasing domestic products
171
 This increase in consumption boosted the recovery of domestic industry
 By 1999, Russia’s economy started to grow for the first time since the collapse of the Soviet
Union
 The recovery of domestic manufacturing played a part
 Increases in prices for raw material exports also contributed greatly
 Growth continued until the global financial crisis in 2008
170
171
The International Monetary Fund is an organization of 188 countries that encourages cooperation, stability, and trade.
Every cloud has a silver lining. Think about Russia’s domestic industry next time you’re having a bad day. - Cat
Economics Power Guide | 115
VLADIMIR PUTIN & DMITRI MEDVEDEV
POWER PREVIEW POWER NOTES
During Vladimir Putin’s presidency from 2000 to 2008,
Russia’s economy experienced extraordinary growth with the
rise of global commodity prices. However, the effects of the
resource curse spelled the doom of Russia’s economy in
2008. This section will cover the conditions leading to the
2008 financial crisis and Dmitri Medvedev’s efforts to
improve Russia’s struggling economy.
 According to the USAD outline, 10
questions should come from Section IV.
 10 questions (20%) come from Section IV
on the USAD Economics Practice Test
 This subsection covers pgs. 117-121 of the
USAD Economics Resource Guide
Economic Growth from 2000 to 2008
 President Vladimir Putin
 Vladimir Putin assumed the presidency in 2000
 In his first term (2000-2004), he enacted a series of reforms drafted by Yeltsin
 Flat income tax of 13%
 New legal code
 Systems to prevent money laundering
172
 Regime for liberalizing currency
 Reduction of taxes on profits from 35% to 24%
 New land code allowing Russians to own commercial and residential land
 GDP reached an all-time high of 8.5% in 2000 and sustained high levels growth
Year
# Growth GDP
Year
# Growth GDP
2000
8.5%
2004
7%
2001
6%
2005
7%
2002
6%
2006
7%
2003
7%
2007
9%
 Economic growth
 Between 1999 and the summer of 2008, Russia’s economy grew rapidly
 The result: budget surpluses, no foreign debt, and sizeable hard-currency reserves
 Inflation remained modest
 GDP growth reached an all-time high in 2000
 Rising oil prices
 Russia’s growth coincided with a rise in prices for Urals crude oil
 This crude oil blend was Russia’s chief export
 The value of a barrel increased from $12 USD in 1998 to $70 in 2007
 This rise in prices increased government and personal income
 Higher incomes increased demand for manufactured goods and commercial services
 Professor Philip Hanson states that, “It is by their indirect effects … that oil and gas
price rises fuelled Russian growth.”
172
This involved removing requirements for special bank accounts and making the ruble fully convertible to other currencies.
Economics Power Guide | 116
Resource Curse
 Russia and the resource curse
 The resource curse describes negative effects associated with abundant natural resources
 Some economies experience increasing debt, nationalization of resources, government
corruption, and negative growth
 Russia experienced many negative consequences due to its supply of natural gas and oil
 Dutch disease
 Russia’s heavy volume of mineral exports invoked a sharp inflow of foreign currency
 This influx created a high exchange rate
 As a result, domestic manufactured goods became too expensive
 Russians purchased imported goods instead
173
 This phenomenon is called Dutch disease
Discover natural
resources
Export natural
resources
Increase
quantity of
foreign currency
Increase value
of domestic
currency
Domestic goods
become too
expensive
Consumers
demand fewer
domestic goods
Imported goods
replace
domestic goods
Domestic
manufacturing
worsens
 Decay of other industries
 Russia was excessively dependent on oil exports
 While Russia grew with the record growth of oil prices, Putin loosened fiscal policy
 He began permitting oil companies to take on debt
 Imports increased with the onset of Dutch disease
 In 2003, the state established a Stabilization Fund to store resource extraction tax revenues
 This store of money was intended to serve as an emergency fund if oil prices fell
 The state could use the money to fight inflation or defend the ruble
 In 2008, the government divided the Stabilization Fund into two separate parts
 The new parts consisted of the Reserve Fund and the National Prosperity Fund
 The government did not use the money to improve the poor manufacturing sector
 Russia’s manufacturing received little attention even after the collapse
 The economy lacked alternative industries when oil prices plummeted in 2008
 The state did not invest in improving oil extraction technology and infrastructure
 This problem greatly hindered Russia’s ability to recover from the 2008 financial crisis
 When oil prices crashed in 2008, so did the Russian economy
 Russia’s economy mirrored the conditions of the period following the 1998 crisis
 Analyst Evgeny Gontmakher believes that “this is all a result of incorrect economic policy, oil
dependence, and rampant corruption. Until the system changes, these problems will persist.”
 Increased government ownership
 Government ownership of the economy increased between 2003 and 2007
173
The term Dutch disease was first used to describe how the discovery of natural gas fields in the Netherlands seemed to cause the
decline of its manufacturing sector.
Economics Power Guide | 117
The state pressured firms to invest instead of allowing market forces to provide incentives
 State ownership of oil expanded considerably
174
 The state-controlled natural gas
company Gazprom 175 purchased Sibneft 176
 The government also took over gas company Yukos and oil company Rosneft
 Government control of oil rose from 19% in 2004 to over 50% by 2008
 The Russian gas industry has not undergone privatization yet
 The growth rate of oil production fell between 2004 and 2007
 Exports fell proportionally

Year
% Rise in Oil
Production
2004
+ 10%
2005
+ 5%
2006
+ 3%
2007
+ 2%
The 2008 Global Financial Crisis
 Calm before the storm
 Dmitri Medvedev ascended to the presidency in the spring of 2008
 When he took office, Russia was in an unprecedented period of prosperity
 The stock market thrived
 Foreign direct investment grew rapidly
 But investment remained low compared to other emerging markets
 Real disposable income increased by over 10% a year
 Consumer spending increased remarkably
 Unemployment fell from 12% in 1999 to 6% in 2008
 Poverty fell from 41% at subsistence minimum to 12%
 Russia became a part of four notable emerging markets, collectively known as BRIC
 BRIC consisted of Brazil, Russia, India, and China
 Global financial crisis
 The global financial crisis began in September 2008
 Between June 2008 and January 2009, Russia’s stock market lost 70% of its value
 The ruble lost 1/3 of its value against the dollar
 The Central Bank increased spending to to save the ruble but failed
 Russia’s foreign reserves fell from rising corporate debt, bank trouble, and credit issues
 Inflation hit a fourteen-month high of 13.9 by February 2009
 According to Bank of America Securities-Merrill Lynch, industrial output fell by 16% between
October 2008 and February 2009
 Government revenue fell by 28% in the first quarter of 2009
 A decrease in commodity prices, including Urals crude oil, caused this reduction
 Urals crude oil was Russia’s primary mineral export
174
Though both are fossil fuels, oil is liquid from petroleum and natural gas consists (mostly) of gaseous methane.
In 1989, the Soviet Union’s Ministry of Gas Industry transformed into a corporation named Gazprom. Gazprom is Russia’s largest
industry and the world’s largest natural gas extractor. The state still owns most of Gazprom.
176
Sibneft, Russia’s fifth largest oil producing and refining company, was created in 2005. Gazprom bought 80% of Sibneft’s shares
in 2005; Sibneft is now called Gazpromneft.
175
Economics Power Guide | 118
 GDP growth declined to -0.2% in 2009
Russia experienced budget deficits for the first time since the 1998 economic crisis
 Stunted recovery
 By the first quarter of 2009, Russia exhibited
the same ailments as it did in the 1990s
 Negative growth
 High unemployment
 High inflation
 Low oil export prices
 Weak manufacturing
 Prudent fiscal policy 177 and rising oil prices
aided Russia’s transition out of the 1998 crisis
 Boris Yeltsin’s administration established
these policies before Putin entered office
 Putin introduced a more authoritarian
developmental model
 He implemented more autocratic and stateled economic policies
 Russia’s growth did not result from these policies
 In fact, Putin’s approach stunted Russia’s ability to transition out of the 2008 crisis
 Recovery depended on several factors that would prove difficult to achieve
 Domestic consumer demand would have to increase
 High unemployment and inflation strongly worked against this goal
 World oil prices would have to rise
 The global recession suppressed demand for oil
 The state would have to implement prudent fiscal policy

Russia Today
 Enduring problems
 Russia’s manufacturing sector fails to compete in the
global marketplace
 Russia can only compete in raw materials exports
 Russia’s GDP over-relies on oil and gas
 The economy is at the mercy of world markets
 Modernization
 Dmitri Medvedev initiated a new “modernization”
 The effects of the global economic crisis
necessitated that Russia diversify its economy
 Dependence on oil exports made Russia’s economy fragile
 Medvedev launched the construction of a Russian Silicon Valley called Skol’kovo
 This project intended to use Russia’s educated labor force to innovate new products
 Medvedev located the site in a new economic zone outside Moscow
 Skol’kovo will probably not contribute significantly to GDP for years or decades
 Medvedev promised to stabilize Russia’s legal regime and approach to property
 This change would encourage and protect foreign investors
177
Prudent fiscal policy prioritizes balancing the state budget.
Economics Power Guide | 119
SECTION I - III SUMMARIES
POWER PREVIEW
This section covers the summaries at the end of each
of the first three sections, which encompass the
theoretical portion of the economics resource. This
section organizes the main topics of economics
fundamentals, microeconomics, and macroeconomics
into broad subtopics. These subtopics focus on
important testable definitions, lists, and concepts.
POWER NOTES
 According to the USAD outline, 40 questions
should come from Sections I – III.
 40 questions (80%) come from Sections I – III on
the USAD Economics Practice Test
 Section I-III Summaries cover pgs. 8, 55 – 56, and
102-103 of the USAD Economics Resource Guide
Section I: Fundamentals
 Definitions
 Economics studies how individuals make choices and how these choices interact
 These choices revolve around how to allocate scarce resources
 Scarcity describes the inescapable limited nature of resources
 Humans desire unlimited goods and services
 Every choice requires a trade-off
 An individual must give something up, his opportunity cost, to get something else
 Rationality states that people use cost-benefit analysis to choose the most beneficial actions
 All voluntary trade benefits everyone involved
 These benefits are called gains from trade
 Economic models illustrate economic phenomena by depicting only essential details
 Positive economics analyzes economic phenomena objectively
 It predicts future outcomes based on certain circumstances
 Normative economics analyzes economic phenomena subjectively
 It compares the costs and benefits of different outcomes
 Pareto efficiency describes a situation in which resources are fully used
 No person can be made better off without making others worse off
Section II: Microeconomics
 Supply and demand
 Microeconomics focuses on how supply and demand interact
 Firms supply goods and services by combining inputs such as raw materials and capital
 Firms aim to maximize economic profit
 Consumers purchase goods and services from firms and other suppliers
 The demand curve illustrates how much a buyer is willing and able to pay at each price
 The law of demand states that quantity demanded decreases as price increases
 The position of the demand curve depends on several factors
 Prices of complements
 Prices of substitutes
 Tastes
 Expectations
 Number of buyers
 The supply curve illustrates how much a seller is willing and able to sell at each price
Economics Power Guide | 120
The law of supply states that quantity supplied increases as price increases
 The position of the supply curve depends on several factors
 Price of inputs
 Technology
 Expectations
 Number of sellers
Elasticity
 Elasticity measures how responsive supply and demand are to changes in price
 This measure ignores units when calculating price and quantity
Perfect competition
 A perfectly competitive market meets three important criteria
 Large number of buyers and sellers
 Homogenous goods or services
 Market participants are informed of the market price
 A competitive market reaches equilibrium when market participants have no reason to change
their behavior
 Equilibrium maximizes total surplus
 This point occurs where the supply and demand curves intersect
 The competitive market model illustrates equilibrium price and quantity
 The model can determine how economic conditions affect equilibrium
 It can also measure changes in consumer and producer surplus
 Firms enter and exit competitive markets until all firms make zero economic profits
Imperfect competition
 Barriers to entry cause the creation of imperfect competition
 Three main types of imperfectly competitive markets exist
 Monopolies have one producer
 Oligopolies have few producers
 Monopolistic competition has many producers of similar but differentiated products
 The outcome of imperfect competition differs from perfect competition in a few main ways
 Lower equilibrium quantity
 Higher equilibrium price
 Lower total surplus
Trade
 Trade makes all participants better off
 International trade increases total surplus
 However, free trade hurts some members of the economy
 Free trade often faces opposition
Market failure
 Market failure is the inability of a market to reach a socially efficient outcome
 This happens when externalities occur or private property breaks down
 Externalities describe economic interactions that occur outside of markets
 Creating a market for externalities can solve this problem
 Government regulation can also resolve externalities
Categorization of goods
 All goods and services are classified by their rivalry and excludability
 They are categorized as private, common, collective, or public







Economics Power Guide | 121
 Government
 Institutions, organizations, and governments organize human interaction through rules
 Governments are unique in that they can tax citizens and use force
 Governments increase well-being by protecting private property and market transactions
 They impose price ceilings and floors, taxes, and subsidies
 Revenues from taxes pay for important services
 They also increase inefficiencies through pork barrel politics and rent-seeking
Section III: Macroeconomics
 Main topics
 The study of macroeconomics seeks to answer two questions
 What causes the long-run growth and size of an economy?
 What causes and results from short-run changes in economy activity, employment, and
inflation?
 Gross Domestic Product (GDP)
 GDP measures the total output or production of an economy
 This includes the market value of all final goods produced domestically within a specific
period of time
 Production equals expenditures equals income
 Expenditures fall into four categories
Consumption
Investment
Government
purchases
Net exports
 Since 1900, GDP of the U.S. has increased by a factor of about 32

U.S. population has increased by a factor of 4
 GDP per capita measures the quantity of output per person
This measure depends on average labor productivity
 Labor productivity depends on four factors

Quantity of physical and human capital

Natural resources

Technological knowledge

Political and legal climate
 Business cycle
 The business cycle describes fluctuation between expansions and recessions
 Expansions occur when the economy experiences rapid growth
 Recessions occur when the economy experiences slower or negative growth
 Financial markets
 Savings denotes income not spent on consumption within a certain period
 Investment describes the purchase of capital
 Financial markets coordinate the supply and demand for savings
 Individuals and firms borrow other individuals’ savings to invest
 Interest rates adjust to balance the supply and demand for savings
 Savings equal investment in a closed economy
 Savings equal investment plus net capital outflows in an open economy

GDP
Economics Power Guide | 122
 Money supply
 Money is a medium of exchange, unit of account, and store of value
 Economists categorize money as M1 and/or M2
 The Federal Reserve System serves as the central bank of the United States
 The Fed was established in 1913
 12 district banks and a Federal Reserve Board comprise the Fed
 The district banks are located in major cities across the nation
 The Federal Reserve Board is located in Washington, D.C.
 The Fed manipulates the economy’s money supply
 It lends money to banks as a last resort
 In the long run, changes in money supply do not affect real quantities
 They only affect prices
 In the short run, changes in money supply affect saving and borrowing
 They also affect economic activity
 Unemployment
 The unemployment rate measures the percentage of the labor force who would like to work
but cannot find jobs
 Economists divide unemployment into frictional, structural, and cyclical unemployment
 Inflation
 Inflation describes an increase in all prices in an economy
 The Consumer Price Index and Gross Domestic Product Deflator measure inflation
 Short-run fluctuations
 Economists distinguish between potential output and actual output
 Potential output is the quantity produced with all resources fully employed
 The difference between potential and actual output is the output gap
 In the long run, an economy produces at potential output
 In the short run, firms set prices and sell based on demand
 An economy’s level of output depends on its aggregate demand
 Aggregate demand may or may not equal potential output
 Differences between actual and potential output cause aggregate price level to change
 Changes in aggregate price level return the economy to potential output
 The government can use monetary and fiscal policy to help close the output gap faster
 But the effects of government policy often occur too late
 This setback often worsens the economic situation
Economics Power Guide | 123
SECTION IV SUMMARY
POWER PREVIEW
This section covers the summary of Section IV, which
encompasses the portion of the curriculum pertaining to the
economies of the Soviet Union and Russia. This section
divides Russia’s history based on its leadership and succinctly
examines the mechanics and effects of various economic
reforms.
POWER NOTES
 According to the USAD outline, 10
questions should come from Section IV.
 10 questions (20%) come from Section IV
on the USAD Economics Practice Test
 Section IV Summary covers pgs. 121-123 of
the USAD Economics Resource Guide
Communist Economic Systems
 Planned economy
 Marxism-Leninism provided the ideological backbone of the Soviet economy
 This ideology emphasized public ownership of all means of production
 Stalin collectivized farms in the 1930s
 The state took every Russian farmer’s private property
 Nationalizing property gave the bureaucracy immense economic control through planning
 Shifting to a planned economy had three main aims
 Remove the anarchy of the market
 Organize the economy on a national scale
 Distribute goods equitably
 From 1928 until the late 1980s, the Soviet economy operated on five-year plans
 Each plan coordinated bureaucratic commands among several agencies
 Firms made exactly the amount stated in individual target plans
 Managers lacked incentives to innovate
 The bureaucracy controlled prices through price lists for every product sold
 Planning caused dire economic distortions
 Every sector experienced chronic shortage
 Consumer goods particularly suffered from shortage
 Shortage and scarcity necessitated the creation of a black market (shadow economy)
 Rampant illicit activity fueled economic corruption
Mikhail Gorbachev
 Perestroika
 Mikhail Gorbachev came to power in March 1985
 Gorbachev aimed to reform and reconstruct the communist system
 This policy was called perestroika
 He did not intend to transition to a market-based liberal system
 Gorbachev’s first reforms consisted of an anti-alcohol campaign and uskorenie
 These reforms targeted economic productivity
 Uskorenie, meaning acceleration, involved increasing investment in old infrastructure
 The anti-alcohol campaign worked against investment efforts
 Both policies failed to increase economic productivity
 Gorbachev then launched a policy for social openness called glasnost
 This effort included a policy called demokratizatsiia
Economics Power Guide | 124
Demokratizatsiia, or democratization, allowed some accountability in politics
 These reforms granted managers more say in their production
 They also introduced quasi-private property rights
 Gorbachev’s incomplete reforms worsened the economy
 End of communism
 The fall of communism in Eastern Europe terminated markets for poorly made Soviet goods
 Production fell by roughly 10% every year by 1991
 The Soviet Union’s 15 constituent republics questioned the viability of staying united
 In August 1991, Gorbachev’s politburo forced his resignation with a failed coup
 In December 1991, the Soviet Union collapsed

Communist Legacy
 Successes of the planned economy
 Soviet leaders industrialized the primarily agricultural economy in 70 years
 The population achieved a 99% literacy rate
 Costs of the planned economy
 The economy experienced chronic shortage
 Industrial production far outstripped consumer production
 Technological innovation was nonexistant
 Monopolies controlled much of the economy
 The deteriorating manufacturing sector failed to compete globally
 Poor manufacturing caused Russia to become dependent on natural resource exports
Boris Yeltsin
 Shock therapy
 In 1992, Boris Yeltsin, Russia’s new president, adopted a policy called “shock therapy”
 This reform package was brought forth by a group of economists led by Yegor Gaidar
 “Shock therapy” involved three major changes
 Stabilization of the macro-economy
 Liberalization of trade
 Privatization of property
 The implementation of these changes would cause short-term negative changes (“shock”)
 But the economy would eventually latch on to market mechanisms and grow
 The shock therapy policies had significant backlash
 Industrial managers, who no longer received subsidies, demanded credits
 Yeltsin’s compliance to this request ended “shock therapy”
 Issuing credits violated the initial goal of fiscal austerity and minimizing deficit spending
 Voucher system
 In August 1992, the Russian state distributed privatization vouchers to every Russian citizen
 Russians could use these vouchers in a variety of ways
 Buy shares of privatizing firms directly
 Buy shares of privatizing firms through mutual funds
 Buy shares in a voucher fund
 Sell them
 Give them away
 State auctions
 In July 1994, Yeltsin initiated the second stage of privatization
Economics Power Guide | 125
 The second stage involved selling remaining state holdings for cash at auctions
The firms received some of the proceeds as capital for restructuring
 The government received the rest of the proceeds
 The state hoped this process would alleviate the budget deficit without increasing inflation
 Government leaders hoped the auctions would raise billions of dollars
 The second stage of privatization failed in many ways
 “Loans for shares”
 In 1995, the government developed a new idea to earn much-needed revenues
 The “loans for shares” scheme involved auctioning off 12 reputable companies
 The state auctioned off each company separately to a group of commercial banks
 A small group of wealthy business people gained a huge portion of the Russian economy
 This group of elites became known as the oligarchs
 The process was unpleasant and riddled with corruption
 The “loans for shares” scheme delegitimized privatization in the public’s minds
 1998 economic crisis
 By 1996, over 75% of large and mid-sized firms had been privatized
 90% of industrial output had been privatized
 The state failed to collect taxes
 This failure benefited large oil and electrical firms
 These firms could export without paying taxes or tariffs

In exchange, they provided energy to firms who could not afford it
 The state stopped paying government employees in an effort to decrease inflation
 In the first eight months of 1998, Russia’s foreign debt increased by $18.5 million
 Reduction in foreign currency reserves hurt the state’s efforts to protect the ruble’s value
 The International Monetary Fund gave Russia a package to pay off wages and debt
 Instead, Russia used an IMF package to support the ruble, and failed
 On August 17, 1998, Russia defaulted on its debt and devalued the ruble
 As a result, domestic industry improved because goods became too expensive to import

Vladimir Putin
 Economic growth
 Vladimir Putin replaced Boris Yeltsin as president of Russia in 2000
 Between 1999 and the summer of 2008, Russia’s economy improved in many ways
 Increasing budget surpluses
 Elimination of foreign debt
 Increasing hard-currency reserves
 Low inflation
 Resource curse
 Increasing oil and gas prices commanded Russia’s growth
 Russia experienced many symptoms of the resource curse
 The economy depended heavily on revenues generated from exporting oil
 Russia suffered from “Dutch disease”
 Dutch disease involves a high exchange rate caused by large inflows of foreign currency
used to purchase natural resources
 This phenomenon causes domestic manufacturing to become expensive
 Consumers import goods instead of purchasing domestic goods
 The result: more and more reliance on natural resources
Economics Power Guide | 126
 Putin’s government ignored the ailing manufacturing sector while oil prices rose
 In 2008, extractive commodity prices fell
Russia had little else to sustain its economy
 Putin’s legacy
 Between 2003 and 2007, the government gained much control over the economy
 Russian firms often chose to invest only after being politically pressured

Dmitri Medvedev
 2008 global financial crisis
 Dmitri Medvedev entered office months before the global financial crisis in September 2008
 Russia experienced many problems it experienced during the 1990s
 Negative growth
 High unemployment
 High inflation
 Low oil export prices
 President Medvedev recognized the need to stabilize and diversify Russia’s economy
 He spearheaded the policy of “modernization”
 He promised to stabilize the legal environment to protect foreign investors
Economics Power Guide | 127
POWER TABLES
Factors Of Production
Factor
What Is It?
What Is Its Reward?
Examples
Land
Natural resources
Rent
Farmland; oil; water
Labor
Human resources
Wages
Physical or mental activity
Capital
Goods used to produced other
goods
Interest
Computers; factory machinery
Entrepreneurship
New or improved ways to
produce goods and services
Profits
An intelligent businessman
invents a new, more efficient
production process for
microchips
Factors That Shift Supply
Factor
Relationship to Supply
Cost of Inputs
Negative/Inverse:
Increase in costs leads to decrease in supply
Technological Progress
Positive/Direct:
Increase in technology (technological development) leads to more supply
Number of Suppliers
Positive/Direct:
Increase in number of suppliers leads to increase in supply
Expectations of Changes in Price
Negative/Inverse: Expectations of lower prices in the future leads to increase in
supply now
Factors That Shift Demand
Factor
Relationship to Demand
Other Notes
Number of Demanders
Positive/Direct: Increase in number of demanders leads to
increase in demand
N/A
Price of Complementary Good
Negative/Inverse: Increase in price of complementary
good leads to decrease in demand
Use cross-price elasticity formula to
determine if two goods are
complements
Price of Substitute Good
Positive/Direct: Increase in price of substitute goods
leads to increase in demand
Use cross-price elasticity formula to
determine if two goods are
complements
Consumer Income
Normal goods—Positive/Direct: Increase in consumer
income leads to increase in demand
Inferior goods—Negative/Inverse: Increase in consumer
income leads to decrease in demand
Use income elasticity formula to
determine if a good is normal or inferior
Tastes or Preferences
Positive/Direct: Increase in popularity leads to increase in
demand
N/A
Economics Power Guide | 128
Factors That Shift Demand
Factor
Relationship to Demand
Other Notes
Expectations
Depends on which factor the expectation is related to
Example: Expectations of higher price in the future lead to
increase in demand
N/A
Shifts In Supply And Demand
Demand Shifts…
Supply Shifts…
Effect on Price
Effect on Quantity
To the right
No shift
↑ Increase
↑ Increase
To the left
No shift
↓ Decrease
↓ Decrease
No shift
To the right
↓ Decrease
↑ Increase
No shift
To the left
↑ Increase
↓ Decrease
To the right
To the right
? Ambiguous
↑ Increase
To the right
To the left
↑ Increase
? Ambiguous
To the left
To the left
? Ambiguous
↓ Decrease
To the left
To the right
↓ Decrease
? Ambiguous
Elasticity
Name
Relation to Total Revenue
(TR)
Graphical
Representation
Other Notes
Perfectly inelastic
Increase in price leads to
increase in TR; decrease in
price leads to decrease in TR
Perfectly vertical
line
Purely theoretical for demand
Occasionally exists for supply of
goods that can no longer be
produced
E<1
Inelastic
Increase in price leads to
increase in TR; decrease in
price leads to decrease in TR
Steep line
Applies to goods that are
necessities and goods that have few
available substitutes; goods are
more inelastic in the short run
E=1
Unit elastic
Change in price has no effect
on TR
Line with a slope
of 1 or -1
None
E>1
Elastic
Increase in price leads to
decrease in TR; decrease in
price leads to increase in TR
Flat line
Applies to goods that are luxuries
and goods that have many available
substitutes; goods are more elastic
in the long run
E=∞
Perfectly elastic
Change in price leads to loss of
all TR
Perfectly
horizontal line
Purely theoretical
Number Range
E=0
Economics Power Guide | 129
Comparing Market Types
Type of Market
Number of
Producers
Kind of
Competition
Barriers to Entry
Another Name for
Firms
Special
Traits
Monopoly
One
None
No entry possible
Price-setter
Only one firm
Oligopoly
A few
Primarily non-price
competition
Medium barriers
(difficult entry)
N/A
Firms can collude
and behave as a
monopolist
Monopolistic
Competition
Many
Non-price
competition; price
competition
Low barriers
(easy entry)
Price-maker
Product
differentiation and
branding
Perfect
Competition
A great many
Price competition
No barriers
(free entry)
Price-taker
Perfectly elastic
demand
Calculating GDP
Method
Process
Expenditures Approach
Add up the value of all finals goods and services in an economy;
C + I + G + NX = GDP = Y = income = expenditures
Income Approach
Remember that income equals production equals expenditures
Add all of the income of the workers and employers together
Types of Unemployment
Type of Unemployment
Definition
When It Occurs
Frictional
Unemployment resulting from the time lag
between when workers leave jobs and
when they find new jobs
Always present in the economy
Structural
Unemployment resulting from structural
changes in the economy; results from a
mismatch of skills demanded and skills
supplied
Always present in the economy, but can be
reduced by retraining unemployed workers
Cyclical
Unemployment resulting from changes in
the business cycle
Only occurs with a downturn in the
business cycle
Tools of Monetary Policy
Who Acts?
What Happens?
Expansionary/
Contractionary
How Does It
Work?
Utilized When?
Open-Market
Operations
FOMC
The Federal Reserve buys and sells
American securities
E: Buy
securities
C: Sell
securities
Injects or removes
money from the
economy
Daily
Discount Rate
(DR)
Board of
Governors
The Federal Reserve changes the
interest rate for loans from the
Federal Reserve to member banks
E: ↓DR
C: ↑DR
Changes the cost
of borrowing from
the Fed
Rarely
Policy Tool
Economics Power Guide | 130
Federal Funds
Rate (FFR)
Board of
Governors
The Federal Reserve changes bankto-bank lending rates
E: ↓FFR
C: ↑FFR
Changes the cost
of loans between
all banks
About once per
quarter
Reserve
Requirements
(RR)
Board of
Governors
The Federal Reserve changes the
reserve requirements for banks
E: ↓RR
C: ↑RR
Changes the
amount of
reserves banks
must maintain
Very rarely
Russian Reforms
Policy
Enactor
Year(s)
Goal(s)
Details
Result
Perestroika
Mikhail
Gorbachev
1985-1991
Restructure the
communist system
Encompassed the antialcohol campaign,
uskorenie, glasnost, and
demokratizatsiia
Indecisiveness and halfmeasures damaged the
economy
Anti-alcohol
campaign
Mikhail
Gorbachev
1985-1986
Eliminate chronic
alcoholism
Decrease worker
absenteeism
Increase worker
productivity
Closed down some alcohol
factories
Failed to reduce
alcoholism or improve
worker productivity
Russians produced
liquor illegally
Caused sugar shortages
Uskorenie
Mikhail
Gorbachev
1985-1986
Increase investment in
decaying infrastructure
Implemented at the same
time as the anti-alcohol
campaign
Failed because the antialcohol campaign
lowered state revenues
Glasnost
Mikhail
Gorbachev
1987-1988
Allow public discussion
on the merits of
communism and
capitalism
Included demokratizatsiia
Spurred introduction of
private property
Allowed politicians and
media to discuss
important issues
pertaining to the
election of the 1989
super parliament
Demokratizatsiia
Mikhail
Gorbachev
1987-1988
Introduce some
accountability and
democratic aspects to
the political process
Allowed interest groups to
participate in the political
process
Contributed to the fall
of communism in
Eastern Europe
Shock therapy
Boris
Yeltsin
January 1992
Transition Russia to a
liberal market-based
economy
Rapidly stabilize the
economy, liberalize
trade, and privatize
property
Eliminated price lists
Increased prices by 245%
overnight
Increased inflation
Increased unemployment as
unprofitable firms failed
Strong backlash from
“red managers” after
termination of subsidies
Ended with the issuance
of Central Bank credits
Failed by spring 1992
Corporatization
Boris
Yeltsin
July 1992
Separate ownership from
management
Held managers accountable
to a board of directors
Introduced incentives
guided by the principles of
profit and loss
N/A
Economics Power Guide | 131
Voucher
program
Boris
Yeltsin
August 1992
Transfer ownership of
firms from public to
private hands
Involved all Russian citizens
in the process of
privatization
Succeeded in part
Opposed by many firms
because they did not
receive money
Sold 20% of all shares
for vouchers
State auctions
Boris
Yeltsin
July 1994
Finance the budget
deficit without increasing
inflation
Increase foreign
investment
Auctioned off state
holdings for money
Used part of the proceeds
to restructure firms
Failed when Vladimir
Polevanov, Minister of
Privatization, halted
privatization
Discouraged foreign
investment
Modernization
Dmitri
Medvedev
2008
Diversify Russia’s
economy
Use educated labor to
innovate new
technologies
Constructed a Russian
equivalent of the Silicon
Valley called Skol’kovo
N/A
Economics Timeline
1920
The Russian Civil War ends
1920s
Joseph Stalin and the Soviet government collectivize agriculture
late 1970s
The Soviet Union’s production levels fall
late 1980s
The Soviet Union’s production levels reach a free fall
The system of ministerial control declines
March 1985
Mikhail Gorbachev becomes the General Secretary of the Communist Party of the Soviet Union
1987
Mikhail Gorbachev initiates glasnost
November 1989
The Berlin Wall falls
1990
Boris Yeltsin is elected speaker of the new Russian parliament
summer of 1990
A group of economists presents the Five Hundred Day Plan to Mikhail Gorbachev
fall of 1990
Mikhail Gorbachev rejects the Five Hundred Days Plan
early 1990s
Barter economies present in both agriculture and industry
1990s
Most of Russia’s transformation to a market system takes place
1991
Shortage and inflation persist
Most Russians are on the state payroll
June 1991
Boris Yetsin is elected president of Russia
August 1991
The Soviet Politburo oust Mikhail Gorbachev from office through an attempted coup
fall of 1991
Boris Yeltsin surveys reform options proposed by groups of economists
December 25, 1991
The Soviet Union collapses
January 2, 1992
Boris Yeltsin frees prices
April 1992
Industrial managers most oppose shock therapy
spring of 1992
The Russian Central Bank responds to opposition by issuing credits to firms, ending shock therapy
Economics Power Guide | 132
Economics Timeline
June 1992
Yegor Gaidar and Boris Yeltsin pass legislation initiating the process of privatization
July 1992
Boris Yeltsin initiates the privatization program
Yeltsin creates the State Committee on Property
August 1992
The voucher program begins
December 1992
Share auctions begin
January 1993
Latest date to claim vouchers
May 1993
Boris Yeltsin issues a decree stating that firms must trade 29% of all shares for vouchers
July 1994
Boris Yeltsin initiates the second stage of privatization
July 1, 1994
Latest date to invest vouchers
1995
Boris Yeltsin initiates the “loans for shares” scheme
1996
75% of all mid to large-sized firms are privatized
90% of all industrial output is privatized
September 1, 1996
Earliest date banks could sell the shares they received from the “loans for shares” scheme
1996-1997
Inflation and the ruble exchange rate stabilize
The state falls behind on paying wages and pensions
late spring, summer 1998 Russia starts borrowing foreign currency to finance domestic debt
July 20, 1998
The International Monetary Fund offers Russia a package to pay wages and short-term debt
The state uses it to defend the ruble’s value and fails
August 17, 1998
The 1998 financial crisis occurs
Russia devalues the ruble and defaults on its domestic and international debts
1999
The Russian economy starts growing for the first time since the Soviet Union’s collapse
Unemployment is at 12%
2000
Vladimir Putin assumes the presidency
GDP growth reaches an all-time high of 8.5%
2004
Vladimir Putin’s first term ends
2008
Unemployment is at 6%
Oil prices fall
Russian government divides the Stabilization Fund into the National Prosperity Fund and the Reserve Fund
spring of 2008
Dmitri Medvedev assumes the presidency
June 2008
Russia’s stock market begins to lose value
September 2008
The global financial crisis begins
October 2008
Industrial output starts falling
First quarter of 2009
Government revenue falls by 28%
January 2009
Russia’s stock market loses 70% of its value since June 2008
February 2009
Inflation hits a 14-month high of 13.9
Industrial output has fallen 16% since October 2008
2011
Russia transitions to a market-based economy
Economics Power Guide | 133
POWER LISTS
PERCENTAGES

-0.2% (119)
Percent growth of Russia’s GDP in 2009

2% (118)
Percent growth of Russia’s oil production in 2007

3% (111, 118)
Percent growth of Russia’s GDP in 1989
Percent growth of Russia’s oil production in 2006

5% (118)
Percent growth in Russia’s oil production in 2005

6% (119)
Russia’s unemployment rate in 2008

9.7% (72)
The United States’ unemployment rate in August 2009

10% (110, 118,
119)
Yearly percent decline in Russia’s production between 1989 and 1991
Percent growth in Russia’s oil production in 2004
Increase in Russia’s real disposable income between 1999 and 2008

12% (#)
Russia’s unemployment rate in 1999
Percent of Russians living on subsistence minimum in 2008

13%
Flat income tax rate imposed by Vladimir Putin during his first term (2000-2004)

16% (86, 119)
Decline in the United States’ CPI from 1920 to 1922
Percent decline in Russia’s industrial output between October 2008 and February
2009, according to Bank of America Securities-Merrill Lynch

-17% (111)
Percent growth of the Soviet Union’s GDP by the time of its collapse in 1991

19% (118)
Percent of Russia’s oil coming from state-owned firms in 2004

20% (114)
Average percent of shares sold by each firm during Boris Yeltsin’s voucher program

24% (117)
Russia’s tax rate on profits after Vladimir Putin’s tax cuts

25% (86, 114)
Decline in the CPI from 1929 to 1933
Percent of insider ownership allowed under Boris Yeltsin’s voucher program

28% (119)
Decline in Russian government revenue by the first quarter of 2009

29% (114)
Percent of shares that had to be sold during the voucher program under Boris
Yeltsin’s decree

35% (117)
Russia’s tax rate on profits before Vladimir Putin’s tax cuts

41% (119)
Percent of Russians living at subsistence minimum in 1999

50% (118)
Percent of Russia’s oil coming from state-owned firms in 2008

66% (72)
The United States’ current labor force participation rate

70% (119)
Percent decline in the value of Russia’s stock market between June 2008 and
January 209

75% (115)
Percent of Russia’s large and mid-sized firms privatized by 1996

90% (115)
Percent of Russia’s industrial output privatized by 1996

99% (107)
The Soviet Union’s literacy rate at the time of its collapse

100% (111)
The Soviet Union’s inflation rate at the end of 1991
Economics Power Guide | 134

245% (112)
Average percent increase in prices the day after Boris Yeltsin freed prices on January
2, 1992
NUMBERS

2 (59)
Amount (in U.S. dollars) that the average inhabitant of Ghana earns per day

12 (114, 117)
Number of blue-chip companies auctioned off in the loans for shares scheme
Price of a barrel (in US dollars) of Urals crude oil blend in 1998

13 (105)
Number of time zones covered by the Soviet Union

13.9 (119)
Russia’s inflation rate in February 2009, a 14-month high

15 (110)
Number of countries created from the dissolution of the Soviet Union in 1991

20 (104)
Number of years it took Russia to transition from a command to market-based
economy

29.6 (86)
The CPI of the United States in 1960

43 (92)
Length of decline (in months) of the Great Depression, starting August 1929

50 (114)
Average monthly wage (in US dollars) during Boris Yeltsin’s voucher program

70 (107, 117)
Number of years it took the Soviet Union to industrialize
Price of a barrel (in US dollars) of Urals crude oil blend in 2007

84 (114)
Value of a voucher (in US dollars) during Boris Yeltsin’s voucher program

200 (113)
Maximum number of employees to be classified a small firm
Minimum number of employees to be classified a medium firm

215.3 (86)
The CPI of the United States in 2008

458 (59)
Average output per person in Ghana

1,000 (113)
Minimum number of employees to be classified a large firm Maximum number of
employees to be classified a medium firm

3,000 (111)
The number of exchange rates for every item in the Soviet Union

10,000 (114)
Value of a voucher (in rubles) during Boris Yeltsin’s voucher program

43,000 (58)
Average output per person in the United States in 2008

47,000 (6)
Number of items in the average American supermarket

100,000 (104)
Number of workers employed at many Soviet firms

15 million (72)
Number of unemployed in the United States in August 2009

18.5 million (116)
Increase of Russia’s foreign debt (in US dollars) over the first 8 months of 1998

140 million (72)
Number of employed in the United States in August 2009

154.6 million (72)
Number of people in the United States labor force in August 2009

236 million (72)
Number of working-age people in the United States in August 2009

1 billion (55, 115)
Cost of United States sugar price supports to American consumers a year
Russia’s government revenues (in US dollars) earned from loans for shares scheme
Economics Power Guide | 135
TERMS — FUNDAMENTALS OF ECONOMICS

Absolute advantage (36)
When one party can produce more of a good than another

Comparative advantage (39)
When one party can produce a good at a lower opportunity cost than
another

Cost-benefit analysis (12, 15)
How rational decision-makers decide on one choice or course of action
as opposed to another, by weighing the pros and cons of a decision in an
attempt to maximize utility

Economics (6)
The study of how individuals make choices regarding allocating scarce
resources to satisfy unlimited wants

Marginal
To have “one more” of something

Marginal utility
The amount of satisfaction one derives from consuming one more of a
good or service

Normative economics (7)
Economic analysis that focuses on what should be, rather than what
actually is or can be; involves opinion

Opportunity cost (7)
The cost of what is given up when you make a decision; the cost
(monetary or otherwise) of the “next best” alternative

Pareto efficient (8)
A state where it is impossible to improve one person’s well-being
without reducing someone else’s well-being

Positive economics (7)
Economic analysis that seeks to describe and explain economic
phenomena

Production Possibilities
Frontier (PPF) (36)
A graphical representation of the different combinations of output that
can be produced

Rational (7)
The state of mind of people that effectively engage in cost-benefit
analysis, only making decisions that benefit them

Scarcity (6)
The fact that all resources are finite

Trade-offs (7)
The idea that in order to get something, we must give up something else

Unlimited wants (6)
The assumption that all people have unbounded desires that can never
be fully fulfilled

Utility (76)
The amount of satisfaction one derives from something; usually
expressed as a number
TERMS — MICROECONOMICS

Accounting costs (40)
Part of total costs; includes only actual monetary expenditures

Accounting profit (40)
Profit that does not include opportunity costs

Average cost (44)
Total production costs divided by quantity produced; total production cost
of one input

Barriers to entry (43)
Prevent competitors from entering a market

Binding (34)
Describes a price floor above the equilibrium price, or a price ceiling below
the equilibrium price

Cartel (45)
What results when firms in an oligopoly agree to behave as a monopolist

Coase Theorem (50)
The private market should be able to resolve externalities as long as the
involved parties can negotiate and property rights are clearly defined
Economics Power Guide | 136

Collusion (45)
A situation in which firms in an oligopoly make decisions as one

Complement (15)
Two goods for which a rise in the price of one leads to decline in demand
for another

Consumer surplus (19)
The surplus that consumers receive when buying something at a lower
value than they would be willing to pay

Contracts (54)
Agreements entered into voluntarily

Contrived scarcity
When a monopolist purposely undersupplies the market, increasing prices
above what would otherwise be the market price

Creative destruction (46)
When old practices or goods disappear in favor of newer, more efficient,
better goods that increase social welfare

Deadweight loss (34)
Reduction in social welfare that results from a distortion of the market,
such as government intervention

Demand curve (13)
Depicts the relationship between quantity demanded and the good’s price

Demand schedule (13)
A table, depicting the quantity demanded of a good at certain prices

Economic costs (39)
The total cost of producing a good, including opportunity cost

Economic profit (40)
Difference between the revenue a producer receives and the opportunity
cost of producing the good

Elasticity (25)
Percent change in quantity due to a percent change in price

Entrepreneurs (46)
Individuals who take on risk when creating new goods and services, and are
rewarded with economic profits

Equilibrium (17)
In economics, the single combination of price and quantity where a market
settles

Excludability (53)
Describes the ability to control whoever consumes the good in question

Externalities (48)
When the actions of one person affects another’s well-being, but neither
party pays or is paid for these effects

Firms (39)
The economic actors who supply goods and services for an economy

Fixed costs (40)
Costs that cannot be changed in the short run

Homogenous
When goods are exactly the same as each other

Imperfectly competitive (43) Markets with only one or a few suppliers

Inferior goods (15)
Goods for which quantity demanded falls as income of the buyers rises

Innovate (46)
What entrepreneurs do in an attempt to establish market power

Institutions (54)
Formal (and informal rules) that govern human interactions

Internalize (50)
When firms solve externalities by combining the activities that produced
the externalities

Law of demand (12)
The negative relationship between a good’s price and quantity demanded

Law of supply (15)
The positive relationship between a good’s price and quantity supplied

Logrolling (55)
Vote trading by legislators in an attempt to gain support for pet projects

Marginal cost (41)
The additional cost of producing one more of a good

Marginal revenue (41)
The additional revenue of selling one more of a good

Marginal tax
A tax that creates a “price wedge” between consumers and producers

Market (10)
Composed of all of the buyers and sellers of a good
Economics Power Guide | 137

Market demand curve (13)
Shows relationship between quantity demanded of a good and its price;
obtained by adding the quantities demanded by all buyers in the market

Market failure (46, 48)
When competitive markets fail to produce socially desirable outcomes

Market power (43)
Firms can choose from combinations of price and quantity determined by
market demand; firms with this face a downward sloping demand curve

Market supply curve (15)
Shows relationship between quantity supplied of a good and its price;
obtained by adding the quantities supplied by all buyers in the market

Microeconomics (10)
Concerns itself with the interaction of supply and demand within markets

Monopolistic competition
(45)
Combines parts of the monopoly and perfectly competitive models; firms
sell similar, but differentiated, products

Monopoly (43)
A market with only one supplier

Negative externalities (48)
Externalities that harm third parities

Normal goods (15)
Goods whose quantity demanded rises as income rises, and quantity
demanded falls as income falls

Oligopoly (45)
A market with a small number of sellers; often characterized by collusion

Organizations (54)
Organize human interaction through formal rules and structures; much
more formal than institutions

Perfect price discrimination
(45)
When firms can sell their product to each customer at the exact value the
customer placed on the product

Perfectly competitive market Market characterized by price taking behavior, lack of market power,
(10)
homogenous goods, no barriers to entry, no transaction costs, perfect
information, and rational behavior

Perfectly price-elastic (28)
A characteristic in which increasing prices above equilibrium results in
nothing supplied or demanded, and decreasing prices results in an infinite
amount being supplied or demanded; purely theoretical

Perfectly price-inelastic (28)
A characteristic in which prices can be raised or lowered without changing
the quantity demanded or supplied; on the demand side, purely theoretical

Pork barrel politics (54)
The tendency for elected officials to steer money to their constituents via
pet projects

Positive externalities (48)
Externalities that benefit third parties

Price ceilings (31)
A maximum price on a good

Price controls (30)
Limits on the prices of a good

Price elasticity of demand
(25)
Measures how much the quantity demanded of a good responds to changes
in price

Price elasticity of supply
(28)
Measures how much the quantity supplied of a good responds to changes
in price

Price floors (34)
A minimum price on a good

Price taker
For a perfectly competitive market; when buyers and sellers must accept the
market price

Price-elastic (25, 28)
When a 1% change in price results in a greater than 1% change in quantity

Price-inelastic (25, 28)
When a 1% change in price results in a less than 1% change in quantity
Economics Power Guide | 138

Producer surplus (21)
The surplus that producers receive when selling something for more than
they would be willing to

Product differentiation (45)
Distinguishing between different goods that serve the same purpose in the
same market

Property
Social institution that allows an individual exclusive use of a good

Quantity demanded (11)
The amount of a good that consumers are willing and able to buy

Quantity supplied (15)
The amount of a good that sellers are willing and able to produce

Quota (51)
A numerical limit on how much of something is allowed

Rent seeking (55)
Socially unproductive activities that direct, rather than create, economic
benefits

Revenue
What firms receive from selling goods

Rivalry (53)
If one person consumes a good, then that reduces the amount available for
everyone else

Shortage
When quantity demanded exceeds quantity supplied; often happens with
an effective price ceiling

Specialization (36)
When individuals and countries focus on producing what they produce
best (for the lowest opportunity cost relative to others)

Substitute (15)
Goods for which an increase in the price of one increases the demand of
the other

Supply curve (15)
Depicts the relationship between quantity supplied of a good and that
good’s price

Supply schedule (15)
A table, depicting the quantity supplied of a good at certain prices

Surplus
When quantity supplied exceed quantity demanded; often happens with an
effective price floor

Tax revenue
The tax per unit times the quantity of units; sits as a rectangle between
producer and consumer surplus

Total costs (39)
The comprehensive cost of supplying a good or service

Total market surplus (21)
The sum of producer and consumer surplus; the total benefit market
participants receive from buying and selling

Total revenue (28)
Equal to equilibrium price times equilibrium quantity; shown graphically
as a rectangle

Tragedy of the commons
(52)
When a resource that is owned jointly is overused because no one accounts
for negative externalities caused by overuse

Unit elastic (25, 28)
When a 1% change in price results in a 1% change in quantity

Variable costs (40)
Costs that can be altered in the short run
TERMS — MACROECONOMICS

Aggregate demand (95)
Total demand in the economy at all price levels; reflects the total
expenditures in the economy

Aggregate supply (97)
Total supply in the economy at all price levels; maps price levels to the
real output supplied by firms

Aggregation (63)
Combining many different things into a single variable
Economics Power Guide | 139

Assets
Things owned by an individual or entity

Average labor productivity (58)
The total output of the economy divided by the number of workers
employed

Bank run (86)
When depositors rush to withdraw their deposits from a financial
institution

Banks (77)
A type of financial intermediary; these loan to small businesses and
accept deposits from people who want to save

Bond (77)
A certificate of indebtedness; a form of an IOU; the borrower must pay
the holder of this back, along with interest

Budget deficit (78)
What occurs when taxes minus government spending is negative

Budget surplus (78)
What occurs when taxes minus government spending is positive

Bureau of Labor Statistics
(BLS) (69)
Agency that calculates the Consumer Price Index (CPI) every month

Business cycle (91)
Alternation of expansions and recessions in an economy

Business fixed investment (67)
When firms buy factories, offices, machinery, and other capital goods

Business sector
The part of the circular flow model occupied by firms

Capital goods (65)
Goods that are long-lived and produced to make other goods

Central bank (83)
Institution that regulate the supply of money and oversees a country’s
banking system

Circular flow model (73, 74)
A model that traces the path of money, goods, and services through an
economy

Commodity money (83)
Money with intrinsic value

Consumer durables (67)
Long-lived consumer goods

Consumer nondurables (67)
Short-lived consumer goods

Consumer Price Index (CPI)
(69)
Measures the cost of purchasing a basket of goods and services at market
price that is intended to represent the consumption of an average
consumer; used to measure inflation

Consumption (95)
Spending by households; see consumption expenditures

Consumption expenditures
(95)
Spending by households; see consumption

Contractionary fiscal policy
Spending by legislatures or the government to slow an expansion

Currency (83)
Bills and coins owned by the public; the most liquid asset

Cyclical unemployment (73)
Unemployment caused by the ups and downs of the business cycle

Date of maturity (77)
Specifies the date a loan will be repaid

Debt finance (77)
The sale of bonds

Default (77)
When the borrower of a bond fails to pay some or all of the principal or
interest

Demand deposits (82, 83)
Another name for checking accounts

Depression
An extremely severe recession

Diminishing returns to scale
(41)
An increase in inputs results in a smaller increase in the quantity
produced each time
Economics Power Guide | 140

Discount rate (86)
The interest rate that the Federal Reserve charges on loans to banks

Dividends (77)
The profits enjoyed by shareholders whenever stocks are sold

Downturn
A period in which the economy begins to decline

Employment
The state of either working for pay or being on leave from a regular job

Employment rate
The percentage of the labor force that has a job or is on leave from a
regular job

Equation of exchange
MV = PY; see quantity theory of money

Equity finance (77)
Sale of shares of stock

Eurodollars
All dollar accounts held outside of the United States

Expansion (91)
Periods when the economy grows faster than its long-run trend

Expansionary fiscal policy
Spending by legislatures or the government to mitigate a recession

Exports
Goods that a country sells to foreigners

Factor market (74)
The market where labor, land, and capital are bought and sold

Factors of production (74)
The name for land, labor, capital, and entrepreneurship

Fed
Another name for the Federal Reserve system

Federal funds rate (86)
The interest rate that banks charge when loaning to other banks

Federal Open Market
Committee (FOMC) (84)
Organization that meets every six weeks in Washington, D.C. to
determine if any changes in monetary policy are necessary; composed of
the seven Fed governors and five regional bank presidents

Federal Reserve System (83)
Serves as the central bank of the United States; created in 1913 and
consists of 12 regional banks

Fiat money (83)
Money with no intrinsic value

Final good (65)
What results from a long, complex chain of production activities

Financial institutions
Coordinate the saving and investment decisions in an economy

Financial markets (76)
Institutions where savers can supply their savings to those who wish to
borrow the money for investment

Fiscal policy (101)
Government spending

Foreign direct investment (79)
When a company or individual acquires assets in another country that
they will actively manage

Foreign exchange effect (97)
At a lower domestic price level, domestic consumers will buy fewer
imports, causing net exports to increase and GDP to increase; one of the
reasons aggregate demand slopes downward

Fractional reserve banking
A type of banking where the bank will loan out some of the deposits,
keeping only some in reserve

Frictional unemployment (72)
Unemployment due to the process of matching employees and
employers; this type of unemployment is always present

GDP deflator (71)
A measurement of the relationship between real and nominal GDP that
tells about the degree of inflation

Government purchases (67)
The goods and services purchased by federal, state, and local
governments

Government saving (78)
Equal to taxes minus government purchases
Economics Power Guide | 141

Gross Domestic Product
(GDP) (65)
The market value of all final goods produced within a country during a
certain period of time

High-powered money (85)
Another name for the monetary base; currency plus reserves

Human capital (75)
Skills and experience acquired by humans through training, education,
and on-the-job experience

Identity (78)
An equality that is always true

Imports
Goods that a nation brings in from other countries

Inflation (61)
When all prices rise together

Interest effect
At a low price level, people will have more money than they want and
will try to acquire less liquid assets, increasing the supply of savings; this
decreases interest rates and causes people to borrow more; one of the
reasons aggregate demand slopes downward

Intermediary (77)
A third party that links two others

Intermediate goods (65)
Goods used up while producing another, final good

Inventories (67)
Additions of unsold goods to company inventories

Investment (76)
Spending by firms on final goods; purchases of houses by households

Keynesian model (97)
Model using aggregate curves to explain the economy’s short-run
fluctuations

Labor force (60)
All people that are either employed or unemployed

Lender of last resort (86)
The Fed’s responsibility, if a bank looks like it is about to fail

Liabilities
To a bank, the deposits of depositors

Liquidity (83)
How easily something can be converted into money

Long run
The time period in which an economy moves back to equilibrium

Long run aggregate supply
(LRAS) (97)
Drawn as a vertical line where output equals potential output

M0
All of the currency and coins in an economy

M1 (83)
A component of the money stock; includes currency, demand deposits,
nonbank travelers checks, and other checkable deposits

M2 (83)
The best definition of the money supply; includes M1, savings deposits,
small time deposits, and retail money funds

Macroeconomics (57)
The branch of economics concerned with the performance of national
economies

Market for goods and services
(74)
The market where firms sell and households buy final goods

Medium of exchange (82)
An item that can be used to buy goods

Monetary base (85)
See high-powered money; the amount of currency plus reserves

Monetary policy (101)
Instrument used by the Federal Reserve to alter the money supply and
offset short-run economic fluctuations

Money (82)
Anything that is a medium of exchange, unit of account, and store of
value

Money market accounts
A form of deposit similar to retail money funds
Economics Power Guide | 142

Money multiplier (85)
The reciprocal of the reserve ratio; determines the effect of altering the
reserve ratio on the stock of money in the economy

Money supply (84)
The amount of money in the economy, controlled by the Fed

Mutual funds (78)
A portfolio of stocks that inexperienced savers can purchase, allowing to
diversify their holdings

National savings (78)
Equal to national income minus consumption minus government
purchases

Natural rate of unemployment
(95)
Level of unemployment present when actual output is equal to potential
output; includes only frictional and structural unemployment

Net capital outflow (78)
The purchase of foreign assets by domestic residents minus the foreign
purchase of domestic assets

Net exports (67, 68)
Value of domestically made goods sold to foreigners minus value of
foreign-made goods bought by domestic buyers

Neutrality of money (90)
In the long run, changes in the quantity of money have no effect on real
quantities in the economy

Nominal
The cost of anything, without adjusting for inflation

Nominal GDP (69)
GDP calculated with current year prices

Okun’s Law (95)
Every 1% that the unemployment rate is off from the natural rate of
unemployment, the output gap deviated by 2%

Open-market operations (84)
The buying and selling of bonds by the Federal Reserve to change the
money supply

Output gap (94)
Difference between actual output and potential output

Peak
The high point of a business cycle

Per capita (57)
Latin phrase; literally means “per head” (per person)

Portfolio investment (79)
When an individual or firm buys shares of stocks or bonds issued by a
foreign company

Potential output (94)
The quantity of goods that can be produced when the economy is using
all of its resources at normal rates; not fixed over time

Price level
The sum of all prices in the economy

Principal (77)
The original amount loaned out

Private savings (78)
National output minus consumption minus government spending

Quantity theory of money (91)
See exchange equation; also called quantity equation; MV = PY; velocity
of money times the quantity of money equals nominal GDP

Real
Anything expressed with corrections for the effects of inflation

Real Gross Domestic Product
(Real GDP) (68)
GDP adjusted for inflation

Real interest rate (80)
The nominal interest rate minus the rate of inflation

Recession (60)
Periods of slow growth (or even decline) in output/GDP

Reserve requirement (85)
The amount of money banks are required to have in their vaults to pay
back depositors

Reserve-deposit ratio (85)
Also called the reserve ratio; the percentage of deposits banks are
required to keep as reserves
Economics Power Guide | 143

Reserves
The portion of deposits that banks must hold to ensure depositors can
withdraw from their accounts

Residential fixed investment
(67)
When households purchase new homes and apartment buildings

Saving (76)
The difference between what a person earns and what that person
spends

Savings deposits
Another name for a savings account

Services (67)
Intangible goods, such as education, insurance, and financial services

Short run (101)
The period of time the economy deviates from long-run predictions;
usually one to three years

Short-run aggregate supply
(SRAS) (97)
The potential supply of all goods at all price levels; upward-sloping

Solvent (86)
When a bank’s assets exceed its liabilities

Stock (77)
Represents ownership of a portion of a company

Store of value (83)
An item that people can use to transfer purchasing power from the
present into the future

Structural unemployment (72)
Unemployment due to mismatches between job openings and job seekers

Technological knowledge (76)
Knowledge about the techniques that transform inputs into goods and
services to be purchased by households

Time deposits
A deposit that cannot be withdrawn for a length of time, but accrues
significant interest in the meanwhile

Trade deficit (62)
When imports exceed exports

Trade surplus (62)
When exports exceed imports

Transfer payments (67)
Redistributes money but does not create anything; does not count
toward government purchases and GDP

Traveler’s checks
A preprinted check

Trough
The lowest point on the business cycle; signals the start of an expansion

Unemployment (57)
State of actively seeking paid work, but unable to find it

Unemployment rate (57, 60)
Percentage of people who would like to work but cannot find jobs

Unit of account (83)
A yardstick that established the value of different goods

Upturn
Another word for expansion

Velocity of money (91)
The number of times the average dollar bill is used in a year

Vertical integration (65)
When industries at different stages of production of a good are
combined

Wealth (76)
The total value of assets, as a store of value

Wealth effect (97)
A phenomenon in which money becomes more valuable and people buy
more goods and services when the aggregate price level declines
TERMS — ECONOMY OF COMMUNIST AND POST-COMMUNIST RUSSIA

Barter (112)
Transactions of goods and services without the use of money

Black market (107)
Illegal trade of goods and services
Economics Power Guide | 144

Budgetary institutions (104)
One form of property under the Soviet system, includes universities,
educational and research institutions, training centers and trade schools,
hospitals, and museums

Bureaucracy (105)
A group of un-elected state officials, responsible for planning the Soviet
economy

Capitalists (104)
A class of individuals who owned property (or “capital”) without
contributing labor

Central management (106)
Organizational structure in which most of a firm’s decision-makers are
located at one place

Classical socialist system (104)
Consists of three types of property: the state-owned firm, budgetary
institution, and cooperative

Collectivization (104)
Transferring ownership of property from individuals to communities

Command economy (104)
See “planned economy”

Communism (104)
A theory advocating a fully developed version of socialism in which all
means of production are owned by the state

Convertibility (110)
The ability to exchange one currency for another

Cooperative enterprises (108)
Small businesses created by Mikhail Gorbachev that introduced quasiproperty rights and competitive practice but lacked clear ownership

Cooperatives (105)
One form of property under the Soviet system, huge mostly agricultural
firms, includes social services

Corporate governance (114)
The direction and administration of a firm

Cradle-to-grave (104)
Services that last a person’s entire lifetime, important in communism

Downward flow of
information (106)
Process of plans traveling from the Soviet bureaucracy to ministries,
directorates/sectors, and individual firms

Disaggregation of plans (106)
Practice of separating a bureaucratic plan into more manageable parts

Dutch disease (117)
Negative effects caused by a large inflow of foreign currency, associated
with the discovery of natural resources and subsequent decline of the
manufacturing sector

Economies of scale (104)
The advantages of expanding a firm’s scale of production

Exchange rate (111, 117)
Price of one currency in terms of another, used for conversion purposes

Five-year plans (105)
Bureaucratically crafted statements of intent that dictated the Soviet
economy from 1928 until the late 1980s

Kolkhoz (105)
Collective farm

Large firms (113)
Category established by the State Committee on Property under Boris
Yeltsin, consists of over 1000 employees

Liberalization (110)
Removal of restrictions

Managers (106)
Individual in charge of all or part of a firm

Market-based economy (104)
An economy that emphasizes private property ownership and the
reliance on market forces to allocate resources

Market system (110)
See “market-based economy”

Marxism (105)
Karl Marx’s highly diverse theories on society and politics, used by his
followers to develop the practice of communism
Economics Power Guide | 145

Marxism-Leninism (104)
Ideology created by Vladimir Lenin from Karl Marx’s writings on
communism, emphasized government ownership of all means of
production

Medium firms (113)
Category established by the State Committee on Property under Boris
Yeltsin, consists of 200-1000 employees

Ministerial control (110)
Government control

Mobility (104)
Ability to change one’s residence

National firms (104)
State-owned firm controlled by the Soviet national government

Nationalization
Transfer of property from individual to government ownership

Oligarchs (115)
Small group of wealthy business people who inherited a large portion of
the Russian economy as a result of the “loans for shares” scheme

Planned economy (104)
An economy in which output and price is regulated by the government
instead of by the market

Plan targets (106)
Plan specifying an exact level of output that an individual firm is
responsible for producing, written by bureaucratic planners

Plenum (108)
A planning meeting

Price lists (106)
Lists designating prices for every item sold in an economy, written by
bureaucratic planners

Privatization (109, 110, 112)
Transferring property ownership from the state to individuals

Production plans (104)
See “plan targets”

Propiska (104)
A housing permit that allows laborers to move to different cities

Quasi-property rights (108)
Partial property rights introduced by Mikhail Gorbachev

Red managers (112)
Industrial managers who opposed Boris Yeltsin’s shock therapy policies

Regional firms (104)
State-owned firm controlled by Soviet subnational governments

Resource curse (117)
Negative effects associated with discovering natural resources

Sabotage (106)
Intentionally causing damage for personal gain, Soviet managers accused
of this could be sentenced to death

Sequencing reform (108)
Choosing easier political reforms

Shadow economy (107)
See “black market”

Shortage economy (107)
A state of persistent high scarcity of goods and services

Small firms (113)
Category established by the State Committee on Property under Boris
Yeltsin, consists of under 200 employees

Socialism (104)
A theory that supports public ownership of an economy’s means of
production

Socioeconomic stratification
(112)
Hierarchy of classes based on social and economic status

Stagflation (110)
High unemployment and inflation

State coffers (104)
State treasuries holding government revenues

State-owned firms (104)
One form of property under the Soviet system, huge mostly heavy
Economics Power Guide | 146
industrial firms, includes social services, consists of national and regional
firms

Upward flow of information
(106)
The process of lower levels of the Soviet economy sending
recommendations on target output to higher levels during the plan
drafting process
EVENTS

Great Depression (57, 91)
Lasted from August 1929 to 1933 (43 months); most severe episode of
economic decline observed to date; during this time, real GDP declined
by nearly 25%

World War II (60)
Lasted from 1941 to 1945; featured high inflation; provided an impetus
for the U.S. to perfect methods of measuring national output

Russian Civil War (104)
Civil war fought in Russia between the Bolsheviks and anti-Bolsheviks
PEOPLE

Aslund, Anders (113)
Stated that in an efficient market economy, no less than 2/3 of national
employment must exist in the private sector

Boskin, Michael (71)
In 1996, he was assigned to head a committee to review the methods
used to calculated the CPI

Coase, Ronald (50)
Reached the insight that the private market ought to be able to resolve
externalities, as long as the parties involved can negotiate and property
rights are clearly defined

Colton, Timothy (107)
Stated that the Soviet Union’s bureaucratic planners needed to
computerize and robotize their jobs but had trouble anticipating the
need for it

Hanson, Philip (117)
Stated that, “It is by their indirect effects, … that oil and gas price rises
fuelled Russian growth.”

Ford, Henry (76)
Introduced the assembly line

Gaidar, Yegor (111)
Primary author of the “shock therapy” reform enacted by Boris Yeltsin,
acting prime minister of Russia under Yeltsin

Gontmakher, Evgeny (117)
Analyst; commented on Russia’s experience with the resource curse. He
stated, “This is all a result of incorrect economic policy, oil dependence,
and rampant corruption, Until the system changes, these problems will
persist.”

Gorbachev, Mikhail (107)
General Secretary of the Community Party of the Soviet Union from
1985 to 1991

Keynes, John Maynard (95)
British economist; lived from 1883 to 1946; wrote the 1936 book The
General Theory of Employment, Interest, and Money

Kornai, Janos (104)
Economist; stated that the distinction between Soviet national and
regional firms was meaningless because national governments strictly
controlled regional governments

Kuznets, Simon (67)
Economist; commissioned by the U.S. Department of Commerce in
1932 to develop a system to measure national output; received the
Nobel Prize in Economic Science for 1971
Economics Power Guide | 147

Lenin, Vladimir (104)
Head of the Bolshevik Party before Joseph Stalin

Medvedev, Dmitri (119)
Russia’s president from 2008 to 2012

Okun, Arthur (95)
One of President Kennedy’s chief economic advisors in the early 1960s

Pareto, Vilfredo (8)
Italian economist (1848-1923); first came up with the concept that an
outcome was efficient only if there was no way to improve someone’s
well-being without reducing someone else’s well-being

Petty, Sir William (67)
In the mid-17th century, attempted to measure British national output
to assess the ability of the Irish to pay taxes

Polevanov, Vladimir (114)
Russia’s Minister of Privatization during Boris Yeltsin’s presidency,
halted Yeltsin’s second stage of privatization, advocated renationalization of some firms

Putin, Vladimir (117)
Russia’s president from 2000 to 2008

Schumpeter, Joseph (46)
Economist; described impact of entrepreneurs as “creative destruction”

Shatalin, Stanislav (110)
Economist and Gorbachev advisor; helped produce the 500 Day Plan

Smith, Adam (6)
Economist and author of the 1776 An Inquiry into the Nature and
Causes of the Wealth of Nations

Stalin, Joseph (104)
Vladimir Lenin’s successor as head of the Bolshevik Party, collectivized
agriculture in the Soviet Union in the late 1920s and 1930s

Xiaoping, Deng (108)
Leader of China in the early 1980s, often compared to Gorbachev

Yavlinsky, Grigori (110)
Economist; helped produce the Five Hundred Day Plan

Yeltsin, Boris (110)
President of Russia 1991-2000, Russia’s first popularly elected president
ORGANIZATIONS

Bolshevik Party (104)
Faction that came to power after the Russian Civil War, eventually
became the Communist Party of the Soviet Union

Central Committee of the
Communist Party (105)
Approved plans

Communist Party of the Soviet
Union (104)
Presided over the Soviet Union, formerly the Bolshevik Party

Council of Ministers (105)
Enacted plans

Gazprom (118)
Russia’s largest company, largest natural gas extractor in the world, also
controls companies many other sectors such as media and finance

Goskomimushchestvo (113)
See State Committee on Property

Gosplan (105)
See State Committee of Planning

International Monetary Fund
Known as IMF; transnational organization that offered Russia loans

Politburo (109)
Executive committee of elite communist party officials

Rosneft (118)
Russia’s largest oil company, mostly state-owned

Sibneft (118)
The oil branch of Gazprom, fifth largest oil company in Russia, now
called Gazpromneft

State Committee of Planning
Devised plans to manage the Soviet economy

State Committee on Property
Classified and oversaw firms eligible for privatization under Boris Yeltsin
Economics Power Guide | 148

Yukos (118)
Russian petroleum company that failed to merge with Sibneft and
declared bankruptcy in 2006
TEXTS

The General Theory of
Employment, Interest, and
Money (95)
Work published by John Maynard Keynes in 1936; developed an
explanation for short-run economic fluctuations to respond to the
inadequacy of the microeconomic model
MISCELLANEOUS

Boskin Commission (71)
Acted in 1996; group headed by economist Michael Boskin to review
the CPI and determine how much CPI overstated price inflation (1.3%)

BRIC (119)
Abbreviation for rapidly rising markets of Brazil, Russia, India, and China

Chicago Mercantile Exchange
An example of a highly organized market

DeBeers company (43)
Company that until recently owned 80% of diamond mines

Five Hundred Day Plan (110)
Reform plan by a group of economists who sought to emulate Poland’s
successful economic shock therapy, rejected by Mikhail Gorbachev

NASDAQ (77)
An example of an organized stock exchange

National Prosperity Fund (118) One of the two parts the Stabilization Fund was divided into in 2008

New York Stock Exchange
(NYSE) (10, 77)
An example of an organized stock exchange

Nobel Prize in Economic
Science (67)
Simon Kuznets received this award in 1971 for his contributions to the
measurement of national production

Organization of Petroleum
Exporting Countries (OPEC)
A cartel formed between oil-producing nations (most in the Middle
East) to influence the price of oil worldwide

Reserve Fund (118)
One of the two parts the Stabilization Fund was divided into in 2008

Russian Federation (110)
Title adopted by Russia after the fall of the Soviet Union

Sherman Anti-Trust Act (44)
Passed in 1890 to increase market competition

Skol’kovo (120)
Name of Russian Silicon Valley constructed under Dmitri Medvedev

Stabilization Fund (118)
A fund established in 2003 to store extractive resource tax revenues to
handle future inflation or support the ruble’s value, broken into the
Reserve Fund and National Prosperity Fund in 2008

U.S. Department of Commerce In 1932, commissioned Simon Kuznets to develop a system to measure
(67)
national output
Economics Power Guide | 149
POWER EQUATIONS
MICROECONOMICS
% change in QD
Price elasticity of demand
E=

Price elasticity of supply
E=

General equation
E=

General maximization
condition
Marginal revenue = marginal cost

Profit maximization for firms
Price = marginal cost

Average total cost
Average Total Cost =
% change in P
=
(QD1 - QD 0 ) ÷ QD 0 )

(P1 - P0 ) ÷ P0
% change in QS (QS1 - QS 0 ) ÷ QS 0 )
=
% change in P
(P1 - P0 ) ÷ P0
% change in dependent var iable
% change in independent var iable
MR = MC
Total Fixed Costs + Total Variable Costs
Total Number of Units Pr oduced
MACROECONOMICS

Gross domestic product
Y = C + I + G + NX

CPI (to find inflation)
CPI =

GDP Deflator (relation to
nominal and real GDP)
Re al GDP =

GDP Deflator
GDP deflator =

Money supply

Money multiplier

Equation of exchange
(quantity theory of money)
Basket price in year t
Basket price in base year
× 100
No min al GDP
so GDP Deflator =
GDP Deflator
No min al GDP
Re al GDP
× 100
Money supply
= deposits + C
=
M-C
R
MM =
+C=
1
RR
MV = PQ
R ×C+M-C
R
=
M + (R - 1) × C
R
No min al GDP
Re al GDP
Economics Power Guide | 150
PRACTICE TEST ANALYSIS
Of the first 40 questions (Sections I-III), 15 (37.5%) are vocabulary questions, 10 (25%) test facts and
concepts verbatim, 5 (12.5%) require matching a term to an example, 5 (12.5%) test applying concepts to
models, 4 (10%) are math problems, and 1 (2.5%) asks a specific question about the U.S. economy. With
this in mind, I recommend you spend most of your time solidifying your ability to define and understand
terms. Then, expand your knowledge of each term by applying the concepts and models to which they
relate. I will provide more detailed explanations of the 25% of this portion which consists of application,
math-based, and oddball questions followed by a brief breakdown of the last 10 questions (Section IV).
Before we go through the sections, I have a few broad tips. Use questions with two-part answers (which
most professional test-writers avoid for this exact reason!) to your advantage. Eliminate the answer choices
that don’t fit in the first blank. Then do the same for the second (and third, etc.). Draw out models
whenever you can to help you visualize concepts. Lastly, read the answer choices before you work out a
time-consuming problem; there might be an easier way.
The first 5 questions (1-5) cover Section I: Fundamental Economic Concepts. These questions test your
understanding of vocabulary in a straightforward way. Prepare for these questions by memorizing the
definitions of all the assumptions.
The next 20 questions (6-25) are the largest chunk of the test and cover Section II: Microeconomics. This
section contains a mix of all the types of questions above. It also contains all of the math problems for the
entire test. These require two mental steps: identifying the equation in question and solving it. The first
step often poses a larger problem than the second. On a timed test, skip these questions and come back if
you have trouble figuring out how to solve them. I will run through how to solve a couple particularly
math-based questions and one application question.
Question 11 looks tricky on the surface, but once you figure out what the question is actually asking, the
answer is obvious. The first step to answering this question is knowing to set Q(S) equal to Q(D). The
second is solving the equation. Some quick test takers might also notice that using process of elimination
can easily crack this question. Since Q(S) is a vertical line at 6, Q(D) has to intersect Q(S) at Q = 6. The
only answer choice containing Q = 6 is the correct answer, A. Question 13 repeats the same concept but
re-arranges the equation. Plugging in the P value of 30 shows you that Q(S) = 60. Since we are setting
Q(S) equal to Q(D), Q(D) must also equal 60. Plugging 30 into all of the answer choices until one choice
equals 60 shows that E is the correct answer.
Question 15 requires you to apply elasticity to a model. Prepare for questions like these by understanding
how every concept fits on a model. Memorize what each axis represents and draw them out on your tests.
This is the easiest and most effective way to answer application problems. For this question, memorize the
different levels of elasticity and how they fit into the models on Figures 13 and 14 on page 27.
The next 15 questions (26-40) cover Section III: Macroeconomics. This section is broad but more
straightforward than microeconomics. Most questions test vocabulary and very few require application.
Question 26 is a curveball. I’m not sure if USAD meant to test the text, which gives the average output in
2008 (the question asks about 2007) or Figure 31, which shows a line graph of output per capita from
1900 until 2008. Either way, $45,000 comes closest to the correct answer. Don’t spend too much time
memorizing these minor facts since this kind of question only appeared once in the entire test.
Economics Power Guide | 151
Question 36 requires understanding the difference between aggregate demand and quantity demanded.
Remember that changes in the price of the goods in one market affect quantity demanded or quantity
supplied, not aggregate demand or aggregate supply. This type of distractor will probably show up at least
once on each test later on, so know the difference!
Question 40 requires the application of concepts to a model. You should be able to eliminate B and E
right off the bat because nothing (at least in the resource) causes the supply curve to rotate. For future
reference, nothing will cause the supply curve to do anything (like steepen, flatten, etc.) but shift, so you
can eliminate those choices as distractors. Remember that increases in supply (such as a positive supply
shock) shift the curve right and vice versa.
The last 10 questions (41-50) cover the Russian economy. All of these questions test fill-in-the-blank
factual information verbatim from the resource. Only one of the 10 questions tests information from after
the fall of the Soviet Union. Even though Section IV covers pages 104-121, half the questions come from
pages 104-107, about the mechanics of the Soviet system. Spend most of your time studying the details of
this portion of the guide. But also have a firm grasp on each Russian leader’s reforms and the effects of
these reforms. There may not be as many questions on post-Soviet Russia, but the questions are specific.
Q#
Topic
USAD PG.
Q#
Topic
USAD PG.
1
Scarcity I
6
26
U.S. economy III
58, 59
2
Opportunity cost I
7
27
Business cycle III
60
3
Pareto efficiency I
8
28
Trade surplus and deficit III
62
4
Positive economics I
7
29
Capital goods vs. intermediate goods III
65
5
Microeconomics and Macroeconomics I
8
30
Real GDP vs. nominal GDP III
68
6
Markets II
10
31
Abbreviations CPI and BLS III
69
7
Income and shifts in the demand curve II
15
32
Types of expenditures included in GDP III
67
8
Substitutes and shifts in the demand curve II
15
33
Labor force III
71
9
Market supply curve II
15
34
Types of unemployment III
72
10
Shifts in the supply curve II
17
35
Equity finance vs. debt finance III
77
11
Calculating equilibrium II
19
36
Aggregate demand vs. quantity demanded III
97
12
Law of demand II
12
37
Contractionary vs. expansionary policy
Fiscal vs. monetary policy III
101
13
Calculating equilibrium II
19
38
Aggregate supply curve III
99
14
Calculating demand elasticity II
25
39
Quantity equation III
101
15
Graphing elasticity II
27
40
Shifts in the aggregate supply curve III
99
16
Price floors II
34
41
Introduction IV
104
17
Deadweight loss II
34
42
Soviet industry size IV
104
18
Comparative advantage II
39
43
Soviet manager incentives IV
106
19
Comparative advantage II
39
44
Black market IV
107
20
Oligopolies II
45
45
Soviet manager incentives IV
107
21
Diminishing returns II
41
46
Anti-alcohol campaign IV
108
22
Marginal cost II
41
47
Boris Yeltsin IV
110
23
Four types of goods II
53
48
Soviet system IV
111
24
Positive externalities II
48
49
Resource curse IV
117
25
Government corruption II
55
50
Shock therapy IV
111
Economics Power Guide | 152
ABOUT THE AUTHOR
In her lifetime, Catherine Tran has donned black, brown,
blonde, red, and pink hair. This picture shows the result of
what might have been her most impulsive decision ever, next to
joining Academic Decathlon.
Cat competed as an Honor on the 2011 Seven Lakes High
School Academic Decathlon team. She joined the team to feed
her deranged love for studying and test-taking (and to get a
hockey jersey with her name on it). She credits AcDec 178 for her
ability to make it through her first year of college without
falling into a pit of confusion, tears, and stress eating. She
credits Tiesto for her ability to make it through AcDec.
You can normally find Cat in the library simultaneously studying and boogying to dance music through
her headphones. Cat will enter her sophomore year at the University of Texas at Austin this fall. She
studies philosophy and religious studies with aspirations for law school. During her first year of college,
she tutored underprivileged children for a non-profit organization called Learn to Be. She also directed the
Disarmament and International Security Committee at the Central Texas Model United Nations
Conference and will moderate Human Rights Council in October.
Her hobbies include writing about social and political issues, baking, shopping, going to concerts, playing
violin, dancing, making music mash-ups, befriending minor celebrities, dying her hair, and accidentally
leaving her former AcDec coach two-minute voicemails of her rapping to Nicki Minaj. She highly
recommends reading Bossypants by Tina Fey, The Unlikely Disciple by Kevin Roose, and The Grapes of
Wrath by John Steinbeck 179.
If you want to hear her mash-ups, talk about Breaking Bad or Game of Thrones, or ask a difficult moral
question, shoot her an E-mail at [email protected]. She would love to hear from you!
Vital Stats





178
179
Competed with Seven Lakes High School at the Texas State competition in 2011
Team placed 2nd at State with a score of 48,862
Achieved an 8,382 individual score at State
Decathlon philosophy in a phrase: “It’s like mental weight-lifting.”
Joined DemiDec in June 2012
Yes, I do omit the second “a.” Sorry, I’m not sorry.
I got to read this three times when I was a decathlete, yippee!