Principles of Economics

Commodity Money

An item that is used as money, but which also has value from its use as something other than money

Quiz: A seller has 10 hours to either bake cakes or make holiday ornaments to sell at the local farmers market. The seller is currently producing at a point on their production possibility frontier. Which decision is both attainable and efficient?

Producing less of one good and more of the other good This is the correct mix that is both attainable and efficient.

To Decrease Money Supply

1. The Fed sells securities to banks 2. Increase required reserve ratio 3. Raise the discount rate 4. Raise interest paid on reserves

Federal Budget

Government spending covers a range of services provided by the federal, state, and local governments. When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit. Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, the government is said to have a balanced budget. Whether a nation runs a budget deficit or a surplus depends on decisions about spending and taxes, as well as economic conditions. For example, in 2009, the U.S. government experienced its largest budget deficit ever, as the federal government spent $1.4 trillion more than it collected in taxes. This deficit was about 10% of the size of the U.S. GDP in 2009, making it by far the largest budget deficit relative to GDP since the mammoth borrowing used to finance World War II. There were two reasons for this deficit. First, the nation was in the midst of a severe economic downturn. Even with no policy changes, when there is high unemployment and slumping output, tax revenues will decrease. Additionally, transfer payments increase as incomes fall, and more people qualify for assistance. Economic downturns make a nation's budget situation worse. Next, to combat the recession, the government engaged in an expansionary fiscal policy, purposefully reducing taxes and increasing spending. The combination of automatic stabilizers and discretionary budget changes produced a massive deficit. To gain an understanding of the forces driving government budget outcomes, it is helpful to examine trends in government spending and government taxes separately. This helps pinpoint the impact of specific budget policies on the overall budget in the context of existing economic conditions. To investigate government spending behavior over time, it is useful to look at data on federal spending, expressed as a share of GDP. This removes the normal expenditure growth arising from increases in population, prices, and wealth, making it possible to identify trends in federal spending that have been driven by Congressional decision-making in light of changes in economic conditions. The top line in the figure above shows the level of federal spending since 1960, expressed as a share of GDP. Despite a widespread sense among many Americans that the federal government has been growing steadily larger, the graph shows that federal spending has hovered in a range from 18% to 22% of GDP most of the time since 1960. The other lines in the figure show the major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, you can see that national defense spending as a share of GDP has generally declined since the 1960s, although, there were some upward trends in the 1980s buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percentage of GDP. Healthcare expenditures include both payments for senior citizens (Medicare) and payments for low-income persons (Medicaid). Medicaid is also partially funded by state governments. Interest payments are the final main category of government spending shown in the figure. These four categories—national defense, Social Security, healthcare, and interest payments—account for approximately three-quarters of all federal spending. The remaining quarter covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for the poor; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government.

Negative Externality

A cost that is suffered by a third party as a result of an economic transaction

Imperfect Information

A situation in which the parties to a transaction have different information, as when the seller of a used car has more information about its quality than the buyer. Imperfect information increases the risk of making bad consumption or production decisions and limits the willingness of buyers and sellers to participate in the market. Buyers make purchases based on their beliefs about the satisfaction that the good or service will provide. These beliefs are formed using available information. For many products, the only information buyers or sellers can access is imperfect or unclear. Consumers may regret a purchase made based on imperfect information, or they may avoid making a purchase when they do not have sufficient information. The presence of imperfect information in a market affects the behavior of buyers and sellers, alters outcomes, and causes inefficiency. To correct these problems, buyers and sellers have created mechanisms that allow them to make mutually beneficial transactions, even in the face of imperfect information. For a market to reach an efficient equilibrium, sellers and buyers must have full information about the product's price and quality. If there is imperfect information, transactions that would benefit both parties are less likely to be completed, and trades that are detrimental to one of the parties involved are more likely. Unfortunately, many economic transactions occur in situations where not all the information necessary to make an informed decision is known by the buyers and sellers. For example, consumers confront the problem of imperfect information when shopping online. A dress might look perfect in a picture, but there are many potential problems—size may be inaccurate, fabric quality is unknown, and fit can never be certain. In addition to worrying about the product, a consumer's information about the seller may also be imperfect. A seller might not provide the product or might not provide any customer service if there is a problem with the product. The more uncertainty is introduced, the less comfortable the consumer is with making a purchase. This situation is considered a market failure if a transaction that could have benefited both the consumer and producer does not happen because of imperfect information. It is also a market failure if either the buyer or seller suffers from making the trade. In some cases, one party, either the buyer or the seller, has more information about the product's quality or price than the other party. This is known as asymmetric information. Asymmetric information causes an imbalance of power. For example, consider the courier service owner Daniel Miller. Daniel has seen an increased demand for deliveries outside of the downtown area. He is having trouble meeting this demand on his Vespa scooter. Daniel knows that to expand his delivery services to areas beyond the city and still keep them fast, he needs a car. Right now, he can only afford a used car. Daniel does not know much about cars, but he has done his homework by reading online reviews, asking family and friends, and comparing different models. Daniel has even decided to pay a mechanic to inspect any car he is thinking about buying before making a final decision. Even after doing all this research, Daniel knows that he cannot be absolutely sure that he is buying a high-quality used car, and he could end up with a "lemon." Suppose Daniel finds two used cars of the same model that are very similar in terms of mileage, appearance, and age. One car costs $10,000, whereas the other car costs $10,600. Which car should Daniel buy? Daniel faces asymmetric information. Each seller likely knows more about the car's problems than he does and has an incentive to hide the information. After all, disclosing issues could lower the car's selling price. Asymmetric information makes it very difficult for Daniel to make the best decision about which car to purchase. Insurance markets suffer from another form of imperfect information. In this case, the seller does not know important things about the buyer. Insurance is used by households and firms to protect themselves against the detrimental financial effects of an adverse event. Insurance companies price their plans based on the probability of certain events occurring among a pool of people. Members of the group who then suffer a specified bad experience receive payments from this pool of money. Imperfect information about the characteristics and behavior of individuals makes it difficult to accurately price insurance products. It is difficult for an insurance company to estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident because, even within that group, some drivers will drive more safely than others. Thus, adverse events occur out of a combination of people's characteristics and choices that make the risks higher or lower and out of the good or bad luck of what actually happens. As can be seen from these examples, imperfect information complicates market transactions. The presence of imperfect information can lead to market failure, reducing the benefits produced through exchanges between consumers and producers. Imperfect information is when there is a lack of information available to buyers and sellers to make an informed decision in an economic transaction. Market equilibrium can only be achieved when there is full information available about price and quality of the transaction. This imbalance leads to inefficiency. Asymmetric information is when one of the parties, either the buyer or seller, has more information than the other party involved. To alleviate the effects of imperfect information, money-back guarantees, warranties, and service contracts are offered to buyers to assure them of product quality.

Economic Indicators

A statistic about an economic activity

Economic Rent

Any payment for a factor of production in excess of the minimum required to supply that factor. It is considered excessive payments beyond what is economically necessary.

Quiz: What is a benefit of a government being able to run a deficit?

Economic stabilization The government can strategically use deficits to stabilize economies.

Summary

In the long run, all costs are variable. This makes it possible for a firm to consider changing the quantities of all its factors of production. Firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, to produce at the lowest possible LRAC. Firms can choose a production process with lots of labor and not much capital if labor is cheaper than capital, or vice versa if labor is more expensive than capital. The second choice a firm has, in the long run, is the scale or overall size of its operations. A firm may choose to expand, contract, or even go out of business if the endeavor is unprofitable. Economies of scale refer to a situation where the cost per unit is less expensive the more that is produced. A firm's ability to exploit economies of scale is limited by the market's demand for its products. The LRAC curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. If the LRAC curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be of the same size. If the LRAC has a flat segment at the bottom, so that a range of different quantities can be produced at the lowest average cost, the firms competing in the industry will display a range of sizes. If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the LRAC curve where the cost of production is lowest, many firms will compete in the market. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm. According to the theory of the firm, the goal of all firms is to make money. With this in mind, evaluating costs and revenue is essential to determine how much profit has been earned. Both economists and accountants analyze firms' profits, but they use the information for different purposes. An accountant wants to know exactly how much profit the firm earned for paying taxes and evaluating cash flows. An economist wants to know if the firm's owners are satisfied with the amount of profit earned. For that reason, accounting profit only considers explicit costs while economic profit also considers lost opportunity costs. When evaluating costs, firms consider the most cost-effective production method in both the short run and the long run. The short run is defined as a period in which at least one input to production, commonly the firm's plant, is a fixed cost. Having a fixed cost limits the range of possible responses when the output does not fall into the predicted range. The long run is defined as a period when all costs are variable, and therefore, any input to production can be altered. Firms use cost information to make output decisions. They decompose the total cost into its two components: variable cost and fixed cost. In addition to considering total cost, the firm also examines average cost and marginal cost. The average cost is useful because it provides a per-unit measure of cost that can be compared to price. The marginal cost is useful because it identifies the change in cost associated with a change in output. It is used by the firm to determine whether further production will increase or decrease overall profit. Evaluating both short-run and long-run costs helps a firm make decisions that lead to higher profits. The shape of long-term curves can help firms gather information about the competitive space for future planning.

Money Market Funds

The deposits of many investors are pooled together and invested in a safe way like short-term government bonds

Debit Card

Like a check, it is an instruction to the user's bank to transfer money directly and immediately from your bank account to the seller

Quiz: Which economic framework would a student use to explain past price changes in a specific industry?

Microeconomic analysis focuses on pricing as it relates to a specific company or industry.

Quiz: Which economic reasoning is used in deciding among public policy goals?

Normative statements deal with fairness and are often an important consideration of public policy.

Which statement represents an implicit cost?

Owner's time and effort The owner's time and effort is not something that requires outflow of cash from the organization, which makes it implicit.

A Budget Constraint

Represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. The budget constraint shows the combinations of two goods that a person can purchase given a limited income.

Starting Point

Starting point from which changes in prices are measured

Securities

Stocks and bonds

Smart Card

Stores a certain value of money on a card and then the card can be used to make purchases

Unit of Account

The common way in which market values are measured in an economy

How should the the four-firm concentration ratio be calculated?

The market share of the four largest firms in an industry are added together. This is the calculation for a four-firm concentration ratio.

Deficit Spending

A government practice of spending more than revenue collected in a given budget year

Cartels

A group of firms that collude to produce the monopoly output and sell at the monopoly price

Thin Market

A market with few buying or selling offers

Thick Market

A market with many buying or selling offers

Aggregate Demand-Aggregate Supply (AD-AS) Model

A model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level

Adverse Selection

A process in which markets deteriorate when buyers and sellers have access to different or imperfect information; also known as asymmetric information.

Quiz: The national government has begun a new deficit spending program that it hopes will increase domestic spending on goods and services. Which effect will this action have?

A right shift in the aggregate demand curve An increase in government spending would increase aggregate demand, resulting in a right shift of the aggregate demand curve.

Business Cycles

A series of growing and shrinking periods of economic activity measured by increases and decreases in GDP

Economics Models

A simplified version of reality that allows people to observe, understand, and make predictions about economic behavior

Moral Hazard

A situation in which a party will take risks because the costs that are incurred will not be felt by the party taking the risk

Reducing the Risk of Imperfect Information

Imperfect information can easily cause a decline in the prices or quantities of products sold. However, buyers and sellers also have incentives to create mechanisms that help them make mutually beneficial transactions, even in the face of imperfect information. For example, buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality. In the goods market, the seller of a good might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it. L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. L.L. Bean started using money-back guarantees in 1911 when the founder stitched waterproof shoe rubbers together with leather shoe tops and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, 90 pairs were returned. L.L. Bean took out a bank loan, repaired all the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back guarantees for a few weeks or months, but L.L. Bean offers a complete money-back guarantee. Anything you have bought from L.L. Bean can always be returned, no matter how many years later or what condition the product is in, under a full money-back guarantee. The combination of a money-back guarantee and a reputation for quality helped the firm overcome the problem of imperfect information inherent to mail order sales. Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain period of time. The seller may also offer a buyer a chance to buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often used with large purchases such as cars, appliances, and even houses. Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the cost of a ticket to a customer who walks out complaining about the show. Likewise, although restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied. Consider how a warranty might influence Daniel's car buying decision. Though he perceived the more expensive car to have higher quality, the seller of the less expensive car could convince him to purchase that car by offering a warranty. Daniel wants a quality car because he does not want to risk buying a car that will incur lots of unexpected costs by breaking down. The warranty reduces Daniel's risk of damages by shifting the burden of these costs from Daniel to the seller. It also encourages Daniel to improve his perception of the car's quality. Knowing that the seller is also cost averse, his or her willingness to offer an extended warranty suggests confidence in the quality of the product. In this way, warranties help sellers reduce buyer reluctance caused by imperfect information. The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others; as such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer's market, where the buyer may never see the seller again.1

Quiz: Which form of spending contributes the greatest amount to gross domestic product (GDP) in the United States?

Consumption expenditures For the United States, consumption expenditures on final goods and services greatly exceed all other spending and accounts for around two-thirds of the value of GDP.

Quiz: Which action is taken by the Federal Reserve to increase the money supply?

Decrease the interest paid on reserves Because banks will be receiving a lower interest rate, they will hold less cash and instead lend that money out.

Demand Elasticity

How responsive the quantity demanded is to a change in price in percentage terms

Quantity Demanded

Quantity demanded is the specific quantity consumers choose to purchase at a particular price.

Quantity is measured on the:

Quantity is measured on the horizontal axis.

Revenue Tariffs

Revenue tariffs are tariffs levied to raise revenue for the government.

Quiz: An economist is doing research to consider the total gains, both private and external, that result from making particular investments. What is this economist identifying?

Social benefit is the sum of both private and external benefits resulting from a decision.

Quiz: What is the outcome when the price is above the equilibrium?

Suppliers will produce more than the quantity demanded, and a surplus will exist. Suppliers will overproduce if they think they can get a higher price.

Protective Tariffs

Tariffs to protect a domestic industry by making imported goods more expensive than equivalent goods produced domestically Protective tariffs are tariffs levied to reduce imports of a product and protect domestic industries.

Scarcity Shown on the PPF

The PPF depicts the impact of scarcity by providing a clear demarcation between the set of attainable and unattainable outputs. Combinations found on the PPF are both efficient and attainable. Options on or below the production possibilities frontier are attainable, and options above the production possibilities frontier are unattainable. It is the existing resource and technology limitations that establish this productive boundary. This means that changes in these limiting conditions can alter the available output choices. Loosening resource or technology limitations expands production options, making some previously unattainable options attainable.

How to produce it:

There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled workers or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new raw materials or recycled raw materials to make their products?

Equilibrium

A state where supply and demand are balanced and, in the absence of external influences, the price and quantity will not change

Opportunity Set

All possible combinations of consumption that someone can afford given the price of goods and the individual's income

Production Technologies

Alternative methods of combining inputs to produce outputs

The Concentration Ratio

An early tool to measure the degree of monopoly power in an industry, which measures the share of the total sales in the industry that are accounted for by the largest firms, typically the top four to eight firms Regulators have struggled for decades to measure the degree of monopoly power in an industry. An early tool was the concentration ratio, which measures the share of the total sales in the industry that is accounted for by the largest firms, typically the top four to eight firms. Imagine that the market for replacing broken automobile windshields in a certain city has 18 firms with the market shares shown in the following table. The market share is each firm's proportion of total sales in that market. The four-firm concentration ratio is calculated by adding the market shares of the four largest firms—in this case, 16 + 10 + 8 + 6 = 40. This concentration ratio would not be considered especially high because the largest four firms have less than half the market.

Price Elasticity

An economic measure of the change in the quantity demanded or purchased of a product in relation to its price change. Price elasticity measures the responsiveness of quantity demanded or quantity supplied to a change in price in percentage terms. Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in the quantity demanded (or supplied) divided by the percentage change in price. Elasticity can be described as elastic (quantity is very responsive), unit elastic (equal change in quantity), or inelastic (quantity is not very responsive). Price elasticity is the ratio between the percentage change in price and the corresponding percentage change in the quantity demanded or supplied. The degree of elasticity can be elastic, inelastic, or unitary.

Supply refers to:

Supply refers to the entire set of possible price-quantity combinations that exist when all other things are constant.

Which description illustrates a monopoly's pricing strategy?

Consumer demand constrains price. A monopoly is constrained by the highest price consumers are willing to pay at each quantity.

Trade and Wages

Even if trade does not reduce the number of jobs, it could affect wages. Here, it is essential to separate issues about the average level of wages from issues about whether the wages of individual workers may be helped or hurt by trade. Because trade raises the amount that an economy can produce by letting firms and workers play to their comparative advantage, trade will also cause the average level of wages in an economy to rise. Workers in industries with a competitive advantage will be in higher demand, which will increase wages in that labor market. By contrast, barriers to trade will reduce the average level of wages in an economy. However, even if trade increases the overall wage level, it will still benefit some workers and hurt others. Workers in industries that are confronted by competition from imported products may find that demand for their labor decreases, lowering their wages decline with a rise in international trade. Conversely, workers in industries that benefit from selling in global markets may find that demand for their labor shifts to the right, so trade raises their wages. One concern is that while globalization may benefit high-skilled, high-wage workers in the United States, it may also impose costs on low-skilled, low-wage workers. After all, high-skilled U.S. workers presumably benefit from increased sales of sophisticated products like computers, machinery, and pharmaceuticals, in which the United States has a comparative advantage. Meanwhile, low-skilled U.S. workers must now compete against extremely low-wage workers worldwide for making simpler products like toys and clothing. As a result, the wages of low-skilled U.S. workers are likely to fall. There are, however, a number of reasons to believe that, while globalization has helped some U.S. industries and hurt others, it has not focused its negative impact on the wages of low-skilled Americans. First, about half of U.S. trade is intraindustry trade. That means the U.S. trades similar goods with other high-wage economies like Canada, Japan, Germany, and the United Kingdom. For instance, in 2014, the U.S. exported over two million cars from all the major automakers and imported several million cars from other countries. Most U.S. workers in these industries have above-average skills and wages—and many of them do quite well in the world of globalization. Some evidence suggested that intraindustry trade between similar countries had a small impact on domestic workers, but later evidence indicates that it all depends on how flexible the labor market is. In other words, the key is how flexible workers are in finding jobs in different industries. Second, many low-skilled U.S. workers hold service jobs that cannot be replaced by imports from low-wage countries. For example, lawn care services, moving and hauling services, or hotel maids cannot be imported from countries long distances away like China or Bangladesh. Competition from imported products is not the primary determinant of their wages. The benefits and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy. However, the growth of international trade has helped raise the productivity of U.S. workers as a whole—and thus helped to raise the average level of wages. Finally, while the focus of the discussion here is on wages, it is worth pointing out that low-wage U.S. workers suffer due to protectionism in all the industries—even those that do not work in the U.S. For example, food and clothing are protected industries. These low-wage workers, therefore, pay higher prices for these basic necessities. As such, their dollar stretches over fewer goods.

Quiz: How will the arrival of a new company that generates high levels of pollution affect the economic environment?

It will generate negative externalities and increase social costs in the local community. Levels of pollution emitted into the community are characteristic of negative externalities and additional costs to society.

Supply

A fundamental economic concept that describes the total amount of a specific good or service that is available to consumers Supply refers to the entire set of possible price-quantity combinations that exist when all other things are constant. Supply represents the amount of a particular good a producer is willing and able to sell at a particular price. The law of supply states that there is a positive relationship between price and supply when all other things are held constant. In other words, as price increases, the quantity supplied increases and vice versa.

Wholesalers

A person or company that sells goods in large quantities at low prices, typically to retailers

Factors That Shift Demand

Income is not the only factor that causes a change in demand. Other things that shift demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. As shown in the following graph, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Take a closer look at the nonprice factors affecting demand. Changing tastes or preferences—The health advice that eating lean white meat like chicken instead of red meat like beef could lower your risk of heart attack impacted consumer behavior. From 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price. In the following graph, the increase in the preference for chicken shifted the demand curve for chicken rightward from D0 to D2. For beef, the decrease in demand is depicted as the leftward shift from D0 to D1. Changes in the composition of the population—The proportion of elderly citizens in the U.S. population is rising. It rose from 9.8% in 1970 to 12.6% in 2000 and will be projected (by the U.S. Census Bureau) to be 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services such as tricycles and daycare facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. In general, a larger population means greater demand for goods and services. Changes in demand caused by adjustments in the size or composition of the population are shown as shifts in the demand curve. Price of related goods—The demand for a product can also be affected by changes in the prices of related goods such as substitutes or complements. A substitute is a good that can be used in place of another good. Lowering the price of a substitute decreases demand for the other product. Consider the relationship between tablets and laptop computers. In recent years, the price of tablet computers has fallen, leading to an increase in the quantity demanded of tablets. How does a decrease in the price of a tablet affect demand for a laptop? People substitute away from laptops as they become relatively more expensive. Demand for laptops decreases, which is shown as a leftward shift of the demand curve for laptops. A higher price for a substitute good has the reverse effect. Goods can also be related as complements for each other. This means that the goods are often used together because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk, notebooks and pens or pencils, and golf balls and golf clubs. When the price of one good rises, demand for its complementary good decreases. For example, if the price of golf clubs rises, consumers buy fewer golf clubs. As a result, demand for a complementary good like golf balls decreases too. This is depicted by shifting the demand curve to the left, shown in the following graph as the movement from D0 to D1. If instead the price of golf clubs fell, the demand for a golf balls would increase, shifting the curve to the right—a movement from D0 to D2. Changes in demand, shifts in the demand curve, are caused by changes in consumer income, tastes, and preferences; the size of the population; prices of other good such as complements and substitutes; and expectations about the future.

Quiz: What are the governmental objectives of attempting to regulate the level of aggregate demand in the economy through its fiscal policy actions?

Price stability, full employment, and economic growth Price stability, full employment, and economic growth would curb inflation, lower the unemployment rate, and increase GDP.

The Effects of Imperfect Information

- Imperfect information can discourage both buyers and sellers from participating in the market, leading to inefficient outcomes. Several problems emerge as a result of this. The issues listed are identified and explored in greater detail here: 1. Buyers become reluctant to participate because they cannot determine the quality of a product. - Take the example of online shopping. When buying online, people have limited information about the product. (They are not able to touch it or examine the quality.) This can make buyers and sellers less likely to participate in the market. - A market with few buyers and few sellers is sometimes referred to as a thin market. By contrast, a market with many buyers and sellers is called a thick market. When imperfect information is severe and buyers and sellers are discouraged from participating, markets may become extremely thin. This is because a relatively small number of buyers and sellers attempt to communicate enough information to agree on a price. Thin markets have greater price volatility. With fewer participants, the balance between buyers and sellers can change quickly, substantially altering prices. 2. Markets have difficulty reaching equilibrium when consumers use price as an indicator of quality. - When facing imperfect information, buyers use the information available to draw conclusions about the quality of the product. Consider Daniel Miller, a car buyer. Facing the choice between two similar cars—one priced at $10,000 and the other at $10,600—he may interpret the price as a measure of quality. There are reasons to believe that price and quality are positively correlated. For example, an established dealership can benefit from having a reputation for selling only high-quality used cars. To maintain this reputation, the dealership must be selective about the cars they sell and inspect the vehicles before offering them to customers. This screening and maintenance increases the dealer's costs and may be reflected in the higher price. For this seller, the short-term benefits of selling their customers a low-quality car requiring a great deal of maintenance could cause a quick collapse in the dealer's reputation and a loss of long-term profits. - When buyers use the market price to draw inferences about the quality of products, markets may have trouble reaching an equilibrium price and quantity. Imagine a situation in which a used car dealer has a lot full of used cars that do not seem to be selling, so the dealer decides to cut the prices of the cars to sell a greater quantity. In a market with imperfect information, many buyers may assume that the lower price implies low-quality cars. As a result, the lower price may not attract more customers. Conversely, a dealer who raises prices may find that customers assume that the higher price means that cars are of higher quality. As a result of raising prices, the dealer might sell more cars. - The idea that higher prices might cause a greater quantity demanded and that lower prices might cause a lower quantity demanded is contrary to the basic model of demand and supply as discussed in previous lessons. These contrary effects, however, will reach natural limits. At some point, if the price is high enough, the quantity demanded will decline. Conversely, when the price declines far enough, buyers will increasingly find value, even if the quality is lower. In addition, information eventually becomes more widely known. An overpriced restaurant will not last forever. 3. Adverse selection results when sellers of high-quality or medium-quality goods opt to leave the market. - Asymmetric information can lead to adverse selection. This is a process by which uneven knowledge causes a decrease in the quality of either the goods provided or the type of buyer. This can happen in the health insurance market. Imagine that an insurance company sets a single price for an insurance plan and makes that plan available to a pool of interested buyers. Because there is imperfect information on the seller's side about the health of any particular buyer, the plan is priced based on the average medical expenses of people in the pool. -Although anyone in the pool can buy the coverage, the plan will be most attractive to people with the worst health. For them, the price will seem very reasonable. At the same price, the plan will not seem very desirable to the healthiest people in the pool. Those with the best health may choose to not buy health insurance. This tendency for healthy people to leave the market while less healthy people remain makes the average health of the pool worse. This worsening of the quality of buyers is adverse selection. It is a consequence of asymmetric information and creates lower market participation and higher prices for insurance products. 4. Insurance creates a moral hazard, leading to riskier behavior by the insured. - Moral hazard is also a result of asymmetric information. A moral hazard is a situation in which a person or firm is willing to take more risks because they are protected against the potential cost of risky decisions. Like adverse selection, moral hazard occurs in insurance markets and is caused by asymmetric information. The two problems differ in the type of information unknown to the insurer. In the case of adverse selection, the buyer's type is unknown. Is the buyer healthy or not? In the case of moral hazard, it is the buyer's behavior that is unknown. Will the buyer be cliff diving or leaving the stove on all day? Behaviors like these increase the likelihood of a claim. - The concern with moral hazard is that by protecting individuals and firms from the potential costs of risky behavior, they make that behavior more likely. For example, people knowing that they are insured could make a drive a bit less careful when backing up in a parking lot. Perhaps that driver is not as quick to shelter his or her car during a hailstorm if damage is covered by insurance. Small changes in driver behavior can be very expensive over a large number of drivers.

Quiz: Principle 5: Trade can leave everyone in a better position.

A farmer is really good at growing corn and exchanges the corn for meat and supplies. Principle 5 is about how trading can allow a producer to specialize in a single product or service.

M1 Money Supply

A narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler's checks

Indexed

A price, wage, or interest rate is adjusted automatically for inflation

Double Coincidence of Wants

A situation in which two people each want some good or service that the other person can provide

Oligopoly

An economic condition in which a small number of sellers exert control over the market of a commodity

Uses of GDP—Comparing GDP among Countries

As mentioned earlier, it is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, a country's GDP is measured in its own currency: The United States uses the U.S. dollar, most countries of Western Europe use the euro, Japan uses the yen, and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has almost three times as many people as Mexico and nine times as many people as Canada. If economists try to compare standards of living across countries, they cannot use straight GDP measures. They need to determine GDP per person. The U.S. economy has the largest GDP in the world by a considerable amount. The United States is also a populous country. In fact, it is the third largest country by population in the world. Is the U.S. economy larger than other countries because the United States has more people than most other countries or because the U.S. economy is larger on a per-person basis? Economists answer this question by calculating the country's GDP per capita; that is, the GDP divided by the population. GDP per capita =GDP / population Notice that the ranking by GDP is different from the ranking by GDP per capita. India has a larger GDP than Germany, but on a per capita basis, Germany has more than 10 times India's GDP per person. Based on the table, China has the second largest GDP of the countries: $9.5 trillion compared to the United States' $16.8 trillion. China has a much larger population; so, in per capita terms, its GDP is less than one-seventh of that of the United States ($6,958.48 compared to $53,013). The Chinese people are still quite poor relative to those in the United States and other developed countries. As a caveat, for reasons that will be discussed shortly, GDP per capita can only give you a rough idea of the differences in living standards across countries. The level of GDP per capita captures some of what is meant by the phrase standard of living. Most of the migration in the world, for example, involves people who are moving from countries with relatively low GDP per capita to countries with relatively high GDP per capita. Standard of living is a broader term than GDP. Where GDP focuses on production that is bought and sold in markets, standard of living includes all elements that affect people's well-being, whether or not they are bought and sold in the market. To illuminate the gap between GDP and standard of living, it is useful to describe some things that GDP does not cover that are relevant to standard of living. Whereas GDP includes spending on recreation and travel, it does not cover leisure time. However, there is a substantial difference between an economy that is large because people work long hours and an economy that is just as large because people are more productive with their time, so they do not have to work as many hours. As you saw in the previous table, the GDP per capita of the U.S. economy is larger than the GDP per capita of Germany, but does that prove that the standard of living in the United States is higher? Not necessarily, because it is also true that the average U.S. worker works several hundred more hours per year than the average German worker. Calculating GDP does not account for the German worker's extra vacation weeks. In certain cases, a rise in real GDP does not imply an improvement in well-being. If a city is wrecked by a hurricane and then experiences a surge of rebuilding construction activity, it may be peculiar to claim that the hurricane was, therefore, economically beneficial. If people are led by a rising fear of crime to pay for installing bars and burglar alarms on all their windows, it could be hard to believe that this increase in GDP has improved their well-being. Similarly, some people would argue that the sales of certain goods, like pornography or extremely violent movies, do not represent a gain to society's standard of living. Even though GDP does not measure the broader standard of living with precision, it does measure production well, and it does indicate when a country is materially more or less successful in terms of jobs and incomes. In most countries, a significantly higher GDP per capita occurs with other improvements in everyday life along many dimensions like education, health, and environmental protection. No single number can capture all the elements of a term as broad as standard of living. Nonetheless, GDP per capita can be a reasonable, simple measure of a country's standard of living.

Quiz: Why do economists refer to all resources as scarce even though many of the factors of production are plentiful in regard to the production possibility frontier?

Because resources are finite, there are trade-offs that must occur when companies or individuals make decisions regarding their wants or needs with their given resources to buy things. Resources are finite, so all people and businesses must make choices and trade-offs because they have finite money to buy or make what they want.

Trade

Buying and selling of goods and services on a market

Quiz: Country A and Country B can both produce butter and toys. Country A can produce either 5,000 pounds of butter or 10,000 toys. Country B can produce either 20,000 pounds of butter or 4,000 toys. What does this say about the countries' absolute advantage and comparative advantage?

Country A has both an absolute advantage and comparative advantage in the production of toys. Country A has the lowest opportunity cost in producing toys and can also produce more toys in absolute terms.

Quiz: Which concept refers to the amount of a good or service consumers both desire and are able to purchase at a variety of price levels and at a given time?

Demand is the amount of a good or service consumers will buy at a variety of prices.

Commodity-Backed Currencies

Dollar bills or other currencies with values backed up by gold or another commodity

Tracking Inflation

Dinner table conversations where you might have heard about inflation usually entail reminiscing about when everything seemed to cost less. The following table compares prices of some common goods in 1970 and 2017. The average prices in this table may not reflect the prices where you live. The cost of living in New York City is much higher than in Houston, Texas, for example. In addition, certain products have evolved over recent decades. A new car in 2017, loaded with antipollution equipment, safety gear, computerized engine controls, and many other technological advances, is a more advanced (and more fuel efficient) machine than your typical 1970s car. However, put details like these to one side for the moment and look at the overall pattern. The primary reason behind the price rises in the table is not specific to the market for housing, cars, gasoline, or movie tickets. Instead, it is part of a general rise in the level of all prices. For example, at the beginning of 2017, one dollar had about the same purchasing power in overall terms of goods and services as 18 cents did in 1972 because of the amount of inflation that occurred over that time period. The power of inflation does not affect just goods and services, but wages and income levels, too. The second to last row of the table shows that the average hourly wage for a manufacturing worker increased nearly sixfold from 1970 to 2017. The average worker in 2017 is better educated and more productive than the average worker in 1970—but not six times more productive. Per capita GDP increased substantially from 1970 to 2017, but is the average person in the U.S. economy really more than eleven times better off in just 47 years? Not likely. A modern economy has millions of goods and services whose prices are continually changing with supply and demand. How can all these shifts in price contribute to a single inflation rate? As with many problems in economic measurement, the conceptual answer is reasonably straightforward: Economists combine prices of a variety of goods and services into a single price index. The inflation rate is simply the percentage change in the price index. Applying the concept, however, involves some practical difficulties. To calculate the price level, economists begin with the concept of a price index that consists of a basket of goods and services that individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate a simple average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others. Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy. The numerical results of a calculation based on a basket of goods can get a little messy. To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, economists typically report the price level in each period as an index number rather than as the dollar amount for buying the basket of goods. Economists create many different price indices to calculate an overall average change in relative prices over time. To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base year or starting point from which changes in prices are measured. The base year, by definition, has an index number equal to 100. The inflation rate is calculated as the percentage change in the index number.1

Rent-Seeking

Economic rent is defined as receiving excess returns or income from resources that are in short supply. Economic rent has been applied to any situation where payment is made for a scarce resource in excess of the minimum required payment for its usage Another source of market power comes from the successful engagement of rent-seeking. Rent-seeking typically occurs when large firms lobby the state, local, or federal government for a direct transfer or to enact legislation that is usually designed to increase the barriers to entry. This has the result of codifying the established producers. The costs of widespread rent-seeking are numerous. The resulting lack of competition stifles innovation, encourages higher prices, and ultimately misallocates scarce resources. An even larger inefficiency comes from the resources wasted in the act to win political favor. It is important to recognize that large industries can have conflicting desires and motivations. For example, one major problem for entertainment production companies is online piracy. Imagine that they lobby policy makers to pass a bill that would crack down on internet providers and search engines that are used when pirating copyrighted material. Legislation of this sort could potentially pit giants like Paramount and Disney against Google and Comcast. Because these companies stand to lose considerably, they will expend a significant amount of resources (Schweizer, 2013). The industries combined can spend more resources than the total benefits to one of them. To see how this works, imagine that the U.S. Department of Housing and Urban Development (HUD) wants to give away $1 million for city development. Because HUD wants to give the money to the most deserving city, it asks petitioning cities to put together a proposal and submit it to them. HUD has turned the money giveaway into a competition. Those competitive forces are going to cause those cities to hire economists, proposal writers, illustrators, and photographers, so the proposal looks nice and is well written. The problem is that every city will do this. Even if it only costs $10,000, which is a modest proposal relative to the potential prize, and if only 100 cities do this, then the cities in the aggregate have wasted the total sum of the prize. In the aggregate, these situations can be incredibly inefficient. Notice that there was no assumption of nefarious behavior on the part of the HUD or the cities. Everyone was trying to do the right thing

Production Efficient

If the economy is operating below the curve, it is operating inefficiently because resources could be reallocated to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology, unless trade occurs. The PPF will shift outwards if more inputs (such as capital or labor) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, technology is reduced, or a natural disaster decreases the stock of physical capital.1 Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. When a country does not trade at all with other nations and consumes only goods it produces itself, it is called autarky. Trade enables consumption outside the PPF. When nations specialize according to their comparative advantage, they can produce more together than the sum of what they could produce without trade and specialization. In a free trade system, more is produced using the same resources because those resources are being used more efficiently.1

Maximizing Profit Using the Marginal Decision Rule

In economics, the goal of a firm is to maximize its profits. In other words, it wants to maximize the difference between its earnings or revenue and its spending or costs. To find the profit-maximizing point, firms look at marginal revenue (MR)—the total additional revenue from selling one additional unit of output—and the marginal cost (MC)—the total additional cost of producing one additional unit of output. When the marginal revenue of selling a good is greater than the marginal cost of producing it, firms make a profit on that product. This leads directly to the marginal decision rule, which dictates that a given good should continue to be produced if the marginal revenue of one unit is greater than its marginal cost. Therefore, the profit-maximizing solution involves setting marginal revenue equal to marginal cost.

Quiz: What is an advantage of a market economy?

Innovation is encouraged and rewarded. There is a lot of competition in a market economy, so innovation is rewarded.

Reasons for Trade

International trade is the exchange of capital, goods, and services across international borders or territories. Trading partners reap mutual gains when each nation specializes in goods and services for which it holds a comparative advantage and then trades for other products. In other words, each nation should produce goods and services for which it has a lower opportunity cost than other nations have. Lower opportunity costs mean that a country gives up less of one good when they increase the production of the another good. Trade allows nations to take advantage of each other's lower opportunity costs. In addition to comparative advantage, other reasons for and consequences of trade include the following: Differences in factor endowments—Countries have different amounts of land, labor, and capital. Saudi Arabia may have a significant amount of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for these resources. Gains from specialization—Countries may gain economies of scale from specialization, experiencing declines in long-run average cost as output increases. Political benefits—Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to global problems. Efficiency gains—Domestic firms will be forced to become more efficient to be competitive in the global market. Benefits of increased competition—A higher degree of competition leads to lower prices for consumers, better customer service, and a wider variety of products. It also promotes innovation.

Quiz: Which criterion must be satisfied to include capital as a physical good or intellectual discovery?

It has been produced already and is used for producing other goods and services. The resulting capital must actually be produced and also be useful for other goods and services.

What is the economic way of thinking?

It is a framework used to study how people make choices about production, distribution, and consumption of resources in an environment of scarcity. The economic way of thinking can help guide informed decisions about what, how, and whom to produce for. It also helps determine what, when, and how much resources to consume.

Surplus

Occurs when income earned exceeds expenses paid

Short-Run Aggregate Supply (SRAS) Curve

Positive short-run relationship between the price level for output and real GDP, holding the prices of inputs fixed

Changes in Supply - input costs

Producing goods must involve using resources, and each of these resources has a cost. These costs can include wages, electricity and fuel bills, or other items used to produce the good or service. As input costs change, the firm's cost of bringing the product to market will change. This alters the firm's supply decisions. Changes in supply (shifts in the supply curve) are caused by changes in prices of inputs, technology, expectations, number of sellers, and government policies and regulations.

Quiz: In the relevant price range, the market for gasoline has an absolute value of the price elasticity of demand equal to 0.5 and an absolute value of the price elasticity of supply equal to 0.8. Which side of this market is more responsive to price changes?

Sellers that are price inelastic The absolute value of the price elasticity of supply is greater than the absolute value of price elasticity of demand. In addition, the price elasticity of supply is less than one.

Competitive Advantage

Something that places a company or a person above the competition

Quiz: Which set of factors is the primary reason that the Phillips curve shifts?

Supply shocks and inflation expectations Supply shocks and inflation expectations cause the Phillips curve to shift since prices or behavior are adjusted. These adjustments make the curve move in ways that contradict traditional curve movements.

Technical Barriers to Trade

Technical barriers to trade are nontariff barriers to trade that refer to standards implemented by countries. Because these standards must be met before goods are allowed to enter or leave a country, they represent international trade barriers. Some examples include the following: Sanitary and phytosanitary measures: These are health standards for plants, animals, and other products and are designed to protect humans, animals, and plants from pests or diseases. Rules for product weights, sizes, or packaging Standards for labeling and testing products Ingredient or identity standards

Quiz: A supply curve is graphed with quantity supplied on the x-axis and price on the y-axis. How does technology affect this type of curve?

Technology affects the supply curve. New technologies will increase the amount of supply. When the supply for a product or service increases as a result of new technology, the supply curve will shift to the right.

Supply and Demand of Money

The Fed influences macroeconomic outcomes by changing the money supply and altering conditions in the money market. This market uses the M1 definition of money. Money demand identifies the quantities of cash, checkable deposits, and traveler's checks that individuals want to have at different nominal interest rates. Money supply identifies the quantity of those same liquid assets available at different nominal interest rates. The interaction of the money demand and the money supply generates an equilibrium interest rate.

Quantity Supplied (Qs)

The quantity of a commodity that producers are willing to sell at a particular price at a particular point of time

Positive Economics

The study of economics concerned with what is and what will happen if a course of action is taken or not taken

Money Supply

The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy

Inefficient

The underemployment of any of the four economic resources (land, labor, capital, or entrepreneurial ability); inefficient combinations of production are represented using a PPC as points below the PPC

Potential Downsides to Specialization

There are also some potential downsides to specialization. They are as follows: Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For example, firms in the United States may see demand for their products fall due to cheaper imports from China. This may lead to structural unemployment. Risk of overspecialization: Global demand may shift so there is no longer a demand for the goods or services produced by a country. For example, the global demand for rubber has fallen due to the availability of synthetic substitutes. Countries may experience high levels of persistent structural unemployment and lower GDP because the demand for their products has fallen. Strategic vulnerability: Relying on another country for vital resources makes one country dependent on another. This reliance can be exploited politically or economically. Workers who lose their job due to specialization and trade do not receive retraining or assistance with finding jobs in other sectors. As a result, these workers often cannot find work at the same level of pay as before. Another disadvantage of specialization and trade is that increasing returns to scale can cause specific industries to settle in a geographical area where there is no comparative advantage. These disadvantages mean some individuals will be left worse off by free trade, at least for a time. However, the benefits of free trade are shared by all, including those who face these disadvantages.8

Price Taker

A firm in a perfectly competitive market that must take the prevailing price as given

Protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas, or other barriers on imports

Market Structure

Defines a industry's characteristics in relation to the number of businesses in the industry and how they compete. A market structure is determined by the number of firms in a market, the ease with which a new firm can enter the market, and the extent of product differentiation. The four types of markets are perfect competition, monopolistic competition, oligopoly, and monopoly. The four markets sit on a continuum with perfect competition at one extreme and monopoly at the other.

Quiz: Two islands have begun trading goods. One island is larger than the other and has a vast forest of hardwood trees. The other island has few forests, but an abundance of iron deposits. Why should these two islands engage in trade?

Differences in factor endowments The two islands have different endowments of resources, so trading would be a benefit to both locations.

Quiz: Which situation is achieved when the quantity demanded and the quantity supplied of money are the same?

Equilibrium Equilibrium is when the supply of money and the demand of money are equal.

Quiz: Which key assumption does the aggregate supply curve require in the short run?

Input prices remain constant The assumption that the prices of factors of production remain constant is required when looking at the short-run aggregate supply curve.

Lesson Summary

International trade is the exchange of capital, goods, and services across international borders or territories. Importing brings goods into a country, and exporting sends them out. The balance of trade is exports minus imports. Free trade results in lower prices and more products for consumers, along with encouraging stronger international relationships and higher rates of efficiency for domestic producers. The work of the WTO in facilitating trade agreements has increased the level of free trade by reducing or eliminating trade barriers. Countries should import goods if the opportunity cost of producing them abroad is lower than the opportunity cost of producing them domestically. Exporting is the act of shipping goods out of the country. Firms that export can have access to a broader market and the ability to take advantage of economies of scale. The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period, measured in the currency of that economy.

What does the circular flow diagram illustrate?

Macroeconomic payments Macroeconomic payments are wages, salaries, and rents.

Lesson Summary

Many economic transactions are made in a situation of imperfect information when either the buyer, the seller, or both are uncertain about the qualities of what is being bought and sold. When information about the quality of products is imperfect, market outcomes will be inefficient. When confronted with imperfect information, buyers will rely on price to indicate the quality of products. As a result, markets may have difficulty reaching an equilibrium price and quantity. In high-quality or medium-quality goods markets with imperfect information, sellers find it difficult to demonstrate the quality of their goods to buyers. Since buyers cannot determine which goods have higher quality, they are likely to be unwilling to pay a higher price for such goods. Imperfect information can lead to riskier behavior due to moral hazard. Guarantees, warranties, and service contracts are used to mitigate the risk of imperfect information.

Standard of Deferred Payment

Money must also be acceptable to make purchases today that will be paid in the future

Monopolies and Society

Most people criticize monopolies because they charge too high a price, but what economists object to is that monopolies do not supply enough output to be allocatively efficient. To understand why a monopoly is inefficient, you can compare it with the benchmark model of perfect competition. Allocative efficiency is an economic concept regarding efficiency at the social or societal level. It refers to producing the optimal quantity of some output, the quantity where the marginal benefit to society of one more unit equals the marginal cost. The rule of profit maximization in all markets is MR = MC, where MR and MC are the marginal revenue and marginal cost of each unit, respectively. In the world of perfect competition, the price (P) is equal to marginal revenue. Thus, MR = P. This is due to the firm's demand curve being perfectly elastic. If the rule P = MR = MC is satisfied, then the result is allocative efficiency. If P > MR = MC, then the marginal benefit to society (as measured by P) is greater than the marginal cost to society of producing additional units, and a greater quantity should be produced. However, in the case of monopoly, price is always greater than the marginal cost at the profit-maximizing level of output. Thus, consumers will suffer from a monopoly because it will sell a lower quantity in the market, at a higher price, than would have been the case in a perfectly competitive market.10 The problem of inefficiency for monopolies often runs even deeper than these issues. There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can produce the same old products in the same old way while still gaining a healthy rate of profit. When AT&T provided all of the local and long-distance phone services in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. Some argue that the government split up of AT&T into several local phone companies, a long-distance phone company, and a phone equipment manufacturer created an explosion of innovation. Services such as call waiting, caller ID, three-way calling, voice mail through the phone company, mobile phones, and wireless connections to the internet all became available. Companies offered a wide range of payment plans as well. It was no longer true that all phones were black. Instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and a wave of innovation aimed at attracting and pleasing customers.10 However, it is not entirely clear that the dissolution of AT&T generated the explosion of new technologies or if AT&T acquiesced to their dissolution because the competition had already eroded several profit margins. Monopolies do charge above marginal cost, but they also tend to be the result of economies of scale. If they are indeed the result of economies of scale, then breaking them up can actually result in higher average costs. It is also important to note that even the monopoly has an incentive to reduce costs. Market Power: Price Maker Long-Run Economic Profit: Yes Efficiency: Least Allocatively and productively efficient Benefits to Society: Deliver services that have high fixed costs and may encourage innovation

Government

Noneconomic factors primarily guide spending by the government. However, at some point, even governments are sensitive to their economic surroundings. Interest rates affect borrowing by state and local governments to finance the construction of roads, schools, hospitals, prisons, libraries, sewer systems, and other public facilities. When interest rates fall, these governments may borrow more and increase their spending on long-term projects, shifting AD to the right. Higher interest rates will have the opposite effect on government purchases. For the most part, however, changes in government spending are determined independently of the factors that may influence spending by households and firms.2

Quiz: Individuals living in a country experiencing hyperinflation are spending much of their time traveling back and forth to the bank so they can hold less cash to battle the effects of inflation. Which term describes what this group is experiencing?

Show Leather Costs This is the total cost in dollars and time that people spend trying to avoid the negative effects of inflation. This is often managed by traveling back and forth to the bank.

Quiz: Which characteristic is associated with a command economy?

Since the government controls the essential industries, there is low domestic competition.

Asset

Something or someone of any value; any portion of one's property or effects so considered

Export Tariffs

Taxes on goods that are leaving a country

Human Capital

The accumulated skills and education of workers

Disposable Income

The amount of money that households have available for spending and saving after income taxes have been accounted for

Quiz: What are the two methods used to calculate the monopoly power of an industry?

The concentration ratio and the Herfindahl-Hirschman index

Total Revenue:

The income that a company receives from its normal business activities, usually from goods and services; defined as price times quantity Total revenue is the income the firm generates from selling its products. Business owners influence the amount of revenue they earn by making decisions about price and quantity. To calculate total revenue, multiply the price of the product by the quantity of output sold: Total Revenue = Price × Quantity

Quiz: Which description characterizes national debt?

The sum of previous years' deficits minus any previous years' surpluses National debt is not just the losses of one year, but the sum of all the previous deficits minus previous surpluses.

Price Elasticity of Supply

The responsiveness of the quantity supplied to a change in price, in percentage terms; calculated by taking the percentage change in the quantity supplied divided by the percentage change in price. The price elasticity of supply is the percentage change in the quantity supplied of a good or service divided by the percentage change in price of that good or service.

Quantity Demanded (Qd)

Total number of units purchased at a specific price

Nominal versus Real GDP

When examining economic statistics, understanding the distinction between nominal and real measurements is crucial. The difference stems from their treatment of inflation. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: Unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to decide if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced.

Expansionary Monetary Policy

When the central bank uses its tools to stimulate the economy that increases the money supply, lowers interest rate, and increases aggregate demand

Quiz: A specialty motorcycle manufacturer created a table to display its costs as seen below: Number of Workers Number of Motorcycles Total Costs 1 15 $30,000 2 32 $62,000 3 50 $90,000

$1,555.55 This is the marginal cost of each motorcycle when production is increased from 32 to 50 motorcycles. ($90,000 total cost - $62,000 total cost) ÷ (50 motorcycles - 32 motorcycles) = $1,555.55

The factors of production in an economy are as follows:

1. Natural resources: Things found in nature that may be used to produce goods and services, such as land, minerals, and petroleum. 2. Labor: The human effort that can be applied to the production of goods and services. People who are employed—or able to be—are considered part of the labor available to the economy. 3. Capital: A factor of production that has been created for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. 4. Entrepreneur: A person operating within a market economy who looks for ways to make profits by finding new ways in which the factors of production may be organized.

Macroeconomics

A branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. Focuses on large economic systems such as national and global economies

Microeconomics

A branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Deals with businesses and individuals.

Profit

A financial gain, especially the difference between the amount earned and the amount spent buying, operating, or producing something

Price Makers

A firm that has the power to set the price, subject to the demand curve

Monopoly

A firm that produces a good that has no close substitute in a market where a barrier to entry prevents other firms from entering the market

Expenditures

A payment with either cash or credit to purchase goods or services. An expenditure is recorded at a single point in time (the time of purchase)

Double Counting

A potential mistake to avoid in measuring GDP in which output is counted more than once as it travels through the stages of production. Double counting occurs when the value of an output is counted more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires purchased by an automaker for use on one of its trucks and then counted the value of a new truck as it was driven out of the lot on those same tires. In this example, the statisticians would have counted the value of the tires twice because the truck's price includes the value of the tires. This would overstate the size of the economy considerably.

Compound Tariffs

A tax on imported goods that is a combination of a fixed amount and an amount based on the value of the goods Compound tariffs are tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might consist of a fixed $100 duty plus 10% of the value of every imported car.3

Quiz: A market for a product has only a small number of sellers and an equally small number of buyers. Buyers have trouble determining market quality. What will be the outcome of this situation?

A thin market with volatile market prices Imperfect information will leave both buyers and sellers unwilling to participate.

Quiz: What is the relationship between the production possibilities frontier (PPF) and production and consumption in countries that engage in free trade?

All countries should produce on their PPF and consume at a point above their PPF. If countries specialize in the goods that they have comparative advantages in and trade for those goods it does not, all countries can benefit through trade. The benefit is shown in the model as being able to consume at a higher level than it could produce on its own.

Standard of Living

All elements that affect people's happiness, whether people buy or sell these elements in the market

Monetary Policy

All of the Federal Reserve actions that change the money supply with the goal of curbing inflation or reducing economic stagnation or recession

Contractionary Monetary Policy

An economic policy used to fight inflation by decreasing the money supply

Depression

An especially lengthy and deep decline in output

Full Employment GDP

Another name for potential GDP, when the economy is producing at its potential, and unemployment is at the natural rate of unemployment.

Savings Deposits

Bank account where you cannot withdraw money by writing a check but can withdraw the money at a bank or transfer it easily to a checking account.

Reserves

Banks' holdings of deposits in accounts with their central bank plus currency that is physically held in the bank's vault

Quiz: The government of a country has been improving the hotel infrastructure to improve the tourist experience. After all the projects were completed, the number of tourists increased, resulting in increased tax revenue. The country's income is now larger than its expenses. Which budgetary situation is being experienced by this country?

Budget surplus A surplus occurs when there is more income than expenses.

Describe how trade policies influence domestic and international markets.

Citizens of the world live in a global marketplace. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and made in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery, airplanes, cars, scientific instruments, or any other technology-related industries, the odds are good that a hearty proportion of the sales of your employer—and hence the money that pays your salary—comes from export sales. Everyone is linked by international trade, and the volume of that trade has grown dramatically in the last few decades. The first wave of globalization started in the nineteenth century and lasted up to the beginning of World War I. Over that time, global exports as a share of global gross domestic product (GDP) rose from less than 1% of GDP in 1820 to 9% of GDP in 1913. It is a late twentieth-century idea that the global economy was invented recently. In fact, world markets achieved an impressive degree of integration during the second half of the nineteenth century. Indeed, if one wants a specific date for the beginning of a truly global economy, one might well choose 1869, the year in which both the Suez Canal and the Union Pacific railroad were completed. By the eve of World War I, steamships and railroads had created markets for standardized commodities like wheat and wool that were fully global in their reach. Even the global flow of information was better than modern observers who are focused on electronic technology tend to realize: The first submarine telegraph cable was laid under the Atlantic Ocean in 1858, and by 1900, all of the world's major economic regions could communicate instantaneously. This first wave of globalization was brought to a halt early in the twentieth century. World War I severed many economic connections between warring nations. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others, including the United States. World War II further hindered international trade. Global flows of goods and financial capital were rebuilt slowly after World War II. However, it was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I.

Quiz: Which term describes the average price of goods and services most commonly purchased in the United States?

Consumer price index This is the average price of the goods and services mostly commonly purchased in the United States.

Peak

During the business cycle, the highest point of output before a recession begins

Trough

During the business cycle, the lowest point of output in a recession before a recovery begins

Capital Goods

Goods that are used in producing other goods rather than being bought by consumers

Average Cost

In making decisions, firms look at average costs as well as total costs. A firm's average total cost of production is the per-unit cost of producing a given quantity. This information is useful for making comparisons to the price, which is always stated on a per-unit basis. The average cost is defined as the total cost divided by the quantity of output produced.

Quiz: An individual moves to a city that imposes rent control on apartment rentals. If rental controls were not imposed, the market price would be $800 per month. The rent control price is $600 per month. What is the likelihood that an individual will easily find an apartment for rent under these conditions?

It is unlikely because a shortage will persist in the market. With a shortage, there would more people looking for an apartment than there were apartments available for rent at the rent-controlled price.

Federal Taxes

Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The following graph shows total federal taxes as a percentage of GDP since 1960. Although the line rises and falls, there appears to be a downward trend over the last two decades. The decline began in the early 2000s, driven primarily by the Bush tax cuts of 2001 and 2003. Additional downward pressure occurred with the great recession beginning in 2007. Notice that the shaded bars on the graph identify periods of recession. For the most part, significant increases in tax revenues occur during economic expansions, whereas decreases in tax revenues as a percentage of GDP are associated with recessions.

Financial Capital

Most commonly refers to assets needed by a company to provide goods or services, as measured in terms of money value

Allocative Efficiency

Producing goods and services demanded by consumers at a price that reflect the marginal cost

Quantity Supplied

Quantity supplied, as stated previously, is the specific quantity producers are willing to sell at a particular price.

Hyperinflation

Rapid, excessive, and out of control price increases in an economy

Store of Value

Something that serves as a way of preserving economic value that can be spent or consumed in the future

Quiz: Which description illustrates the nature of an oligopoly?

Tacit collusion is possible. Oligopolies often practice collusion.

The Relationship of the Short-Run and the Long-Run Cost Curves

The LRAC curve shows the cost of producing each quantity in the long run when the firm can choose its level of fixed costs and thus choose SRACs. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows it to produce Q3 at the lowest cost. A firm that intends to produce Q3 would not choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2, the level of fixed costs is too low for producing Q3 at the lowest possible cost, and producing Q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing Q3 at the lowest possible cost, and average costs would be very high as a result.1

Marginal Cost

The additional cost incurred from consuming an additional unit of something

Quiz: What happens when an economy experiences an adverse supply shock?

The aggregate supply curve shifts to the left. Because adverse supply shocks increase prices for that component, the aggregate supply curve shifts to the left.

Service Contract

The buyer pays an extra amount and the seller agrees, as specified in the contract, to fix anything that goes wrong for a set time period

Quiz: What are the four factors of production?

The four factors of production are natural resources, labor, capital, and entrepreneurship.

Trade Balance

The gap between exports and imports

Calculating Opportunity Cost

The opportunity cost of a trade-off can be calculated by dividing the value of the thing you gave up or sacrificed by the value of what you gained. Opportunity cost=The value of what you give up / The value of what you gain

Supply of Money

The supply of money in the economy is controlled by the Fed and is independent of the interest rate. As a result, the supply of money (SM) is vertical, as shown in the following graph. When the Fed increases the money supply, the money supply curve shifts to the right. This is shown by the movement from SM to SM1 in the graph. When the Fed reduces the money supply, the money supply curve shifts to the left. This is shown by the movement from SM to SM2.

Principle 8: The standard of living for a nation is determined by its ability to produce goods and services

There is a fundamental relationship between productivity and living standards. The more productive a society, the better its people live. Public policy can encourage this productivity by promoting education and access to the necessary tools for its workforce. Principles of Economics Eight to Ten: How the Economy Works as a Whole

Quiz: The price level has increased, expected inflation remains constant, and aggregate demand has shifted to the right. What is its effect on the short-run aggregate supply (SRAS) curve?

There is a movement up the SRAS curve. This is a positive aggregate demand shock that results in an upward movement on a SRAS curve.

Out of the labor force

Those who are not working and not looking for work—whether they want employment or not; also termed "not in the labor force"

Discouraged Workers

Those who have stopped looking for employment due to the lack of suitable positions available

Quiz: A small business owner wants to add a new product to its current product line, but the business can only produce 10% of what it wants. What describes this scarcity situation?

To increase production of the new good, a trade-off is necessary given the available resources and their current production possibilities frontier. The scenario implies that the firm is constrained in the amount of its new product that it can produce by its current resources, so a trade-off is necessary because of scarcity.

Frictional Unemployment

Unemployment that occurs as workers move between jobs

Monopolistically Competitive Markets: Market Power

Unlike a competitive market, firms in a monopolistically competitive market have some market power due to differentiation between products. For this reason, firms competing in a monopolistically competitive market are considered price makers. Because of this market power, firms can influence prices slightly in their segment of the market. Since products in a monopolistic competitive market are not identical, the demand curve has a downward slope (price and quantity are inversely related).

Long-Run Aggregate Supply (LRAS)

Vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run

Medium of Exchange

Whatever is widely accepted as a method of payment

Money

Whatever serves society in four functions: as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment

Dumping

When a country or company exports a product at a price that is below market price to gain an unfair share of the market

Bank Runs

When a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the bank's solvency

Quiz: A supply curve is graphed with the quantity supplied on the x-axis and price on the y-axis. How does increasing the number of suppliers affect this curve?

When a market experiences an increase in the number of suppliers for a product or service, the result is an increase in the overall quantity supplied in the market. Increasing the quantity of suppliers results in a shift of the supply curve to the right.

Movement toward Equilibrium

When a market is not in equilibrium, pressures arise that move the market toward the equilibrium price.1 Disequilibrium occurs when the market price is either too high or too low. In both cases, there will be a difference between the quantities selected by consumers and producers in response to the price signal. First consider what happens when the price is too high. When firms charge a price that is too high, the quantity consumers purchase is less than the quantity supplied. When suppliers are unable to sell all they want at the going price, they face a surplus. A surplus is sometimes called a situation of excess supply. This situation places a burden on the seller who does not want his or her inventories to build up. It is in the seller's interest to respond to the surplus by cutting prices. Falling prices increase the quantity demanded and decrease the quantity supplied, reducing the surplus. Prices continue to fall until the market reaches the equilibrium. Consider the example described in the following table and graph. Imagine the price of a gallon of gasoline is $1.80 per gallon. At this price, the quantity demanded is 500 gallons; however, the quantity supplied at $1.80 is 680 gallons. This market is not in equilibrium because the quantity that consumers want to buy, 500 gallons, is less than the quantity that companies want to sell, 680 gallons. This means that there is a surplus of gasoline in the market. In this case, there is a surplus of 180 gallons. You can see this surplus depicted in the following graph as well. This accumulation of gasoline puts pressure on gasoline sellers. If the product remains unsold, the firms involved in making and selling gasoline are not receiving enough cash to cover their costs. In this situation, producers and sellers will want to cut prices because it is better to sell at a lower price than not to sell at all. Producers lower their price to get rid of their excess supply. As the price falls, the quantity demanded will increase—consumers will buy more at lower prices. However, the quantity supplied will decrease—producers will produce less at lower prices. This decrease in price will continue until the market reaches equilibrium. In this example, the market is in equilibrium at a price of $1.40 and a quantity of 600 gallons. When the price is below equilibrium, a shortage will arise. A shortage occurs because there is excess demand for the product at the price being charged. Sellers can respond by raising their price. As the price rises, the quantity demanded falls, the quantity supplied rises, and the market moves toward the equilibrium. This can be shown using the gasoline example. Suppose the price of gasoline is $1.20 per gallon. This price is below the equilibrium market price and is indicated on the following graph as a dashed horizontal line. At this lower price, the quantity demanded of gasoline is 700 million gallons. Drivers want to buy more gasoline when the price is lower. They might take longer trips or stop sharing rides to work. However, the lower price reduces gasoline producers' incentives to make and sell gasoline. As a result, the quantity supplied of gasoline is only 550 million gallons. There is an excess demand of 150 million gallons. When the price is below equilibrium, there is excess demand, or a shortage. The quantity demanded is greater than the quantity supplied. When gasoline prices are unusually low, eager gasoline buyers go to the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling the gasoline they have at a higher price. As a result, the companies start to increase prices. As prices increase, the quantity demanded falls and the quantity supplied increases, moving the market back toward the equilibrium level. When price is either too high or too low, it is in the firm's self-interest to make price adjustments that move the market toward equilibrium. Consumers and producers alter their market behavior in response to these changes. In this way, price is the mechanism through which the actions of buyers and sellers are coordinated. Once the quantity demanded equals the quantity supplied, the market is in equilibrium and there is no longer pressure to change prices.

Elastic Demand

When the elasticity of demand is greater than one, indicating a high responsiveness of the quantity demanded or to a change in price in percentage terms

Quiz: A supply curve is graphed with quantity supplied on the x-axis and price on the y-axis. What happens to the supply curve when there is a decrease in supply?

When there is a decrease in supply of a product or service, the line shifts to the left or inwards. When the supply changes, the entire supply curve will shift. When the supply decreases, the line will move to the left.

Trade Diversion

When trade is diverted from a more efficient exporter toward a less efficient one by the formation of a free trade agreement or customs union

Gross Domestic Product (GDP)

GDP measures production in the economy, is used to measure economic growth, and is a measure of the prevailing standard of living in a country. Economists measure growth by the percentage change in real (inflation adjusted) gross domestic product. A growth rate of more than 3% is considered good. GDP can be calculated by summing the expenditures made to purchase all final goods and services. As shown in the circular flow diagram, there are four categories of buyers in the economy. Their expenditures are identified as consumption, investment, government spending, and net exports. Together these provide a value for the economy's total production. As an example, the table below shows how these four components added up to the U.S. GDP in 2018. The graph shows the levels of consumption, investment, government purchases, and net exports for 2018, expressed as a percentage of GDP. Consumption—Consumption (C), is the largest component of GDP, accounting for about two-thirds of the GDP in any year. Consumers' spending decisions are a major driver of the economy. Consumer spending does not jump around too much. It has increased modestly from about 60% of GDP in the 1960s and 1970s to 68% in 2018. Consumer spending varies with disposable income, and some spending decisions are influenced by interest rates. Investment —Investment refers to the purchase of physical plant and equipment to be used in the production of other goods. If Starbucks builds a new store or Amazon buys robots, these expenditures count as investment. Investment expenditures are far smaller than consumption expenditures, typically accounting for only about 15% to 18% of GDP, but they are very important to the growth of the economy and the creation of jobs. Unlike consumption spending, investment spending is volatile and fluctuates noticeably. Businesses spend money on new plants and equipment when they believe these expenditures will be profitable. New technology or a new product can spur business investment, but then confidence can drop, and business investment can pull back sharply. Large investment purchases are usually financed, making investment spending sensitive to changes in interest rates. Government—If you noticed any of the infrastructure projects (new bridges, highways, and airports) launched during the 2009 recession, you have seen how important government spending can be for the economy. Government expenditures (G) in the United States account for close to 20% of GDP and include spending by all three levels of government: federal, state, and local. The only part of government spending counted in GDP is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or building a new school (local government spending). A significant portion of government budgets consists of transfer payments like unemployment benefits, veteran's benefits, and Social Security payments to retirees. The government excludes these payments from GDP because it does not receive a new good or service in return or exchange. Instead the payments are transfers of income from taxpayers to others. Net exports—When thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exports—domestically produced goods that a country sells abroad. Similarly, one must also subtract spending on imports—goods that are produced in other countries that residents of this country purchase. Imports are subtracted because those goods and services are not produced in the United States, so they cannot be a part of its GDP. The GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X - M). The gap between exports and imports is called net exports. Net exports are also referred to as the trade balance. If a country's exports are larger than its imports, then a country has a trade surplus. If the exports are less than imports, the country has a trade deficit.2 Based on these four components of demand, GDP can be measured as follows: GDP = Consumption + Investment + Government + Net Exports = C + I + G + (X - M) = C + I + G + NX

Credit Card

Immediately transfers money from the credit card company's checking account to the seller; at the end of the month, the user owes the money to the credit card company; a credit card is a short-term loan

The Result of the Tariff

In this situation, consumers originally purchased 70 million board feet at $400 each and now purchase 50 million at $800 each. Domestic producers now sell 20 million more units for $400, more than previously. (Note that the tariff only applies to imports, not domestic production.) The government charges a $400 tariff on the 20 million remaining imported board feet.7

Quiz: A country is producing on its production possibility frontier (PPF) with respect to capital and consumption goods. Policy makers are considering policies to help the country grow and produce combinations of goods that it currently finds unattainable. Which policy will be successful in meeting this goal?

Increasing skilled labor in public and private sectors through relaxed immigration laws This situation would lead to a larger labor force and shift out the PPF. This would allow the country to grow and produce at points that currently represent unattainable combinations of goods as the PPF shifts out.

Quality and New Goods Bias

Inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living because it does not account for improvements in the quality of existing goods or the invention of new goods

Describe the effects of trade barriers on the economy.

It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does not always occur if a high-cost producer has a free trade agreement and the low-cost producer does not. When free trade is applied to only the high-cost producer, it can lead to trade diversion to a producer that is not the most efficient but the one facing the lowest trade barriers, which results in economic inefficiency. Free trade is highly effective and provides society with a net gain, but only if it is applied nonselectively.1 In this lesson, you will learn how trade barriers such as tariffs, quotas, and nontariff barriers affect the economy and who ends up winning and losing as a result of these barriers.

Quiz: Which economic framework would a student use to study inflation in a country over past years?

Macroeconomics deals with studying issues for the country as a whole.

Quiz: The short-run aggregate supply curve has shifted to the left. What is the effect, if any, on nominal wages?

Nominal wages will decrease their purchasing power. Nominal wages will decrease in purchasing power.

Underutilizing

The condition in which economic resources are not being used to their full potential

Shoe Leather Costs

The cost of time and effort that people spend trying to counteract the effects of inflation

Menu Costs:

The cost to a firm resulting from changing its prices

What happens to the opportunity cost of the two goods when the production point moves from Point A to Point E? Number of Bikes: 0,20,40,60,80 Number of Hats: 2,000 1,700 1,300 700 0

The opportunity cost of bikes increases as the opportunity cost of hats decrease.

Private Enterprise

The ownership of businesses by private individuals

Interest Rate

The percentage of an amount of money charged for its use per some period of time (often a year)

Four-Firm Concentration Ratio:

The percentage of the total sales in the industry that are accounted for by the largest four firms

Market Share

The percentage of total sales in the market

Quiz: Which equation reflects total economic profit?

Total Revenue - (Explicit Cost + Implicit Cost) Total economic profit requires taking both explicit and implicit costs into account and subtracting that from total revenue.

What to produce:

Using the economy's scarce resources to produce one thing requires giving up another. Producing better education, for example, may require decreasing other services, such as healthcare. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.

Economic Inefficiency

When all goods and factors of production are not allocated to serve their highest and best use, minimizing waste and inefficiency

M2 Money

A definition of the money supply that includes everything in M1, but also adds savings deposits, money market funds, and certificates of deposit

Basket of Goods and Services

A fixed set of consumer products and services valued on an annual basis

Automatic Stabilizers

A type of fiscal policy designed to offset fluctuations in the nation's economy through normal operations

Quiz: What is the relationship between price and quantity supplied?

As the price for a good moves up, it becomes more attractive for sellers to offer products at the higher price, so the quantity supplied will also move up.

Quiz: A company produces and plans to sell 13,000 small, electronic devices. They will need to pay $17 for materials and labor cost for each device produced. The firm also has the following annual costs: Rent: $12,000 Utilities: $6,000 Insurance: $3,000 What is the company's expected total costs?

242,000 The formula: 13,000 devices x $17 each = $221,000 is correct. This plus $12,000 for rent, $6,000 for utilities, and $3,000 for insurance provides the company's total costs.

Market Failure

A situation in which the allocation of goods and services by a free market is not efficient, often leading to a net social welfare loss. Market failure occurs when the market's equilibrium quantity is not the optimal quantity. In these cases, the market can overproduce, or generate a quantity that is too much; or the market can underproduce, or generate a quantity that is too low.

Quiz: An economist is interested in identifying individuals who may have employment but who cannot access the employment they desire. Which topic is this economist studying?

Hidden unemployment Hidden unemployment is the gap between employment that individuals have and the employment that they desire.

Quiz: A firm has estimated the levels of production it will need in the future. It has determined that over its likely range of output, long-run average costs will decrease up to a point and afterward remain constant. Which region description is consistent with the firm's operating plans?

It will remain in the constant returns to scale range without change. A profit-maximizing firm will produce at a minimum long run average cost in the long run, which puts the firm in the range of constant returns to scale.

Quiz: A country has a recent innovation in energy production that is leading to low cost renewable energy. What will happen to this country's production of both capital and consumption goods?

Its production possibility frontier will shift out, and more combinations of goods will be attainable. This is the response that occurs when an innovation in energy production leads to low cost and renewable energy for businesses.

Importance of the AD-AS Model

The AD-AS model is a crucial tool for understanding the macroeconomy. Using the model, you can analyze many different scenarios to understand better how different events affect the three macroeconomic goals of steady growth, low inflation, and low unemployment. The model helps economists evaluate current economic conditions as they relate to the business cycle. The usage of the model allows a comparison between current and desired economic performance. Such information is essential for business planning and government policy-making.

To Increase Money Supply

1. The Fed buys securities from banks 2. Decrease required reserve ratio 3. Lower discount rate 4. Lower interest paid on reserves

Heterogeneous

A resource having two different forms or skills

Economic Systems

A system of the production, resource allocation, and distribution of goods and services within a society or given geographic area

Quiz: An economist is conducting research on the total amount of money spent for goods and services at different price levels within a single economy. What is the economist studying?

Aggregate demand Aggregate demand is the total amount of money spent on goods and services at different price levels within a domestic economy.

Deficit

An excess of expenditure or liabilities over income or assets in a given period

Quiz: Some economists support the use of currency that provides governments and central banks with more control, even though it is not backed by any physical goods.

Fiat money Fiat money is money declared to be legal tender by a country that has no commodity backing.

Total Production

In total, Golden and Maple are producing 10,000 guns and 4,500 pounds of butter. It is important to recognize that both countries are producing on their respective PPFs and therefore are producing their quantities as efficiently as possible. Now, Golden and Maple decide to trade with one another, understanding that they each have a comparative advantage in one of the goods. Since these countries face constant opportunity costs, they will specialize in the good for which they have a comparative advantage. This means that Golden will produce all guns and no butter, and Maple will produce all butter and no guns. Calculate the total world production with this change. Total world production=12,000 guns+5,000 lb of butter

Import Tariffs

Taxes on goods that are imported into a country Import tariffs are taxes on goods that are imported into a country. They are more common than export tariffs.

Quiz: Which country is experiencing a negative balance of trade?

The country that imports more than it exports Negative or positive balance of trade is the relationship between importing and exporting goods.

Total Revenue

The income that a company receives from its normal business activities, usually from goods and services; defined as price times quantity

Marginal Benefit

The incremental increase in the benefit to a consumer caused by the consumption of one additional unit of a good or service

Government Procurement Programs

The process of buying goods and services by a government agency through a specific process of issuing bid proposals and seeking responses from companies

Countercyclical Policy

These examples suggest that monetary policy should be countercyclical; it should act to counterbalance the business cycles of economic downturns and upswings. Monetary policy should be loosened when a recession has caused unemployment to increase and tightened when inflation threatens. A countercyclical policy does pose a danger of overreaction. If a loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If a tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. The following figure summarizes the chain of effects that connect loose and tight monetary policies to changes in output and the price level.

Contractionary Gap and the AD-AS Model

When the equilibrium real GDP is less than potential GDP, there is a recessionary or contractionary gap. Though the quantity of GDP demanded is equal to the quantity of GDP supplied, the economy produces less than the full-employment level of output. A recessionary or contractionary gap is illustrated in the following graph. The short-run equilibrium E0, where AD and SRAS cross, is to the left of the LRAS or potential GDP meaning the economy is producing at Y0, which is below potential GDP. The difference between Y0 and Y* is known as the recessionary or contractionary gap. When this is the case, the economy is experiencing a recession. This equilibrium is a short-run equilibrium, but not a long run equilibrium.3

Excess Supply / Surplus

At the existing price, the quantity supplied exceeds the quantity demanded; also called a surplus. If the price is above the equilibrium level, the quantity supplied will exceed the quantity demanded. Excess supply or a surplus will exist.

Quiz: What is a disadvantage of a mixed economic system?

Freedom of choice can fluctuate from too much to too little. Depending on what role the government takes to make regulations, freedom can fluctuate quite a bit.

Quiz: How can protectionist policies in one industry negatively impact other industries?

Higher prices for protected products result in decreased demand for other products. Protectionist policies in one industry can negatively impact other industries because consumers pay higher prices for protected products, which decreases the available spending for other, nonprotected products. This results in a decrease in demand for nonprotected products.

Farmers are ready to sell soybeans, and the current market price is $8 per bushel. Legislators are considering imposing a $12 per bushel price floor on the soybean market. Will this action help the farmers sell more soybeans?

No, a surplus would emerge, and more soybeans will be produced than are sold. With the price floor price being set at a higher price than the efficient market price, the market's quantity supplied would be greater than the quantity demanded. Because of the downward sloping demand curve, the new quantity demanded and sold would be less than the efficient market quantity.

Business Cycle

The economy's relatively short-term movement in and out of recession

Domestic Equilibrium

The equilibrium achieved by a market if it is not open to trade. It is determined by where the domestic demand equals the domestic supply.

Accounting Profit

Total revenues minus explicit costs, including depreciation

Economic Profit

Total revenues minus total costs (explicit plus implicit costs)

Cost-of-living Adjustments (COLAs)

A contractual provision that wage increases will keep up with inflation

Incumbent

A firm that is an established player in the market.

Autarky

National economic self-sufficiency

Quiz: The price of coffee is $3 at a cafe and $0.50 when made at home. The individual drinks one coffee per day. What is the seven day opportunity cost of buying coffee each morning at a cafe instead of making it at home?

$17.50 Total value of buying at the café ($21) minus the total cost of making it at home ($3.50) is equal to $17.50.

Perfectly Competitive Market: Profit

A perfectly competitive firm has only one major decision to make—what quantity to produce. To understand this, consider a different way of writing out the basic definition of profit: Profit = Total Revenue - Total Cost Profit = (Price - Average Cost) × (Quantity Produced)

homogeneous

A resource having one form or set of skills.

Quiz: Some economists believe strongly in having gold to back up all the currency that exists. Which approach is being supported by these economists?

Commodity-backed This is a currency that is backed by a physical commodity.

Quiz: A particular good in the worldwide market is traded at a price of $50. Country A, without trade, has an equilibrium price of $100 for the same good. What will happen in the domestic market of Country A if trade occurs and there is a tariff imposed of $30 per unit imported?

Consumers would pay a market price equal $80. For freely traded goods, the world price would equal the price to all consumers. Here, the domestic price also must account for the tariff.

The current market price for soybeans is $8 per bushel. Legislators are considering imposing a $10 price support and buying the surplus soybeans. How will this action impact soybean farmers' sales?

Farmers will sell more soybeans since the government will be buying the surplus. At the higher price, soybean farmers will make more soybeans available in the market. Consumers will buy fewer soybeans, but the farmers will sell more soybeans because the government will buy any soybeans that are not purchased in the market.

Quiz: What is a reason for the downward slope of the aggregate demand curve?

Foreign price effect If imports are less expensive than domestic goods, then the quantity demanded domestically will decrease.

Effects of Inflation

If you were born within the last three decades in the United States, Canada, or many other countries in the developed world, you probably have very little experience with a high rate of inflation. Inflation is when average prices in an entire economy rise. However, there is an extreme form of inflation called hyperinflation. This has occurred in Germany between 1921 and 1928 and more recently in Zimbabwe between 2008 and 2009. In November 2008, Zimbabwe had an inflation rate of 79.6 billion percent. In contrast, in 2019 the United States had an average annual rate of inflation of 1.71%. It is difficult to comprehend the devastating impact of an inflation rate as high as Zimbabwe's. It is equivalent to price increases of 98% per day. From one day to the next, prices essentially double. What is life like in an economy afflicted with hyperinflation? The government adjusted prices for commodities in Zimbabwean dollars several times each day. There was no desire to hold on to currency as it lost value by the minute. The people there spent a great deal of time getting rid of any cash they acquired by purchasing whatever food or other commodities they could find. At one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers' salaries were in the trillions of Zimbabwean dollars per month; however, this was equivalent to only one U.S. dollar a day. At its height, it took 621,984,228 Zimbabwean dollars to purchase one U.S. dollar. Government agencies had no money to pay their workers, so they started printing money to pay their bills rather than raising taxes. Rising prices caused the government to enact price controls on private businesses, which led to shortages and the emergence of black markets. In 2009, the country abandoned its currency and allowed people to use foreign currencies for purchases. This is an extreme case of how inflation can affect an economy. In contrast, in the last three decades, inflation has been relatively low in the U.S. economy, with the CPI typically rising 2% to 4% per year. Looking back over the twentieth century, there have been several periods when inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation. The following graph shows the trends in U.S. inflation rates from the year 1914 to 2018. The first two waves of inflation are easy to characterize in historical terms: They are right after World War I and World War II. However, there are also two periods of severe negative inflation—called deflation—in the early decades of the twentieth century: one following the deep 1920-1921 recession and the other during the 1930s Great Depression. Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation is a time when the buying power of money in terms of goods and services increases (this will be discussed in more detail later). For the period from 1900 to about 1960, the major inflations and deflations nearly balanced each other out, so the average annual rate of inflation over these years was only about 1% per year. A third wave of more severe inflation started in the 1970s and ended in the early 1980s. Times of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 1920-1921, the Great Depression, the recession of 1980-1982, and the Great Recession in 2008-2009. There were a few months in 2009 that were deflationary, but not at an annual rate. High levels of unemployment typically accompany recessions, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like during wartime. It is important to note that a recession often accompanies higher unemployment and lower inflation, whereas rapid economic growth often brings lower unemployment but higher inflation.

The Law of Demand

In economics, demand is the amount of a good or service that consumers are willing and able to purchase at various prices during a specified period of time, other things remaining constant. The requirement that other things remain constant is also known as ceteris paribus. The common relationship that a higher price leads to a lower quantity demanded of a certain good or service and a lower price leads to a higher quantity demanded while all other variables are held constant. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. This inverse relationship between price and quantity is known as the law of demand. The law of demand assumes that all variables that affect demand, other than price, remain constant.

Quiz: Technological advancements have made weather predictions more accurate and improved shipping efficiency. How does this change impact international trade?

International trade will increase because shipping costs have decreased. Cheaper transportation has increased the availability of international trade.

Comparative vs. Competitive Advantage

It is essential to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with an opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, comparative advantage is more often discussed.6

Explain recession and inflationary gaps in monetary policy.

Money, loans, and banks are all tied together. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions are made smoothly in goods and labor markets and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation. The government of every country has public policies that support the system of money, loans, and banking. However, these policies do not always work perfectly. The organization responsible for conducting monetary policy and ensuring that a nation's financial system operates smoothly is called the central bank. In making decisions about the money supply, a central bank decides whether to raise or lower interest rates and, in this way, influence macroeconomic policy, the goal of which is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation's banking system to protect bank depositors and ensure the health of the banks' balance sheets.1

Quiz: Consider the annual markets for food, new cars, and new houses. Which market is most likely to have the highest absolute value for its price elasticity of demand around its relevant range of prices?

New houses because the price of a new house would represent the largest portion of a consumer's budget. Of the goods listed, new homes would likely have the highest price.

Shifting Patterns of LRAC

New developments in production technology can shift the LRAC curve in ways that can alter the size distribution of firms in an industry. For much of the 20th century, the most common change has been alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the LRAC curve, the downward sloping economies of scale portion of the curve stretched over a larger quantity of output.1 However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years, some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300-600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-sized tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but it did so at a lower average cost than a traditional mid-sized tire plant.1 Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create "winner-take-all" markets where one large company will tend to command a large share of total sales, as Microsoft has done in the production of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers.1

Understanding Profit

Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. Each of these businesses, regardless of size or complexity, tries to earn a profit.1 To do this, the firm combines inputs of labor, capital, land, and entrepreneurship to produce outputs. If the firm is successful, the outputs are more valuable than the inputs, and the firm generates profit.2 The profit earned can be calculated as follows: Profit = Total Revenue - Total Cost

Uses of GDP—Tracking Changes in the Economy

Real GDP is used to track changes in the economy over time. When news reports indicate that "the economy grew 1.2 percent in the first quarter," they are referring to the percentage change in real GDP. The following graph from the FRED website shows the value of U.S. real GDP from 1929 to 2018. Short-term declines have regularly interrupted the generally upward long-term path of the GDP. A significant decline in real GDP is a recession, and an especially lengthy and deep recession is called a depression. The severe drop in GDP that occurred during the 1930s Great Depression is clearly visible in the graph as is the 2008-2009 Great Recession. World War II is also noted as a large expansion immediately after the Great Depression. Real GDP is important because it is highly correlated with other measures of economic activity such as employment. When real GDP rises, typically so does employment. The most significant human problem associated with recessions (and the larger, uglier problem, depressions) is that a slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful financial and personal costs on workers and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at best—or their employers may ask them to take pay cuts. The following table lists the pattern of recessions and expansions in the U.S. economy since 1900. The highest point of the economy, before the recession begins, is called the peak. Conversely, the lowest point of a recession, before a recovery begins, is the trough. Thus, a recession lasts from a peak to a trough, and an economic upswing runs from a trough to a peak. The economy's movement from peak to trough and trough to peak is called the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the 1930s Great Depression. The ongoing expansion since the June 2009 trough will also be quite long, comparatively, having already reached 123 months as of the end of September 2019.2

Scarcity

The basic economic problem; the gap between limited, scarce, resources and theoretically limitless wants. Given scarce resources, individuals, businesses, governments, and nations all make choices to best satisfy their unlimited wants. This balancing act presents a set of decisions that must be made taking into consideration the availability or scarcity of resources. For an economist to consider a resource as scarce, it does not need to be rare. Instead, the term captures the tension between humans' vast, unlimited wants and the relatively small availability of resources to satisfy those wants. Scarcity creates limits that restrict the options available to both consumers and producers. Economists gain an understanding of consumption decisions by first identifying available consumption alternatives. Examining production limitations also provides valuable information. Scarcity forces constraints on both microeconomic and macroeconomic decisions.

Quiz: Which response should be expected if a competitive coffee market is in equilibrium and consumers in the market see an increase of income across the board?

The demand curve shifts to the right, implying a willingness for consumers to pay more. Higher incomes for buyers of a normal good indicates that buyers will pay more at all quantities.

A family has recently experienced an increase in household income. Which outcome results from this increase?

The demand for normal goods increases when income increases.

Central Bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency, and controls interest rates

Economics

The study of how humans make decisions in the face of scarcity Economics is the study of choice under conditions of scarcity. Economics is the study of scarcity and its implications for the use of resources, production of goods and services, growth of production and welfare over time, and a great variety of other complex issues of vital concern to society. Economics studies human actions and decisions related to the production and distribution of scarce resources. There are two main areas of economics: macroeconomics (focusing on large economic systems) and microeconomics (focusing on organizations and individuals).

Which equation reflects accounting profit?

Total Revenue - Explicit Cost Accounting profit is the difference between total revenue and explicit cost.

Principle 5: Trade can leave everyone in a better position

Trade allows people to concentrate on what they do best and exchange their ability with others to supplement their own needs. This provides everyone involved with access to a larger number and variety of goods and services. Principles of Economics Five to Seven: How People Interact

Budget Deficit

When the federal government spends more money than it receives in taxes in a given year

The Cost of Saving Jobs

Why does it cost so much to save jobs through protectionism? The primary reason is that not all the extra money paid by consumers due to tariffs or quotas goes to saving jobs. For example, if tariffs are imposed on steel imports so buyers of steel pay a higher price, U.S. steel companies earn greater profits, buy more equipment, pay bigger bonuses to managers, give pay raises to existing employees—and also avoid firing some additional workers. Only part of the higher price of protected steel goes toward saving jobs. Also, when an industry is protected, the economy as a whole loses the benefits of playing to its comparative advantage—producing what it is best at. Part of the higher price that consumers pay for protected goods is lost economic efficiency. In the following table, you will see the change in employment as a percentage of total nonfarm employment by industry, seasonally adjusted from 1939 to 2015 from the Bureau of Labor Statistics

Unemployment

A social and economic situation in which people who are able to work are not able to find a job

Countercyclical

Moving in the opposite direction of the business cycle of economic downturns and upswings

Introduction to Comparative Advantage Calculation

The power of international trade and its ability to leverage comparative advantage cannot be understated in a conversation of material wellbeing. An example of two countries that produce only two goods will be used to emphasize this point. Although this example is overly simplistic, the general principle holds across many nations and many goods. Imagine that you have two countries, Golden and Maple, and each country can produce guns and butter. To keep the example simple, assume a constant opportunity cost in each nation's PPF, that is, the PPF is a straight line.

Barter

Trading one good or service for another without using money

Quiz: What is expected to happen if production costs increase for a particular good in a competitive market?

Decrease in the supply of the good. An increase in costs would lead to a shortage of supply for the good from decreased supply.

Quiz: What is a consequence of a government printing more money?

Decreased unemployment The printing of more money causes inflation. In the short run, this can lead to more jobs.

Quiz: Which two developments have made it increasingly difficult to define markets for the purpose of determining concentration of market power?

Technology advances and globalization of markets Communication and the internet have made it possible for companies and consumers to access resources and markets that were once difficult to access.

Factors of Production

Describes the inputs used in the production of goods or services to make an economic profit. Factors of production are the resources the economy has available to produce goods and services.

Quiz: A reporter is discussing current record low unemployment, and an economist mentions that the numbers being reported leave out individuals who have stopped looking for work. Which group is being referred to by the economist?

Discouraged workers Discouraged workers refers to individuals who have become given up finding a job and have stopped looking for employment. This group does not appear in unemployment calculations.

Quiz: What is the highest weighted factor in the consumer price index (CPI)?

Housing is the highest weighted factor in the CPI.

Quiz: A speciality watch manufacturer has the following costs: Number of Workers Number of Watches Total Costs 1 12 $6,000 2 30 $12,000 3 50 $15,000 What is the average cost per watch when producing 30 watches?

$400 This is the average cost per watch when producing 30 watches. $12,000 total costs ÷ 30 watches = $400

Demand Schedule

A chart that shows the number of goods or services demanded at specific prices

Imports

A commodity, article, or service brought in from abroad for sale

Quiz: What does it mean to have a positive balance of trade?

A country exports more than it imports. When a country exports more goods than it imports, it will have a positive balance of trade.

Quiz: A recent recession has resulted in declining investment and consumer spending. New austerity measures have prevented the government from increasing spending. Which effect will this action have?

A left shift in the aggregate demand curve A decrease in consumer spending and investment spending with no increase in government spending will result in lower aggregate demand.

Money-back Guarantee

A promise that the buyer's money will be refunded under certain conditions

Warranty

A promise to fix or replace the good for a certain period of time

Tariffs

A tax imposed on imported goods or services

Countervailing Duties

An import tax imposed on certain goods to prevent dumping or counter export subsidies

Quiz: Which statement accurately illustrates the condition of people who are very rich and those who are very poor in relation to scarcity?

Both the very rich and the very poor must make trade-offs because of scarcity. Both groups will still need to make trade-offs due to scarcity. This is a factor that does not change with income.

Quiz: Which key assumption is required when the aggregate supply curve is in the short run?

Capital equipment stock will remain constant. Capital equipment stock should be assumed to be constant.

Quiz: What are firms paying for when they make payments to households in the circular flow model?

Factors for production Factors for production, primarily capital and labor, flow from households to firms.

Patent

Gives the inventor the exclusive rights to the invention or process for a certain period

Quiz: There are a few firms providing cloud services, and these firms directly respond to each other's pricing strategies. It is expensive for other firms to enter the market. What type of market are these firms operating in?

Oligopoly An oligopoly is best characterized by firms that strategically respond to each other.

Equilibrium Price (Pe)

On a graph, the point where the supply curve (S) and the demand curve (D) intersect is the equilibrium. The price at this intersection is called the equilibrium price (PE)

The Power of Advertising

One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Firms that do not offer differentiated products derive no value from advertising. Two ways to differentiate products are through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Businesses generally use advertising in monopolistically competitive markets, oligopolies, and monopolies to cultivate a brand. A brand is a company's reputation in relation to products or services sold under a specific name or logo.5 Advertising is all about explaining to people or making people believe that the products of one firm are differentiated from the products of another firm. In the framework of monopolistic competition, there are two ways to conceive how advertising works. Advertising either causes a firm's perceived demand curve to become more inelastic (i.e., its consumers to be less reactive to price changes) or demands for the firm's product to increase (i.e., the firm's perceived demand curve to shift right). In either case, a successful advertising campaign may allow a firm either to sell a greater quantity or to charge a higher price (or both) and thus increase its profits.6 The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. A brand and the associated reputation are built on advertising and on consumers' past experiences with the products associated with that brand. Reputation among consumers is important to firms competing in a monopolistic competitive market because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality. This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.5 However, there are two ways in which advertising could lead to higher prices for consumers. First, the advertising itself is costly; in 2018, firms in the United States spent about $223 billion on advertising (Guttmann, 2019). By raising production costs, advertising may also raise prices. If the advertising serves no socially useful purpose, these costs represent a waste of resources in the economy. Second, firms may be able to use advertising to manipulate demand and create barriers to entry. If a few firms in a particular market have developed intense brand loyalty, it may be difficult for new firms to enter—the advertising creates a kind of barrier to entry. By maintaining barriers to entry, firms may be able to sustain high prices.11 Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Advertising and brands can help minimize the costs of choosing between different products because of consumers' familiarity with the firms and their quality. Finally, advertising allows new firms to enter a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.5

Quiz: A new electronics company recently began selling an identical product to other competitors in a market that has many buyers and sellers. They entered the market because there are relatively few barriers to entry, and they know that they can easily leave. Which market structure is this company entering?

Perfectly competitive A perfectly competitive market has many buyers and sellers of a well-understood product, and the market is easy to both enter and exit.

Tariff-Rate Quota

Permitting a specified quantity of imported goods to enter a country at a reduced rate during the quota period

Price is measured on the:

Price is measured on the vertical axis.

Quiz: What is the term used when the equilibrium real gross domestic product (GDP) is less than potential GDP?

Recessionary gap A recessionary gap or contractionary gap occurs when the economy produces at a lower level of output than would occur at full employment.

Absolute Quota

Strictly limiting the quantity of goods that may enter a country

Price

The amount of money expected, required, or given in payment for something. Of the many influential factors, a product's price is the most important. Price is relevant to all markets and affects all buyers.

The Federal Reserve Bank (FED)

The central bank of the United States run by a seven-member board of governors in conjunction with 12 regional Federal Reserve banks

Coins and Currency in Circulation

The coins and bills that circulate in an economy that are not held by the U.S Treasury, at the Federal Reserve Bank, or in bank vaults

Market Position

The customer's perception of a brand or product in relation to other brands or products

Potential GDP

The maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions

Reserve Requirement

The percentage amount of its total deposits that a bank is legally obligated to either hold as cash in its vault or deposit with the central bank

World Price

The price set by competitors who have a comparative advantage for producing the good or service

Equilibrium Price

The price where the quantity demanded is equal to the quantity supplied

Production

The process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs

Scarcity of Resources

The resources that are valued—time, money, labor, tools, land, and raw materials—exist in limited supply. There are never enough resources to meet all needs and desires. This condition is known as scarcity. At any moment in time, there is a finite amount of resources available. Even when the number of resources is vast, it is limited. For example, according to the U.S. Bureau of Labor Statistics, in 2018 the labor force in the United States contained more than 128 million full-time workers. That is a lot, but it is not infinite. Similarly, the total area of the United States is 3,794,101 square miles—an impressive amount of acreage, but not endless. As these resources are limited, so are the numbers of goods and services that can be produced with them. Combine this with the fact that human wants seem to be virtually infinite and one may see why scarcity is a problem.

The Size and Number of Firms in an Industry

The shape of the LRAC curve has implications for the number and size of the firms that will compete in an industry. For example, say that 1 million dishwashers are sold every year at a price of $500 each, and the LRAC curve for dishwashers is shown in the following figure. In this figure, the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above $500, and the firms would not be able to compete.1

Normative Economics

The study of economics concerned with what should or ought to be

Principle 7: Governments can sometimes better market outcomes

There are some exceptions to rule six. In some cases, government intervention through policy can promote market efficiency and equity. However, economists are cautious about external interventions because they have been known to cause unintended issues for the economic system. Principles of Economics Five to Seven: How People Interact

Stagflation

When an economy experiences stagnant growth and high inflation at the same time

Stagflation:

When an economy experiences stagnant growth and high inflation at the same time This pattern became known as stagflation or an unhealthy combination of high unemployment and high inflation.

Constant Returns to Scale

When an increase in inputs (capital and labor) causes the same proportional increase in output. Expanding all inputs proportionately does not change the average cost of production

Collude

When firms act together to reduce output and keep prices high

Crowding Out

When government outbids private bond interest rates to get loans, money leaves the private sector and interest rates increase

Indexing and It's Limitations

When a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those people in private markets and government programs observe a wide range of indexing arrangements. As the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another, indexing will take some of the sting out of inflation. In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs), which guaranteed that wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages. Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, the interest rate that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason for this is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower. Some ongoing or long-term business contracts also have provisions that prices will adjust automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation is higher than expected. Buyers like such contracts because they are not locked into a high buying price if inflation is lower than expected. Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person's income rises above certain levels, the tax rate on the marginal income earned rises as well. That is what the expression "move into a higher tax bracket" means. The income levels where higher tax rates become applicable are indexed to rise automatically with inflation. The social security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of social security benefits increases each year along with the CPI. Also, social security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount. The government adjusts this level of income upward each year according to the rate of inflation so that an indexed increase in the social security tax base accompanies the indexed rise in the benefit level. Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, people can worry less about arbitrary redistributions and other effects of inflation. However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. However, as partial inflation indexing spreads, the political opposition to inflation may diminish.2

Acquisition

When one firm purchases another When one firm purchases another, it is called an acquisition. An acquisition may not look just like a merger since the newly purchased firm may continue to be operated under its former company name.

Unitary Elasticities

When the elasticity of demand or supply is equal to one, indicating an equal response in the quantity demanded or supplied to a change in price, in percentage terms. Unitary elasticities indicate proportional responsiveness of the quantity demanded or supply to a change in price.1

Elastic Supply

When the elasticity of supply is greater than one, indicating a relatively high responsiveness of the quantity supplied to a change in price in percentage terms

Inelastic Supply

When the elasticity of supply is less than one, indicating a relatively low responsiveness of the quantity supplied to a change in price, in percentage terms

Budget Surplus

When the government receives more money in taxes than it spends in a year

Challenges to Calculating GDP

To understand the meaning and limitations of the GDP, it is useful to look closely at its definition. GDP is defined as the market value of all final goods and services produced in a nation in a year. The definition includes many qualifiers that restrict the goods included in the GDP. Take a closer look at several of these qualifiers. Final goods—First, what are final goods? These are goods that have been sold to their final user and will not be resold as part of any product. Counting only final goods is essential to accuracy of the GDP because double counting will overstate the size of the economy. Double counting occurs when the value of an output is counted more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires purchased by an automaker for use on one of its trucks and then counted the value of a new truck as it was driven out of the lot on those same tires. In this example, the statisticians would have counted the value of the tires twice because the truck's price includes the value of the tires. This would overstate the size of the economy considerably. To avoid double counting, government statisticians exclude intermediate goods (goods that go into producing other goods) from GDP calculations. From the example above, the statisticians will only count the truck's value. In its decentralized, market-oriented economy, calculating the more than $18 trillion U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians. In a year—Next, notice that GDP includes only the goods produced in a particular year. Sales of used goods are not included because the products were produced in a previous year. This is particularly important in the housing market. The purchase of a newly built home is included in the GDP, whereas the purchase of an older home is not. Market value—GDP is calculated using the current prices of the final goods and services in the economy, or the market value of those goods and services. Goods that are not traded in an official market are not counted in GDP. For instance, measured GDP excludes the entire underground economy. Any services paid that are unreported along with any illegal sales do not get included. In theory these could be counted, but because these transactions do not happen in a legal market, these sales are impossible to track. This omission can result in the significant understatement of total output for some economies. Similarly, the value of home production is not counted in GDP. If you clean your own home, the value of this production is not included in GDP. If you hire a cleaning service to clean your home, it is included in GDP. The impact of excluding home production varies across countries and can make it difficult to accurately interpret international comparisons of GDP. Critics of the GDP often point to this focus on market goods as a problem. Although GDP is used as a measure of well-being, it does not capture many of the things associated with well-being. GDP does not assess the availability of leisure time, the quality of the environment, or the protection of human rights. It only measures the market value of the nation's output. This gives some sense of the well-being of the nation's residents, but it will not provide a complete picture. In a nation—Lastly, a geographic limitation is imposed for inclusion in the nation's GDP. Only goods that are produced within the United States are included in U.S. GDP. Inclusion is not dependent on the ownership of the firm. Goods made by a German company in the United States count toward U.S. GDP. Goods made by a U.S. company in Germany count toward German GDP. Including only the goods produced domestically makes GDP more closely tied to the well-being of the people living within the country.

Two elements of a customer's demand for a product or service:

1. Willingness 2. Ability to Buy Of the many influential factors, a product's price is the most important. Price is relevant to all markets and affects all buyers. Other essential determinants include consumer preferences, prices of related goods, income, population size, and buyer expectations for the future.

You can state some general rules: Price Elasticity of Demand and Total Revenue

1. When demand is inelastic (price elasticity less than one), price and total revenue move in the same direction. 2. When demand is elastic (price elasticity greater than one), price and total revenue move in opposite directions. 3. When demand is unit elastic (price elasticity exactly equal to one), total revenue remains constant when the price changes.

Quiz: A pizza shop plans to sell 12,000 pizzas. Each pizza costs the shop $7 in labor and ingredients. The shop has the following annual costs: Rent: $18,000 Utilities: $7,000 Insurance: $5,000 What is this pizza shop's expected total costs?

114,000 The formula: 12,000 pizzas x $7 each = $84,000 of variable costs. This plus the fixed costs of $18,000 for rent, $7,000 for utilities, and $5,000 for insurance provides the correct answer.

Quiz: What is the opportunity cost of producing one ton of bananas in a country that can produce either five tons of bananas or 10 tons of flowers in a season?

2 tons of flowers The value of what is given up divided by what is gained is how you calculate opportunity cost. For example, giving up 10 tons of flowers for five tons of bananas has an opportunity cost of two tons of flowers.

Lesson Summary

A Phillips curve shows the trade-off between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so higher unemployment means lower inflation and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years. The relationship between the rate of inflation and unemployment is inverse. Aggregate demand and the Phillips curve share similar components. The rate of unemployment and the rate of inflation found in the Phillips curve correspond to the real GDP and price level of aggregate demand. The long-run Phillips curve is a vertical line at the natural rate of unemployment, but the short-run Phillips curve is roughly L shaped. The natural rate of unemployment is the hypothetical level of unemployment the economy would experience if aggregate production were in the long-run state. A well-functioning economy is characterized by three things: stable prices, high employment, and steady growth. During the ups and downs of the business cycle, economies deviate from these characteristics displaying instability in prices, employment, and output. This module focuses on the policies available to help minimize the impact of these fluctuations and stabilize the macroeconomy. Two types of stabilization policies were discussed: fiscal policy and monetary policy. These can be used to address the problems of inflation and unemployment. However, as shown by the Phillips curve, it is difficult to address both problems simultaneously.

Partnership

A legal form of business operation between two or more individuals who share management and profits

Quiz: An economist is trying to identify how consumer appetite for a particular good is influenced by the price of the good. The researcher hopes to produce a table that will list how much of the good consumers desire at several specific price points. What is the economist producing?

A demand schedule is a table that displays quantity demanded for a product at several specific price points.

Export Subsidies

A government policy to encourage export of goods and discourage sale of goods on the domestic market through direct payments, low-cost loans, tax relief for exporters, or government-financed international advertising

Quotas

A limited quantity or dollar amount of a particular product that can be imported or exported in a particular time period

financial market

A market in which people trade financial securities and derivatives at low transaction costs

Price Ceiling

A legal limit imposed by the government on how high the price of a product can be. A price ceiling is a price control that limits the maximum price that can be charged for a product or service. Generally, ceilings are set by governments, although groups that manage exchanges can set ceilings as well. The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a maximum price, a government wants to ensure the good is affordable for as many consumers as possible. A price ceiling will only impact the market if the ceiling is set below the free market equilibrium price. This is because a price ceiling above the equilibrium price does not limit the market's movement toward equilibrium. The product is sold at the equilibrium price both before and after the ceiling is imposed. When the ceiling is less than the equilibrium price, normal market clearing price adjustment is prevented. This can be demonstrated using the following table. In the table, the market reaches equilibrium at a price of $3. At this price, both quantity demanded and quantity supplied are 30 units per month, and there is no tendency for price to change. Imposing a price ceiling that makes it illegal to charge more than $4 for the product has no effect on the market. Firms would still sell their products for $3. To be effective, the price ceiling must be set below the equilibrium price. In the case presented here, the price ceiling must be below $3 to alter the market outcome. Setting a price ceiling below the equilibrium price creates a shortage and causes market inefficiency. Remember that at a lower price, less of a good will be produced. At the same time, quantity demanded will increase. With more people willing to pay to get the good and fewer producers willing to supply the good, a shortage is inevitable. Without the price ceiling, market price would rise, eliminating the shortage. With the price ceiling, adjustment cannot happen so the shortage is sustained. To see an example, look at the previous table. Suppose the price ceiling is set at $2. Though the ceiling allows firms to charge less than $2, the firms would prefer to charge as much as possible. At the price of $2, consumers want to purchase 40 units per month. Unfortunately, suppliers are only willing to bring 20 units per month to the market. This creates a shortage of 20 units per month. Prices are not able to rise, so this shortage will persist. The price ceiling causes market failure by reducing the number of exchanges that take place. Exchanges between buyers and sellers only occur when both parties are willing to trade. Because imposing the price ceiling reduces the reward to selling, firms bring fewer products to the market. As a result, the quantity traded falls from 30 units per month at the equilibrium price to 20 units per month at the price ceiling. When considering market efficiency, it is necessary to understand how buyers and sellers value specific quantities.To be efficient, a market must achieve all possible gains from trade. This means anytime the value consumers place on the product is greater than or equal to the cost of bringing the product to the market, it is socially beneficial to trade. When imposed on a well-functioning market, price ceilings generate market failure.

A Monopoly Market

A monopoly exists when a specific person or enterprise is the only supplier of a particular good. Therefore, it is the least competitive market structure. A monopoly, like all other firms, maximizes profit. However, due to the lack of competition, a monopoly is a price maker and can charge a set price above what would be charged in a competitive market. The monopoly decides the price of goods or products being sold. But a monopoly must consider consumer demand. Consumers can choose to accept the price or choose not to buy the product. In a monopoly market, a single firm is the sole supplier of a particular good. A monopoly exists when the following conditions occur: 1. A single firm produces all the output for a good or service. 2. Other sellers are unable to enter the market due to high barriers of entry. 3. The monopoly sets the price.

Inflation

A quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation's currency

Quiz: In what way are trade barriers restricting foreign goods equivalent to subsidies for domestic producers?

A trade barrier leads to higher domestic prices paid to producers of goods that are protected by the barrier. ! With less competition and fewer producers providing to the domestic market, the no trade scenario would lead to a higher price received by the seller than the price received with trade. This is like the subsidy scenario when a seller receives a higher price than the price received at the allocative efficient quantity in the market.

Transfer Payments

A transfer payment is the provision of aid or money to an individual who is not required to provide goods or services in return. Social Security, Medicaid, and unemployment benefits are examples of transfer payments. Unlike discretionary spending, levels of spending on transfer payments are not explicitly set by the budget. Instead, Congress establishes the program, and spending varies with the number of people who qualify for the benefits. For many types of transfer payments, a person qualifies for the program based on his or her income. Transfer payments are often called automatic stabilizers because the level of spending on transfer payments adjusts automatically to changes in economic conditions. During a recession, when incomes fall, and people lose jobs, more people qualify for need-based assistance raising spending on transfer payments. When the economy expands, incomes and employment rise, reducing the number of people receiving benefits. Spending for those programs, therefore, tends to fall during an expansion. Transfer payments affect AD by influencing consumption (C) expenditures. Recipients use the benefits to purchase goods and services.

Discretionary Spending

A type of government spending that is implemented through an appropriations bill and is therefore optional

Unemployment in the AD-AS Model

Although the AD-AS model does not specifically identify employment, it can be interpreted based on output levels. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so) when the economy is healthy. This baseline level of unemployment that occurs year in and year out is called the natural rate of unemployment. It is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP corresponds to the natural rate of unemployment for an economy as it refers to the amount that can produce at full employment—no cyclical unemployment. The AD-AS diagram shows cyclical unemployment when the economy is to the left of the potential or full GDP employment level in a recessionary or contractionary gap. Relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD-AS diagram. Although the factors that determine the natural rate of unemployment are not shown separately in the AD-AS model, they are implicitly part of what determines potential GDP or full-employment GDP in a given economy.

Fiat Money

Has no intrinsic value, but is declared by a government to be the legal tender of a country

Quiz: Why does a change in government purchases have more of an impact on aggregate demand than a similar change in tax levels or transfer payments?

Any change in government purchases goes directly into the economy and is magnified by the multiplier effect. Government purchases lead to more money going directly into the economy. In turn, this is spent by businesses to buy more equipment and materials or pay more workers.

Excess Demand / Shortage

At the existing price, the quantity demanded exceeds the quantity supplied; also called a shortage. If the price is below the equilibrium level, the quantity demanded will exceed the quantity supplied. Excess demand or a shortage will exist.

Broadly Defined

Broadly defined markets (e.g., food) because it is easier to find close substitutes of narrowly defined goods. Markets that tend to be fairly inelastic and have no good substitutes. Broadly Defined markets (e.g., food) because it is easier to find close substitutes of narrowly defined goods. Goods tend to have more elastic demand over longer time horizons.

Quiz: The government of a tropical country has been completing projects to increase tourism access, but the construction has temporarily reduced tourist numbers. The government now spends more on the projects than it collects through taxes. Which budgetary situation is this country experiencing?

Budget deficit When a government spends more money than they take in for the year, they have created a deficit.

Quiz: Which institution is primarily responsible for creating and implementing fiscal policy in the U.S.?

Congress The U.S. Constitution gives Congress the financial influence, meaning they are responsible for creating and enacting fiscal policy through legislation for taxing and spending.

Government Purchases

Congress can authorize two different types of government spending. It can approve spending for the purchase of goods and services (this is known as discretionary spending), or it can distribute money in the form of transfer payments. These payments are often called automatic stabilizers because their levels adjust with economic conditions. Both types of spending influence aggregate demand (AD) but do so in different ways. Discretionary spending directly determines the government spending (G) component of aggregate demand. During the budget process, Congress authorizes certain spending levels for each government agency. This money is used to purchase goods and services produced by private firms, as well as direct production by government agencies themselves. When more spending is authorized, the government component of GDP increases, leading to an increase in AD. Reductions in spending reduce the amount of government purchases and lead to decreases in AD.

Quiz: An employer has agreed to give a 3% pay raise to all employees because inflation for the past year was 3%. What is the term used for this type of pay raise?

Cost of living adjustment This is an increase in pay sufficient to keep up with inflation.

Variable Costs

Costs that do change with the level of output Variable cost is based on factors such as labor and the cost of materials. Variable costs increase as the number of units produced increases.

Fixed Costs

Costs that do not change with the quantity of output produced. Fixed costs do not change in short-run production. When a firm increases production, the fixed costs can be allocated over more output, and the per-unit fixed cost decreases.

Quiz: Many economists are worried about the potential for an increase in unemployment that would occur if there is a major recession. Which problem is causing this concern?

Cyclical unemployment Cyclical unemployment is when people are unemployed as a result of an economic downturn.

Quiz: In the market for hats, the absolute value of the price elasticity of demand in the relevant price range is equal to 2, and the market price increases by 5%. What happens to the equilibrium quantity in the hat market under these conditions?

Decreases by 10% Using the price elasticity formula, the price increase gives a decrease of 10%. (10% change in demand / 5% change in price) = 2

Consumption

Disposable income is the primary determinant of consumption spending. Disposable income is the after-tax income available to the household. With more disposable income, consumption spending increases. With less, consumption spending falls. Therefore, an increase in AD is expected when income increases or when taxes decrease. This increase in AD is illustrated by the rightward shift in the demand curve from AD0 to AD1 in the graph below. If taxes were to increase or income was to fall, AD would decrease. This decrease in AD is shown as a leftward movement from AD0 to AD2. Changes in consumption may also be caused by changes in interest rates, expectations, or confidence.2

Discuss equilibrium in the aggregate demand and aggregate supply model.

Economic fluctuations, whether those experienced during the 1930s Great Depression, the 1970s stagflation, or the 2008-2009 Great Recession, can be explained using the AD-AS diagram. In the case of the housing bubble, rising home values caused the AD curve to shift to the right as more people felt that rising home values increased their overall wealth. Many homeowners took on mortgages that exceeded their ability to pay because, as home values continued to rise, the increased value promised to pay off any debt outstanding. Increased wealth due to rising home values leads to increased home equity loans and increased spending. All these activities pushed AD to the right, contributing to low unemployment rates and economic growth in the United States. When the housing bubble burst, overall wealth dropped dramatically, wiping out the recent gains. This drop in home values was a demand shock to the U.S. economy because of its impact directly on the wealth of the household sector and its contagion into the financial sector that essentially locked up new credit. The AD curve shifted to the left, as evidenced by the Great Recession's rising unemployment. This shift is an example of the type of economic downturn regularly experienced as part of the business cycle. In this lesson, you will learn how to use the AD-AS model to gain insight into macroeconomic events. By tracking shifts of the LRAS, SRAS, and AD curves, you will learn to understand the implications of different events for output, employment, and prices. The lesson explores the forces that cause movement of the economy away from long-run equilibrium. It then describes the market adjustments that return the economy to its potential GDP. These movements represent different phases of the business cycle. Mastering the AD-AS model will enable you to better understand and predict fluctuations in employment and inflation throughout the economy.1

Investment

Expectations and interest rates strongly influence business spending on capital goods. Firms evaluate potential investments according to how the goods purchased will affect profits. With high expectations for the future of the economy, a firm may decide to buy new machinery to expand its output in anticipation of increased profits. The firm would not make the same decision if it anticipated an upcoming recession. In this way, there is a positive relationship between business expectations and AD. Many investment purchases require financing. A need for financing makes interest rates a critical factor in determining the level of investment spending. Higher interest rates make borrowing more expensive and encourage lower investment spending. This decrease in investment spending shifts AD to the left, a movement from AD0 to AD2. On the other hand, lower interest rates reduce the overall cost of capital goods, leading to an increase in investment and a corresponding increase in AD.2

Fixed Costs Continued

Fixed costs occur only in the short run and are expenditures that do not change with the level of production. One example of a fixed cost is the rent on a factory or a retail space. For the duration of your lease, the rent is the same regardless of how much you produce. Fixed costs can take many forms—for example, the cost of machinery or equipment to produce a product, research and development costs to develop new products, and even an expense like advertising to popularize a brand name. The level of fixed costs varies according to the specific line of business. For instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling company can get by with almost no fixed costs at all if it rents trucks by the day when needed.2

Quiz: An economist is conducting a study on the number of people without work because they have left one job to look for another that is a better match for their skills. Which topic is this economist studying?

Frictional unemployment Frictional unemployment refers to the unemployment that is a result of individuals switching jobs.

Quiz: How are the aggregate demand (AD) curve and the Phillips curve related?

GDP and unemployment are negatively concerned with the influence of price changes on macroeconomic performance. The positive relationship between output and employment means that if AD shows a negative relationship between GDP and the price level, the short-run Phillips curve will show a negative relationship between inflation and unemployment.

Complements

Goods can also be related as complements for each other. This means that the goods are often used together because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk, notebooks and pens or pencils, and golf balls and golf clubs. When the price of one good rises, demand for its complementary good decreases. For example, if the price of golf clubs rises, consumers buy fewer golf clubs. As a result, demand for a complementary good like golf balls decreases too. This is depicted by shifting the demand curve to the left, shown in the following graph as the movement from D0 to D1. If instead the price of golf clubs fell, the demand for a golf balls would increase, shifting the curve to the right—a movement from D0 to D2.

Specific Tariffs

Import tax expressed in an amount of money per unit imported Specific tariffs are tariffs that levy a flat amount on each item that is imported. For example, a specific tariff would be a fixed $1,000 duty on every imported car, regardless of how much the car cost.

Inflationary Gap

However, if an economy is producing at a quantity of output above its potential GDP, in an inflationary gap, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In the following figure, the original equilibrium (E0) occurs at an output of 750, which is above the potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1 so the new equilibrium (E1) occurs at the potential GDP level of 700.

Discuss creation and regulation in fiscal policy.

In December 2007, the United States slipped into what would become its worst economic recession since the Great Depression. In response to this suffering, the federal government passed both the American Recovery and Reinvestment Act of 2009 (ARRA) and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Tax Relief Act). The ARRA added $787 billion of additional spending to the economy through a combination of tax cuts and spending increases, whereas the Tax Relief Act helped spur additional spending by putting more money in peoples' pockets In taking these actions to reduce the severity of the downturn and help steer the economy toward recovery, the federal government engaged in what economists call an expansionary fiscal policy. This lesson identifies the fiscal policy tools available to policymakers and explains how they can be used to influence economic outcomes. The lesson also evaluates different economic situations to clarify the conditions under which different policies are appropriate.

Comparing the Average Variable Cost Curve and the Average Total Cost Curve

In the following graph, average fixed cost, average variable cost, and average total cost are all shown. Note that at any level of output, the average variable cost curve will always lie below the curve of the average total cost, as shown in the graph. The reason is that the average total cost includes average variable cost and average fixed cost. Thus, for Q = 16 ornaments, the average total cost is $12.63 per ornament while the average variable cost is $5 per ornament. However, as the output grows, fixed costs become relatively less important (since they do not rise with output), so the average variable cost approaches the average total cost. The average variable cost is calculated by dividing variable costs by the total output at each level of output. Average variable costs are typically U-shaped.

Quiz: What is the first step in an expansionary monetary policy?

Increase the money supply This is the first step or goal in an expansionary monetary policy.

Quiz: A country focuses its national production in textile manufacturing because of abundant access to raw materials and textile expertise. What is a potential risk of this decision?

Industry overspecialization A country that focuses its national production in textile manufacturing faces the potential risk of industry overspecialization. If demand for textiles shifts, the country will be vulnerable and experience significant decreases in GDP.

Inflation Continued

Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. Inflation implies an ongoing rise in prices. If inflation happened for one year and then stopped, it would not be inflation anymore.

Quiz: What is the term used when the equilibrium real gross domestic product (GDP) is larger than the potential GDP?

Inflationary gap When the economy is above its potential, it leads to an expansionary gap.

Factors That Shift Supply

Input costs are not the only factor that causes a change in supply. Other things that shift the supply curve include: technology, expectations about the future, number of suppliers, and government policies. These factors help determine the quantity of output that a company is willing to sell a given price. Consequently, when any one of these factors changes, there is a change in supply—a shift in the supply curve. Look at these other factors. Technology—This refers to the production technology being used by the company. In most cases, when new technology becomes available to businesses, they can produce faster and at a lower cost. Technological improvements can result in an increase in production for a set amount of inputs and would result in an outward shift in the supply curve. For example, these coffee companies might incorporate a new roaster that allows them to roast the coffee beans faster. This would increase the amount of coffee they could make in a given period, increasing supply and shifting the supply curve to the right. Expectations—Sellers' expectations concerning future market conditions can directly affect supply. If a company expects that the price of the good will be higher in the future, they might store some of their current output to sell later. This would decrease the current supply and increase future supply. Farmers often store their grain rather than sell it when the price is low now but expect it to be higher in the future. Number of suppliers—The number of companies producing the good or service in the market affects the total amount of the good that can be produced. As more firms enter the industry, the total quantity that firms in the market are capable of producing increases. This increases supply, shifting the supply curve outward. Government policies and regulations—Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates, and zoning and land use regulations.3 More regulations or taxes on businesses usually mean higher costs of production for those companies. Higher costs will decrease supply, shifting the supply curve to the left.

How does the expanded circular flow diagram incorporate interactions with other countries?

It incorporates imports and exports. Imports and exports are a direct component of GDP measured as part of macroeconomics. These flows include exports, imports, and borrowing from other countries.

Quiz: What is the shape of the production possibility frontier (PPF) when opportunity costs are constant?

Linear and downward sloping This would indicate constant opportunity cost along with showing scarcity.

Narrowly Defined

Markets that tend to have more elastic demand and substitutes. Narrowly defined markets (e.g., ice cream) tend to have more elastic demand.

Quiz: Retail stores operating in a country with high inflation experience added costs and must keep changing their prices to account for the effects of inflation. Which factor is being managed by these retail stores?

Menu costs This is the cost firms pay because they must keep changing their prices to reflect inflation's impact.

Explicit Costs

Money a firm must pay out to settle its bills and pay its employees. Explicit costs are payments made to cover the firm's bills and are sometimes called out-of-pocket costs. Examples of explicit costs include the wages paid to a firm's employees and the rent a firm pays for its office. Explicit costs are payments made to cover the firm's expenses and are sometimes called out-of-pocket payments. Explicit are out-of-pocket costs.

Quiz: A new fast food restaurant owner recently opened a location in a town with low costs to open that type of establishment. There are many other restaurants in the town that sell a variety of food types. What type of market type is the owner entering?

Monopolistic competition Monopolistic competition is when there are many buyers and sellers in a market that is easy to enter or exit. In that market, the products are similar but still a bit different from each other.

Quiz: Principle 6: Markets are a sound method of organizing economic activity.

Multiple producers and consumers exchange goods and services. Principle 6 is about how free markets allow many producers to specialize.

A new landfill was recently announced near a small city. Homeowners in the city, who were not involved in the decision to open the landfill, recognized an immediate decrease in home values following the announcement. What have the homeowners experienced?

Negative externality The home values declining due to a decision homeowners were not involved in making is a negative externality. The landfill decision was made for private benefit without regard to the homeowner's investments. The home market is experiencing a decrease in value due to the landfill.

Changes in Equilibrium

Once a market reaches equilibrium, as long as there are no changes to any of the nonprice factors underlying supply and demand, the market will remain at that equilibrium. Any change in these underlying factors will disrupt the existing equilibrium, and the market will move to a new equilibrium. Any factor other than price that changes a consumer's willingness or ability to buy a product can change demand. These factors include income, preferences, population, price of related goods, and expectations of the future. Similarly, supply changes in response to changes in nonprice factors including input costs, technology, number of firms, expectations, and government policy. Though there are many factors that can change, economists most often analyze one change at a time. Even so, when given an event, it is difficult to immediately predict how this event will impact a market equilibrium. When the quantity demanded is equal to the quantity supplied, the market is in equilibrium. At that point, though there is no internal tendency to change, changes in nonprice factors can shift supply or demand, altering the equilibrium. Market pressures will push the price toward the equilibrium level. Equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes.

Hidden Unemployment

People who are jobless, but official unemployment figures do not include them In some instances, the categories of employed, unemployed, or out of the labor force do not accurately describe a person's situation. People who have part-time or temporary jobs but are looking for full-time and permanent employment are counted as employed, although they are not employed in the way they would like to or need to be. These individuals are considered underemployed. This includes those who are trained or skilled for one type or level of work but working in a lower paying job or one that does not utilize their skills. For example, an individual with a college degree in finance who is working as a sales clerk would be considered underemployed. The gap between the individuals' desired employment and actual employment is considered hidden unemployment. Discouraged workers, those who have stopped looking for employment and are no longer counted in the unemployed, also fall into this group.

Quiz: A few major companies recently announced plans to move to a midsized city. Homeowners in that city, who are not connected to any of the new companies, recognized an immediate increase in home values. What have the homeowners experienced?

Positive externality A few major companies recently announced plans to move to a midsized city and homeowners recognized an immediate increase in home values. The homeowners have experienced a positive externality because they received a benefit for a decision that they were not involved in making.

Hyperinflation:

Rapid, excessive, and out of control price increases in an economy

How Much Can the Government Borrow?

So, how much can a government borrow? The U.S. debt in 1945 was 117% of their GDP, and the U.K.'s debt in the early 1950s was 220% of their GDP. There are many factors which influence how much a government can borrow, such as the level of domestic savings, the relative interest rate, whether the government has access to a central bank, the prospects for economic growth, the likelihood of the country's ability to pay back the loan, whether foreign countries are interested in lending money, and the rate of inflation (Pettinger, 2011).

Quiz: A manufacturer is producing its product in two different plants that are located in two different countries. The main difference between the two countries is that labor cost is lower in one of the countries. Which statement is true of the lower labor cost country?

The LRAC for the plant will be vertically lower. Since the only difference between the two locations in terms of production is the cost of labor, the location with the lower labor cost would have lower average costs for all of its production technologies.

Equilibrium Quantity

The quantity of a good or service bought at the equilibrium price. The equilibrium quantity is the quantity produced and bought where the supply and demand curves intersect

Equilibrium Quantity (QE)

The quantity of a good or service bought at the equilibrium price. The equilibrium quantity is the quantity produced and bought where the supply and demand curves intersect On a graph, the point where the supply curve (S) and the demand curve (D) intersect is the equilibrium. The price at this intersection is called the equilibrium price (PE), and the quantity is called the equilibrium quantity (QE)

Shifts in Aggregate Demand

The components of AD are consumption spending (C), investment spending (I), government spending (G), and spending on net exports (NX)—or exports (X) minus imports (M). These categories provide a useful means of sorting buyers into groups whose purchasing decisions respond to similar factors. Sorting buyers is essential because an increase or decrease in any one of these components will shift the AD curve. An increase in AD causes a shift of the AD curve to the right. In the following graph, this is illustrated as a movement of the AD curve from AD0 to AD1. A shift of the AD curve to the left is a decrease in AD. This shift is illustrated in the following graph as a movement from AD0 to AD2. The primary variables that shift the aggregate demand curve include income, taxes, interest rates, expectations, and exchange rates. These factors affect AD through changes in the components of demand for real GDP—household consumption, business investment, government spending, and net exports.2

Net Exports

The difference between the monetary value of exports and imports

Quiz: Which characteristic of the production possibility frontier is most directly related to scarcity?

The downward (negative) slope of the frontier. This profile is seen during scarcity.

Quiz: What is the employment situation when the economy is operating to the left of potential gross domestic product (GDP)?

The economy is experiencing cyclical unemployment. Cyclical unemployment occurs when the economy is producing less output because of a recessionary gap.

An entrepreneur is considering opening a fast food restaurant that is similar to various fast food restaurants in the area. The entrepreneur researches the other restaurants and learns that they are producing the same quantity of output. What does this suggest about the constant returns to scale range of restaurants in this industry?

The flat area of their long-run average cost curves is very small. All of the restaurants appear to be using the same technology and producing at a similar operating level.

Implicit Costs

The opportunity costs of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned. Implicit costs are more subtle but just as important. They represent the opportunity cost of using resources already owned by the firm. Often these resources are contributed by the firm's owners. There are four primary sources of implicit cost: forgone wages, forgone interest, depreciation, and normal profit. Implicit costs represent the opportunity cost of using resources already owned by the firm and do not require an outflow of money. Implicit costs represent opportunity costs.

Federal Funds Rate

The rate that banks charge other banks for overnight loans

Aggregate Supply Curves

The total quantity of output (real GDP) that firms will produce and sell at each price level

Aggregate Supply (AS)

The total supply of goods and services available to a particular market from producers

Purchasing Power

The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. By definition, inflation causes the value of an individual dollar to decrease over time. Each dollar has less purchasing power with inflation. Thus, individuals who have the same wage next year as this year will be able to purchase less. Purchasing power can be maintained if wages increase exactly at the rate of inflation, but this is not always the case. When wages increase less than the rate of inflation, people lose purchasing power.

Customs and Administrative Procedures

This category of trade barriers refers to trade impediments that stem from governmental procedures and controls. Some examples include the following: Bureaucratic delays—Delays at ports or other country entrances caused by administrative or bureaucratic red tape increase uncertainty and the cost of maintaining inventory. Antidumping duties—In international trade, dumping refers to a form of predatory pricing in which exported products are priced below the cost of production or the price charged in the home market. Antidumping duties are usually extra taxes levied on the product to neutralize the predatory pricing and bring the price closer to the world price.

Specific Limitations to Trade

This category of trade barriers stems from regulations on international trade. Some examples include the following: Local content requirements, or domestic content requirements, are rules that mandate how much of a product must be produced domestically to qualify for lowered tariffs or other preferential treatment.3 Manufacturers wishing to evade import restrictions may try to change the production process so the last significant change in the product happens in their country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make apparel, then re-exported back to the United States for a final assembly to escape paying tariffs or to obtain a "Made in the U.S.A." label. Most governments ban addictive drugs such as heroin, cocaine, and marijuana. Their primary reason is that these and similar drugs are deemed to be harmful to those who use them. A secondary reason is that governments may think that the trade of such drugs also has other harmful implications, such as increased crime. The exchange of some goods and services is banned for ethical or moral reasons. Examples include the trading of human organs, the sale of alcohol, and various forms of prostitution. In many places, the consumption and sale of alcoholic beverages are forbidden, often for religious reasons. The sale of alcohol is prohibited in some Muslim countries such as Saudi Arabia and Kuwait. Religious pressure also led to a thirteen-year ban on alcohol in the United States under the 18th Amendment to the Constitution; this state of affairs was known as the Prohibition. In many counties in the United States, the sale of alcohol is still prohibited. Likewise, many other countries in the world have regions that are dry, or alcohol free. Embargoes are prohibitions on trade banning imports or exports. They may apply to specific categories of products or strictly to goods supplied by individual countries. Embargoes, which are similar to economic sanctions, generally involve a direct military or air blockage. They are a complete prohibition of trade with a specific country, state, or region. Embargoes are legal methods to block trade, unlike blockades, which are considered acts of war. Embargoes can vary in restriction from a limitation in trade, the imposition of a tariff, or the complete blockage of trade. A country that has its trade embargoed usually needs to be self-sufficient or needs to develop a closed economy, also called an autarky.

Structural Unemployment

Unemployment that occurs because individuals lack skills valued by employers Another type of unemployment is structural unemployment. This is long-term, persistent unemployment. The structurally unemployed are individuals who have no jobs because they lack skills valued by the labor market, either because demand has shifted away from the skills they do have or because they never learned any skills. An example of the former would be the unemployment among aerospace engineers after the U.S. space program downsized in the 1970s. An example of the latter would be high school dropouts. People worry that technology causes structural unemployment. In the past, new technologies have put lower skilled employees out of work, but at the same time have created demand for higher skilled workers to use the new technologies. Education seems to be the key in minimizing the amount of structural unemployment. Individuals who have skills and education can be retrained if they become structurally unemployed. For people with no skills and little education, that option is more limited.1

Quiz: A used car dealership is trying to specialize in selling exceptionally well-maintained used cars. However, the maintenance of its used cars is unverifiable to buyers. The dealership would like to convince buyers to pay a higher price than found in the market for its used cars based on the idea that they will last longer. Is it possible for the dealership to convince buyers of this fact?

Yes, if the dealership offers a low-cost service contract to overcome the asymmetric information problem This will help to assure a buyer prior to the transaction that the used car is likely to be of superior quality.

Quiz: When are all costs variable costs?

When planning for the long run When you are long-run planning, all your costs are variable because you have opportunities to change inputs.

Inelastic Demand

When the elasticity of demand is less than one, indicating a relatively low responsiveness of the quantity demanded to a change in price, in percentage terms. When demand is inelastic, price and total revenue move in the same direction, so an increase in price will increase total revenue. When demand is elastic, price and total revenue move in opposite directions, so a price increase results in a decrease in total revenue.

Economic Profit and Efficiency

When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing consumers, something remarkable happens: The resulting quantities of outputs of goods and services demonstrate both productive and allocative efficiency. Productive efficiency means producing as little waste as technologically possible such that production is on the production possibility frontier. In the long run in a perfectly competitive market the price in the market is equal to the minimum of the long-run average cost curve because of the process of entry and exit. In other words, firms produce and sell goods at the lowest possible average cost. Allocative efficiency means that among the points on the production possibility frontier, the chosen point is socially preferred. This is because marginal benefits equal marginal costs. The rule of profit maximization in all markets is MR = MC, where MR and MC are the marginal revenue and marginal cost of each unit, respectively. In the world of perfect competition, the price (P) is equal to marginal revenue. Thus, MR = P. This is due to a firm's demand curve being perfectly elastic. If the rule P = MR = MC is satisfied, then the result is allocative efficiency. Perfect competition in the long run is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly (which are more frequently observed in the real world than perfect competition), firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency.5 Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty that may make some people unable to pay for basic necessities of life, government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information. However, the theoretical efficiency of perfect competition does provide a useful benchmark for comparing the issues that arise from these real-world problems.5

Benefits to Specialization

Whenever a country has a comparative advantage in production, it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation's economy. The effects of specialization (and trade) include the following: Greater efficiency: Countries specialize in areas that they are naturally good at and may also benefit from increasing returns to scale for the production of these goods. They benefit from economies of scale, which means that the average cost of producing the good falls (to a certain point) because more goods are being produced. Similarly, countries can benefit from increased learning. They simply are more skilled at making the product because they have specialized in it. Both of these effects contribute to increased overall efficiency for countries. Countries become better at making the product they specialize in. Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally, more goods are produced and prices are lower than previously. Consumers benefit from these lower prices and a greater quantity of goods. Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and benefit further from economies of scale. Gains from trade: Specialization and trade allows countries to consume more than they would be able to produce entirely on their own.

The Government Enacts a Tariff

With such a significant portion of lumber production being imported, the government may choose to introduce a protectionist policy to restrict foreign competition due to pressure from domestic producers. A critical clarification about this model is that the only benefits the U.S. cares about are domestic benefits. Any gain or loss to foreign producers is irrelevant in the U.S.'s decision-making. Suppose the government enacts a $400 tariff on imports to restrict competition. A tariff is a tax imposed on imported goods or services. This creates a new domestic price equal to $800 (world price + the $400 tariff). While this price is still below the domestic equilibrium, more domestic firms are now able to compete. At the new domestic price, only 50 million board feet is demanded, but 30 million board feet of lumber are supplied domestically. This means that imports have dropped from 60 million to 20 million board feet.

Ten Principles of Economics:

1. Everyone faces tradeoffs. 2. The cost of something is determined by what someone gives up to get it. 3. Rational people think at the margin. 4. People respond to incentives. 5. Trade can benefit everyone. 6. Markets are a sound method of organizing economic activity. 7. Governments may be able to improve market outcomes. 8. The standard of living for a nation is determined by its ability to produce goods and services. 9. Printing too much money causes prices to rise. 10. Society faces a short-run trade-off between inflation and unemployment. The ten principles of economics are interrelated and describe how people make decisions and interact and how the economy acts as a whole.

For every factor of production (or input), there is an associated factor payment. These payments are what the firm pays for the use of the factors of production. From the firm's perspective, factor payments are costs. From the owner of each factor's perspective, factor payments are income. Factor payments include:

1. rent for land or buildings 2. wages and salaries for labor 3. interest and dividends for the use of financial capital (loans and equity investments) 4. profit for entrepreneurship In a market economy, payments by the firm for the use of factors of production are an integral part of a system that can be described using the circular flow model. This model tracks the flows of both money and goods in an economy.

Production Possibilities Frontier

A graphical representation used by economists to show the alternative combinations of two goods or services that an economy can produce with the given resources and technology when the resources are fully and efficiently used at a given point in time. The PPF shows the combinations of two goods or services that an economy can produce within a given period when all resources are used efficiently. All points on the production possibilities frontier are efficient. The production possibilities frontier model identifies the combinations of goods that can be produced if all resources are used efficiently.

Quiz: Which scenario matches Principle 4 of economics—people respond to incentives?

A sales manager offers a higher percentage of commission for a product that is not selling well. This demonstrates Principle 4, which is about creating an incentive for a certain choice.

Circular Flow Model

An economic model that shows the flow of money and goods through the economy. The most common form of this model shows the circular flow of income between the household sector and the business sector This model tracks the flows of both money and goods in an economy. Economists use the circular flow model to describe the economic activity created by the exchange between the factors and payments of production. In its simplest form, the circular flow model examines the relationship between firms and households. The circular flow model is described as follows: 1. Businesses supply goods and services to households. In return, households pay for those goods and services. 2. All inputs to production are owned by the households. In return, they are paid wages, rents, interest, and profit.

Command Economy (Centralized)

An economic system in which production, investment, prices, and incomes are determined centrally by a government. A system where the government makes all the decisions. A command (centralized) economic system is an economy in which all economic decisions are made by a central government. In this type of economy, the government owns and controls vital services and industries such as utilities, healthcare, housing, and transportation. Theoretically, command economies can plan, produce, and distribute enough resources for the entire population, including jobs, education, and essential services. In reality, command economies tend to fail due to inadequate incentives, corruption, and inefficiencies. Consequently, the central power cannot provide for everyone's needs. The five fundamental characteristics of a command economy are that: 1. All economic activity is planned and controlled by a centralized government power. 2. The government decides how to use and distribute the nation's natural, capital, and labor resources. 3. A nation's central power controls the priorities for how goods and services will be produced and distributed. 4. Domestic competition is overpowered as the government monopolizes businesses considered essential for economic goals such as utilities, finance, and automotive companies. 5. Businesses are required to follow specific hiring and production targets set by the government. This creates regulations and directives to enforce the centralized plan. A command economy has several advantages such as the following: 1. In this type of system, goods, services, and resources are deployed without concern for environmental or other regulatory issues. 2. The government can transform the entire society to fit the constraints of its national vision through nationalizing industry and deciding where workers will be placed. A command economy can also have disadvantages such as the following: 1. Underlying black market economies tend to develop as a response to difficult access to goods and services. 2. Rationing commonly occurs due to poor planning and an inability to meet societal demands. 3. People are discouraged from innovating and are required to follow orders and keep with the central plan. Command: The government makes all decisions regarding the production and distribution of goods, services, and human resources. Economic access is very limited for the general population.

Market Economy (Decentralized)

An economic system in which the decisions regarding investment, production, and distribution are guided by the price signals created by the forces of supply and demand. A system where businesses make decisions based on consumer demand. In a market economy, decision-making is decentralized. The means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals who make self-interested decisions. While businesses supply goods and services based on demand, this demand is composed of the purchasing decisions of households that act in their own self-interest. In this scenario, economic decisions are determined by market forces, not governments. In other words, consumers influence how much product and services are made available through their purchasing and usage patterns. Though consumers and businesses act independently, their actions are coordinated through price adjustment in a market system. Businesses focus on selling their products at the highest price that consumers are willing to pay. Consumers look for the lowest available prices. This interaction creates competition between businesses but also fosters innovation. There are five key characteristics of a market economy: 1. Privately-owned goods and services are standard, and people and businesses have the right to commercialize their property freely. 2. People can innovate, produce, sell, and purchase goods and services. 3. Prices, production, and job availability are driven by self-motivation and competition, according to the laws of supply and demand. 4. The economy relies on market efficiency where producers and consumers have access to the same information to make economic decisions. 5. Government interference is limited to regulating safety, fair access, environmental, and national defense issues. Market economies have the following advantages: 1. Goods and services are readily available because consumers and businesses have the freedom to negotiate prices. 2. Production methods are efficient, which increases productivity and profitability. 3. Innovation is rewarded and encouraged, benefiting the society. 4. Individuals and organizations invest in successful ventures, which in turn drive innovation and quality improvement. Market economies have the following disadvantages: 1. Competition drives market economies, and, in many cases, there are not enough mechanisms implemented to protect the underprivileged and disadvantaged. 2. There is a tendency for labor resources to be underoptimized because access to education and skills improvement may not be affordable and accessible to everyone. 3. There can be a sharp contrast between the economic power of the privileged versus the power of the underprivileged. Society must decide between self-interest and protecting the vulnerable in a climate where winners are overvalued. Market: Consumer choices drive the economy, and government involvement is limited. Production, distribution, and the prices of goods and services are allocated through consumer demand. There are no true market economies.

The four existent types of economies are the following:

Economic systems refer to how an economy distributes scarce resources. 1. Traditional Economy 2. Command Economy 3. Market Economy 4. Mixed Economy

Positive versus Normative Economics

Economics is primarily concerned with positive analysis. However, economists recognize the critical role of normative judgements in decision-making and priority setting. Positive statements focus primarily on facts, and they can be tested. As a social science, economics focuses on analyzing economic behavior and avoids economic value judgments. For example, "the unemployment rate in France is higher than that in the United States" is a positive economic statement. It gives an overview of an economic situation without issuing a value judgment or opinion on the information. Normative statements are opinions that express value or normative judgments about economic fairness. They focus on what the outcome of the economy or goals of public policy should be. Many normative judgments are conditional. An example of a normative economic statement is that the price of milk should be $6 a gallon to give dairy farmers a higher living standard. It is a normative statement because it reflects an opinion—a value judgment stating what should be done.3 Normative statements cannot be tested as people cannot prove opinions to be right or wrong. Positive and normative economic thought are two specific aspects of economic reasoning. Although they are associated with one another, positive and normative economic thought have different focuses for analyzing economic scenarios. Positive economics clearly states an economic issue, and normative economics provides the value-based solution for the issue.

Principle 6: Markets are a sound method of organizing economic activity

Free markets are comprised of many goods and services as well as multiple buyers and sellers who are mostly focused on their own well-being. Free markets have consistently succeeded in promoting organized economic activity and achieving overall economic well-being. Principles of Economics Five to Seven: How People Interact

Factor of Production: Entrepreneur

Goods and services are produced using the factors of production available to the economy. Two things play a crucial role in implementing these factors of production. The first is technology: the knowledge that can be applied to the production of goods and services. The second is an individual who plays a key role in a market economy: the entrepreneur. Entrepreneurs operate within the context of a market economy to earn profits by finding new ways to organize the factors of production. In nonmarket economies, the entrepreneur is bureaucrats and other decision makers who respond to incentives other than profit to guide their choices about resource allocation decisions. The interplay of entrepreneurs and technology affects all lives. Entrepreneurs use new technologies every day, changing the way factors of production are used. Farmers and factory workers, engineers and electricians, technicians and teachers all work differently than they did a few years ago, using new technologies introduced by entrepreneurs. The music you enjoy, the books you read, and the athletic equipment that you play with are produced differently than they were five years ago. People can dispute whether all the changes have made their lives better. What they cannot dispute is that they have made lives different.

Consumer Goods

Goods bought and used by consumers

Trade-off

If resources are already being used efficiently, then increasing the production of one output requires a reduction in the production of the other. A trade-off occurs when a person gives up one quality, quantity, or property in return for gaining something else. "There is no such thing as a free lunch" Trade-offs exist because of scarcity and the economic problem that there are finite resources and infinite wants. In economics, a trade-off is expressed in terms of the opportunity cost of a particular choice, which is the loss of the most preferred alternative. A trade-off, then, involves a sacrifice that must be made to obtain a particular product, service, or experience, rather than others that could be made or obtained using the same required resources. In the guns versus butter example, if the economy is operating at a point on its PPF, increasing the production of guns inherently means the production of butter must be decreased. Why? On the production possibilities frontier, the economy is operating efficiently. The economy cannot produce another gun without giving up butter. The decision to produce one at the expense of the other is a trade-off. Careful consideration of the benefits and costs of the production of each gun and each pound of butter will help determine the best choice for each situation. A trade-off is a situational decision in which you lose one quality, quantity, or property in return for gaining something else. Like all decisions, a trade-off decision is made after thoroughly evaluating the marginal benefits and marginal costs of each option. Trade-offs result because there are infinite human wants and limited resources or factors of production. Scarcity is what forces you to make trade-offs. If the inputs of production are underutilized, there is not a required decrease in the production of the other good when increasing production to the point that the output combinations sit on the production possibilities frontier.

Quiz: What is a benefit of using a traditional economic system?

In a traditional economy, roles are very well defined.

Modeling and Data

In science, models are used to simplify complex situations for analysis. An economic model is a simplified version of the economy that allows people to observe, understand, and make predictions about economic behavior. The purpose of a model is to take a complex, real-world situation and simplify it to the essentials. If designed well, a model can give the analyst a better understanding of the situation and any related problems. Economic indicators help economists use their models to create predictions about economic changes. Accurate predictions help businesses and individuals make better decisions and prepare for economic downturns. Economic indicators occur daily. For example, a newspaper article may list consumer product prices (microindicators) while another discusses the rate of unemployment (macroindicators). Some indicators may be in the past (last year's housing prices), and some relate to a possible future (how much housing prices are expected to rise this year). A model is a framework designed to show complex economic processes. The focus of a model is to gain a better understanding of how things work, observe patterns, and predict the results. Economic indicators help create predictions about economic changes.

Quiz: Two countries have entered into a mutually beneficial trade agreement. What will happen to production technology and the mix of goods produced in these countries?

It will generate greater innovation in production technologies and increase the amount of attainable combinations of goods produced. This situation will lead to greater innovation and an increase in the amount of goods produced.

Quiz: Which economic reasoning is involved when someone wants to study a country's output of gross domestic product (GDP)?

Macroeconomic theory deals with the country as a whole, including measuring output via GDP.

Efficiency

Producing the maximum amount of goods and services possible given available resources and technology

Payments of Production

Production depends on the use of scarce resources, which are known as the factors of production (land and natural resources, labor, capital, and entrepreneurship). Payments are made to use these resources. Each factor of production receives a specific type of payment: 1. land and natural resources: Rent 2. labor: Wages 3. capital (physical and intellectual good): Interest 4. entrepreneurship: Normal profit The type of economic system of a nation determines who owns the factors of production. Factors of production can be owned by households, businesses, and governments. The supply and payments for these factors circulate in an economy when they move between owners, producers, and consumers. For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production.

Scarcity and Production—Homogeneous Inputs

Production is limited by resource scarcity and the available technology. Given a specific amount of productive resources, only a certain quantity of goods can be produced. This means that choosing to produce one product necessarily limits the production of another product. A production possibility frontier is used to illustrate the limitations faced by an individual, firm, or country. As with the budget constraint, the production possibilities model employs certain simplifying assumptions to limit the scope of the analysis.3These assumptions include the following: 1. Resources are fixed. There is no way to increase the availability of capital, land, labor, or entrepreneurship. 2. All available resources are fully employed. No resources are wasted. 3. Only two things are produced. This assumption is to simplify the situation and allows the usage of each axis for one variable. 4. Technology is fixed

Principle 4: People respond to incentives

Since most decisions are based on costs versus benefits, people's attitudes may change when there is a change in the cost or benefit of something. Example: A student athlete does not prioritize academics and focuses instead on becoming a professional football player. This athlete is told a higher grade point average is needed to continue playing. The student's attitude towards academics may change as it will allow the student to continue playing football. Principles of Economics One to Four: How People Make Decisions

research and development (R&D)

Term commonly used to describe the activities undertaken by firms and other entities such as individual entrepreneurs to create new or improved products and processes

Quiz: A well-established company has been producing goods and wants to create a new line of production. The company needs to decide whether it should use a current factory or find a new location.

The company needs to answer, "How to produce it?" in this scenario.

Quiz: Consider the concept of the production possibility frontier and a limited budget in regard to a model, chart, or graph. What happens as a consumer decreases spending on one of two choices?

The consumer has more money to spend on the other item. Spending less on one item makes more money available for the other item.

Factor of Production: Natural Resources

There are two key characteristics of natural resources: The first is that they occur in nature—that no human effort has been used to make them. The second is that they can be used to produce goods and services. That requires knowledge; people must know how to use the things found in nature before the things become resources. Oil in the ground is a natural resource because it is found (not manufactured) and can be used to produce goods and services. However, 250 years ago, oil was a nuisance, not a natural resource. Pennsylvania farmers in the eighteenth century who found oil coming through their soil were dismayed, not delighted. No one knew what could be done with the oil. It was not until the mid-nineteenth century that a method was found for refining oil into kerosene that could be used to generate energy, transforming oil into a natural resource. Oil is now used to make all sorts of things including clothing, medicine, gasoline, and plastic. It became a natural resource because people discovered it and implemented a way to use it. Defining something as a natural resource only if it can be used to produce goods and services does not mean that a tree has value only for its wood or that a mountain has value only for its minerals. If people gain utility from the existence of a beautiful wilderness area, that wilderness provides a service. The wilderness is thus a natural resource. The natural resources available to society can be expanded in the following three ways: 1. discovery of new natural resources, such as the discovery of a deposit of ore containing titanium 2. discovery of new uses for resources, such as what happened when new techniques allowed oil to be productively used or sand to be used in manufacturing computer chips. 3. discovery of new ways to extract natural resources to use them; New methods of discovering and mapping oil deposits have increased the world's supply of this important natural resource. Natural resources are things found in nature that can be used to produce goods and services.

Types of Lines for PPF:

When the factors of production are homogeneous, the PPF is a straight line. When the factors of production are heterogeneous, the PPF has a bowed-out shape caused by increasing opportunity cost. Since production is efficient on the production possibilities frontier, it is not possible to produce more of one good without sacrificing the production of the other good.

Positive Externality

Beneficial spillovers to a third party or parties A positive externality is a benefit that results from an activity or transaction and that falls on a person who had no role in the decision generating the benefit. Positive externalities cause underproduction in the market, creating inefficiency. Consumers make decisions based on private benefits, not social benefits. For example, when homeowners think about making improvements to the exterior of their home—repainting, landscaping, and new roof—they evaluate the benefits of doing this work. They may think about the satisfaction and pride of creating a beautiful, welcoming home and consider how the improved curb appeal could raise their home's value. These benefits are captured by the homeowner and are considered private benefits. These may be substantial, but they are not comprehensive. Homeowners are not able to capture the benefits their improvements provide to neighbors. Home buyers do not just choose a house; they also choose a neighborhood. This means that when exterior enhancements make the neighborhood more attractive, it improves the selling speed and the selling price of other homes in the neighborhood. These are the external benefits of the home improvement. They do not impact the homeowner's decision because they cannot be captured by the homeowner. The sum of the private and the external benefits is called the social benefit. An economically efficient decision would take both private and external benefits into account, executing decisions where the sum of these benefits exceeds the cost of the project. However, because homeowners focus on private benefits and these are lower than social benefits, a homeowner will often decide against a project that is socially beneficial. As a result, fewer home improvements are done than would be socially optimal. This inefficient outcome is known as market failure. Positive externalities are present in several socially important transactions. Education decisions impact a nation's growth. Inoculation decisions have public health consequences, and basic research decisions determine the path of technological change. In each of these cases, the people taking action are presumably not doing it for the sake of the community, but for their own purposes. Unfortunately, because of the positive externality, people choose fewer of these essential goods than is socially desirable. Government policy can be used to help correct this inefficiency. Appropriate policies take several forms, but all have a similar goal: to help the party creating the positive externality receive a greater share of the social benefits. In the case of vaccines like flu shots, an effective policy might be to provide a voucher to any citizen who wishes to get vaccinated. This voucher would act as income that could be used to purchase only a flu shot. Suppliers of the flu shots would receive payment per vaccination, whereas consumers of flu shots would redeem the voucher and only pay a price of the subsidy. When the government uses a subsidy in this way, a more socially optimal quantity of vaccinations is produced. In addition to subsidies, governments may also set rule or may decide to publicly provide the good or service. Both of these policies are used in education. Public education is provided for children in grades K-12, and there is a minimum age for leaving school. Markets underproduce when a positive externality is present, generating inefficient outcomes. Government intervention in markets with positive externalities can encourage actions that create benefits for others by providing incentives to increase production.

How Firms Differentiate Their Products

A firm can differentiate its products from those of its competitors in several ways, such as the physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. Physical aspects of a product include all the phrases you hear in advertisements (for example, unbreakable bottle, nonstick surface, freezer-to-microwave, nonshrink, extra spicy, and newly redesigned for your comfort). A firm's location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably attract more customers because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory. Intangible aspects can differentiate a product, too. Some intangible aspects include promises (like a guarantee of satisfaction or money back), a reputation for high quality, services (like free delivery), or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded. But because of past habits and advertising, they have strong preferences for specific brands. Advertising can play a role in shaping these intangible preferences.4 Unlike perfectly competitive markets, consumers do not have perfect information about products. The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and thus monopolistic competition.

Differentiated

A product that is different from similar ones. Differentiation is due to buyers' perceiving a difference. Hence, causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The objective of differentiation is to develop a market position that potential customers see as unique. A unique position in the market primarily affects performance by reducing competition. A successful product differentiation strategy will move a product from competing based primarily on price to competing based on non-price factors such as product characteristics, distribution strategy, or promotional variables.

Intermediate Goods

A product used to produce a final good or finished product

Equilibrium

A state where supply and demand are balanced and, in the absence of external influences, the price and quantity will not change. An equilibrium exists when there is no tendency for the market to change. This happens when market price reaches the level that equates the quantity demanded with the quantity supplied. On a graph, the point where the supply curve (S) and the demand curve (D) intersect is the equilibrium. The price at this intersection is called the equilibrium price (PE), and the quantity is called the equilibrium quantity (QE) The equilibrium price and equilibrium quantity occur where the supply and demand curves cross. The equilibrium occurs where the quantity demanded is equal to the quantity supplied. Equilibrium is a state in the market in which the price is at a point where the quantity demanded equals the quantity supplied. On a graph, the equilibrium is the intersection of the supply and demand curves, determining the equilibrium price and quantity. Markets are always moving toward equilibrium as surpluses and shortages emerge. As supply and demand curves shift, the point of equilibrium also shifts accordingly. After each shift, the market moves back to equilibrium at a new equilibrium price and quantity. Markets are in constant flux as demand and supply are subjected to varying driving forces and influences. These shifts play a critical role, altering market equilibrium price points and volumes for products and services.

Economies of Scale

A proportionate savings in costs gained by an increased level of production In the long run, once a firm has determined the least costly production technology, it can then consider the optimal scale of production. To change scale, the firm multiplies its cost-minimizing labor-capital combination by a chosen scale factor. If a firm that is currently using 10 units of labor and 4 units of capital wants to double in size, it can scale up by multiplying its inputs by a factor of 2. The firm will increase its labor usage to 20 units and its capital usage to 8 units. Scaling the company in this way impacts both the firm's output and its costs. Economists describe the relationship between output and cost in the long run using scale economies. A firm experiences economies of scale when, as the quantity of output goes up, the cost average cost goes down. This occurs when a firm scales inputs up by a certain factor and generates an increase in output that exceeds that factor. For example, if the firm's output triples when inputs are doubled, the firm exhibits economies of scale. Doubling inputs doubles costs; however, because output more than doubles, per-unit costs fall. Economies of scale are behind the success of warehouse stores like Costco or Walmart. That is, a larger factory can produce at a lower average cost than a smaller factory. The shape of the LRAC curve, as drawn in the following figure, is relatively common for many industries. The left-hand portion of the LRAC curve, which slopes downward from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the LRAC curve, an increase in scale leads to lower average costs. In the middle portion of the LRAC curve—the flat portion around Q3—economies of scale have been exhausted. In this situation, using double the inputs generates double the outputs. This is called constant returns to scale. In this range, LRACs are constant as the firm expands.1

Perfectly Competitive

A type of market with many consumers and producers, all of whom are price takers because they sell identical products In a perfectly competitive market, a large number of firms compete against each other. Firms are said to be in perfect competition when the following conditions occur: 1. Many firms produce identical products. 2. Many buyers are available to buy the product, and many sellers are available to sell the product. 3. Sellers and buyers have all relevant information to make rational decisions about the product being bought and sold. 4. Firms can enter and leave the market without any restrictions. In other words, there is free entry and exit into and out of the market.1 This freedom to enter and leave is made possible by relatively low barriers to entry in terms of both the required capital and knowledge to produce a product and the lack of government regulations or other restrictions to prevent a firm from participating in the market (Meek, Morton & Schug, 2008).

Summary

According to the theory of the firm, the goal of all firms is to make money. With this in mind, evaluating costs and revenue is essential to determine how much profit has been earned. Both economists and accountants analyze firms' profits, but they use the information for different purposes. An accountant wants to know exactly how much profit the firm earned for paying taxes and evaluating cash flows. An economist wants to know if the firm's owners are satisfied with the amount of profit earned. For that reason, accounting profit only considers explicit costs while economic profit also considers lost opportunity costs. When evaluating costs, firms consider the most cost-effective production method in both the short run and the long run. The short run is defined as a period in which at least one input to production, commonly the firm's plant, is a fixed cost. Having a fixed cost limits the range of possible responses when the output does not fall into the predicted range. The long run is defined as a period when all costs are variable, and therefore, any input to production can be altered. Firms use cost information to make output decisions. They decompose the total cost into its two components: variable cost and fixed cost. In addition to considering total cost, the firm also examines average cost and marginal cost. The average cost is useful because it provides a per-unit measure of cost that can be compared to price. The marginal cost is useful because it identifies the change in cost associated with a change in output. It is used by the firm to determine whether further production will increase or decrease overall profit. Evaluating both short-run and long-run costs helps a firm make decisions that lead to higher profits. The shape of long-term curves can help firms gather information about the competitive space for future planning.

Which measure combines the four sources of expenditures in the circular flow model?

Aggregate demand Aggregate demand is the sum of the four sources of buying and selling within the circular flow model.

Long-Run Aggregate Supply and Potential GDP

Although the short-run aggregate supply (SRAS) curve slopes upward, in the long run, the AS curve is vertical. This verticality occurs because nominal prices in input markets have time to adjust. As a result, real input prices are constant along the long-run aggregate supply (LRAS) curve. There is no increase in profitability associated with changes in the general price level. Consequently, the level of real GDP supplied does not change with price. The vertical line on the graph above shows LRAS, also known as the potential GDP. The line identifies the amount of real GDP an economy can produce by fully employing its existing levels and quality of labor, physical capital, and technology in the context of its existing market and legal institutions. When an economy is operating at its potential GDP, machines and factories are running at capacity and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full employment GDP.

Labor Force Participation Rate

Another important statistic is the labor force participation rate. This is the percentage of adults in an economy who are either employed or who are unemployed and looking for a job. Using the data from the graph and table shown previously, those included in this calculation would be the 159.716 million individuals in the labor force. The rate is calculated by taking the number of people in the labor force—the number employed and the number unemployed—divided by the total adult population and multiplying by 100 to get the percentage. Labor force participation rate = Total labor force / Total adult population × 100 For the data from January 2017, the labor force participation rate is 62.9%. Historically, the civilian labor force participation rate in the United States climbed beginning in the 1960s as women increasingly entered the workforce, and it peaked at just over 67% in late 1999 to early 2000. Since then, the labor force participation rate has steadily declined slowly to about 66% in 2008, early in the Great Recession, and then more rapidly during and after that recession, reaching its present level where it has remained stable since the end of 2013.1

Shifts in the Demand Curve

As shown in the following graph, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. The demand curve is a graphical representation depicting the relationship between a good or service's price and the quantities consumers are willing to buy at those prices. The curve can be derived from a demand schedule, which is a table view of the price-quantity pairings that compose the demand curve. A change in price will result in a movement along a demand curve (up or down)—a change in quantity demanded—while a change in a nonprice variable will result in a shift in the demand curve (left or right)—a change in demand. Nearly all demand curves share the fundamental similarity that they slope down from left to right.

Are AD and AS Macro or Micro?

As this lesson on aggregate supply closes, it is essential to clear up any confusion that sometimes arises between the AD-AS model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital. These models have a superficial resemblance, but they also have many underlying differences. For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price for an individual good or service. In contrast, the vertical axis of aggregate supply and aggregate demand diagram expresses the level of a price index like the CPI—combining a wide array of prices from across the economy. This price index essentially represents the average price of all products in an economy. The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market. In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons behind the shapes of the curves in microeconomic models. Demand curves for individual goods or services slope downward primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves. The individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to the price in that specific market, but the slopes of the AD and AS curves are much the same in every diagram. In short, although the supply and demand model is similar to the AD-AS model, there are some differences.

Banks and the Fractional Reserve System

Banks operate by taking in deposits and making loans to borrowers. They can do this because not every depositor needs his or her money on the same day. Thus, banks can lend some of their depositors' money while keeping some on hand to satisfy daily withdrawals by depositors. This is called the fractional reserve banking system: Banks only hold a fraction of total deposits as cash on hand. The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Fed. If, for example, the reserve requirement is 1%, then a bank must hold reserves equal to 1% of its total customer deposits. These assets are typically held in the form of physical cash stored in a bank vault and in reserves deposited with the central bank. Banks can also choose to hold reserves in excess of the required level. Any reserves beyond the required reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. In general, as banks make less money from holding excess reserves than they would lending them out, economists assume that banks seek to hold no excess reserves.

Quiz: Which action helps the Federal Reserve increase the money supply?

Buying securities from banks By increasing the cash with each bank, the money supply is increased.

Factors Affecting Consumer and Business Confidence

Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left. In a self-fulfilling prophecy, those actions contribute to effects causing the downturn that the president warned against in the first place. The following AD curve shows a shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level.2

Demand

Consumers' willingness and ability to consume a given good. Demand refers to the entire set of possible price-quantity combinations that exist, all other things held constant. Demand is based on the consumers' needs and wants and their ability to pay. The law of demand states that there is an inverse relationship between price and the quantity demanded when all other things are held constant. In other words, as price increases, the quantity demanded decreases and vice versa.

Determining Comparative Advantage

From the table, you can see that Golden has a comparative advantage in guns because its opportunity cost of guns is less than that of Maple: 0.5 is less than 1.25 pounds of butter. For each gun produced, Maple must give up 1.25 pounds of butter, but Golden only must give up 0.5 pounds of butter. This then implies that Maple has a comparative advantage in butter. It is essential to recognize that even though Golden had an absolute advantage in both goods, it only has a comparative advantage in one good. Also, notice that given the way opportunity costs are calculated, it is impossible for a nation to have a comparative advantage in both goods produced. Even if this concept was extended to all possible goods, there would still be at least one good in which they do not have a comparative advantage. As it turns out, this fact is a good thing and is the primary mechanism through which many poorer nations are lifted out of poverty through trade.

Price Controls

Government-mandated legal minimum or maximum prices set for specified goods; they are usually implemented as a means of direct economic intervention to manage the affordability of certain goods. Price controls restrict the price adjustment necessary to clear the market. Laws that a government enacts to regulate prices are called price controls. There are two types of price controls. A price ceiling keeps a price from rising above a certain level (the ceiling), whereas a price floor keeps a price from falling below a given level (the floor). Although these laws are enacted for the purpose of solving a perceived problem, price controls—either price ceilings or price floors—often have unanticipated side effects. Ex. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing too high or falling too low. The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity and thus will create an inefficient outcome. Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied and excess demand or shortages will result. Price floors prevent a price from falling below a certain level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded and excess supply or surpluses will result. Government-imposed price controls may have positive effects if they are used to correct an existing market failure. When price controls are applied to well-functioning markets, the market outcome is inefficient. Price controls are implemented with the desire to create affordability or sustainability, or both. However, such policies disrupt normal market adjustment and generate inefficient outcomes. Price ceilings prevent a price from rising above a certain level, whereas price floors prevent a price from falling below a certain level. These policies result in either a shortage or a surplus as the market is prevented from reaching equilibrium.

Recessionary Gap

If the economy is in a recessionary gap facing high unemployment with output below potential GDP, an expansionary monetary policy can help the economy return to potential GDP. The following figure illustrates this situation. The original equilibrium of E0 occurs at an output level of 600. This is below the potential GDP of 700, indicating that the economy is experiencing a recession. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1 so the new equilibrium (E1) occurs at the level of potential GDP of 700 and at a higher price level of 100.

Describe the benefits and costs of free trade using the PPF model.

Imagine you are a doctor in a busy medical office. You have two assistants who take brief histories, weigh patients, and enter the necessary information into the medical records. One day, you raced with your two assistants to see who could get all the necessary patient information the fastest. You were three minutes faster than the fastest assistant; does this mean you should take care of triaging your own patients? Consider the salaries of the two roles. As a family physician, you make between $60 and $90 per hour. Your assistant makes $15 per hour. You could do the assistant's work, but the assistant cannot diagnose and treat patients. You will come out better if you trade money for assistant's work and focus on taking care of patients. In this lesson, you will use the production possibilities curve to show how countries with absolute advantages in production in every category can still benefit from trade. You will learn what absolute and comparative advantages are and their relationship to international trade.

Monopolistic Competitive Market and Society

In a perfectly competitive market, each firm produces at a quantity where the price is set equal to marginal cost, both in the short and long run, resulting in allocative efficiency. This means that the social benefits of additional production as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. When the price is greater than marginal cost as it is in a monopolistic competitive market, the benefits to society of providing additional quantity (as measured by the price that people are willing to pay) exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry and therefore is not allocatively efficient. Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own. Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles than in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out the ways of attracting customers by methods such as friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.

Production Possibilities Frontier Continued

In economics, the production possibilities frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another given the existing levels of the factors of production and the state of technology. PPFs are normally drawn as bowing outward from the origin but can also be represented as a straight line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed to produce more butter. If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of more interest, C if more butter is more desired, or D if an equal mix of butter and guns is demanded.1

Scarcity and Production: Heterogeneous Inputs

In most cases, as additional units of resources are used to produce a specific output, smaller amounts of additional output are produced. In other words, the input's productivity is not uniform. When this occurs, inputs are considered heterogeneous. Heterogeneous inputs generate a curved production possibilities frontier. Return to the guns versus butter example discussed at the beginning of the module. This example is used to illustrate the choice a nation with scarce resources faces as it decides how much of its productive capacity to dedicate to military output and how much to dedicate to civilian goods. As before, simplifying assumptions are imposed. The nation produces only two goods: guns and butter. Guns are used to represent either capital goods or national security, and butter is used to symbolize consumer goods.3 It is also necessary to assume that the nation has a fixed quantity of productive resources and a fixed level of technology. Consider a situation in which 30 farmers, 30 machinists, and 30 people who are equally skilled at making butter and producing guns are available to work. These 30 people with equal skills would be considered a homogeneous resource, whereas the farmers and machinists would be a heterogeneous resource. In the previous example depicting your weekend plans, the scarce resource was your time. In this example, the scarce resource is labor. You have 90 people whose labor can be used to make guns or to make butter: 1. If all 90 people were assigned to make butter, 400 million pounds of butter would be produced, but no guns. The 30 machinists would be forced to make butter. Lacking experience, they would be much slower than the farmers at producing butter. 2. If all 90 people were assigned to make guns, 200 million guns would be produced. As expected, the farmers would be much slower at making guns than the machinists. 3. All 90 workers can be allocated to producing guns or butter in many different combinations. Several of the possible combinations fully utilizing the scarce resource, workers, are shown in the following table.

Long Run

In the long run, a firm can consider changing the quantities of all its factors of production. That gives the firm opportunities it does not have in the short run. Should it choose a production process with lots of labor and not much capital? Or should it select a process that uses a great deal of capital and relatively little labor? The choice is guided by the firm's desire to maximize profits. To support this goal, managers select the combination of inputs that produce the desired output at the lowest cost. Because all inputs are variable, there are no fixed costs in the long run. The firm's total cost is composed entirely of variable costs. With the ability to select the cost-minimizing combination of inputs for whichever quantity it wants to produce, a firm's long-run total cost will always be lower than or equal to the total cost in the short run. In the long run, the firm can also select the scale (or overall size) of its operations. This choice is not available in the short run because the law of diminishing marginal returns limits a firm's ability to increase the output given its fixed resource. In the long run, this limitation is removed. The firm can expand the use of all of its factors of production, making it possible to alter the firm's scale of operations. Firms consider the impact of scale on cost when making long-run decisions. In the long run, all inputs are variable.

Equilibrium in the AD-AS Model

Macroeconomic equilibrium occurred when the quantity of real GDP demanded equals the quantity of real GDP supplied. In the AD-AS model, the intersection of the AS and AD curves identifies the equilibrium level of real GDP and the equilibrium price level in the economy. The following graph depicts the AD curve and the SRAS curve within a single diagram. Equilibrium occurs at Point E, where AD and AS cross, at a price level of 90 and an output level of 8,800. To understand why this is an equilibrium, consider what happens if the price level is 85. At this price, the quantity of GDP demanded exceeds the quantity of GDP supplied, creating a shortage. Firms respond to decreases in inventories by raising prices and increasing output. In this way, the economy will continue to adjust until it reaches equilibrium. At that point, there will be no pressure for firms to continue adjusting prices. If the price level were above the equilibrium price at 105, the pressure would exist for firms to lower prices. At the high price, the quantity of GDP demanded is less than the quantity of GDP supplied. To sell their output, firms lower their prices until the equilibrium price is reached.2 In macroeconomics, there are three types of equilibrium. There is a full-employment equilibrium when the equilibrium real GDP is equal to potential GDP. This equilibrium is considered the long-run equilibrium. It is also possible for the equilibrium real GDP to be above or below potential GDP.

Quiz: A salesperson is salaried and is not evaluated based on the number of sales closed; he is evaluated on customer satisfaction. The sales manager assigns him to contact a startup business to introduce the product line and secure a sale by the end of the month. He chooses to wait until the following sales cycle to contact the business. Which behavior is the salesperson exhibiting?

Moral hazard related to performance The salesperson chooses to wait until the following sales cycle to contact the business. This behavior represents a moral hazard related to performance due to compensation structure.

Just like budget constraints that can be observed when trade-offs are applied between two items for an individual, companies that use the production possibility frontier model also use certain assumptions to simplify the analysis. What is one of the assumptions?

No resources are wasted. Resources are limited and are not wasted in the process, so no surplus can alter the analysis.

Quiz: A 22-year-old recent college graduate feels confident that she will not have to worry about unemployment as much as other age groups. The graduate believes that because she is young, she can be more versatile and that she will more easily avoid unemployment. Is this college graduate correct in this assumption?

No, because individuals in the 55+ age group have the lowest unemployment rate over time Individuals in the 55+ age group consistently have the lowest unemployment rate.

Oligopolies: Profit

Oligopoly is a market structure in which a few firms are producing a product.3 Oligopolies are defined by one firm's interdependence on other firms within the industry. hen one firm changes its price or level of output, other firms are directly affected. Unlike other market structures, uncertainty about how rival firms interact makes the specification of a single model of oligopoly impossible. Economists often simplify firm behavior into two strategies: competition or collusion. Firms can compete, in which case the market outcome will resemble that in perfect competition. Or they can collude, in which case the market outcome will more closely resemble monopoly. When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result. Firms can collude explicitly, as in the case of cartels, but this type of behavior is illegal in many parts of the world. An alternative to overt collusion is tacit collusion in which firms have an unspoken understanding that limits their competition. One way in which firms achieve this is price leadership. One firm serves as an industry leader and sets prices while other firms raise and lower their prices to match. For example, the steel, cars, and breakfast cereals industries have all been accused of engaging in tacit collusion. Tacit collusion can be difficult to identify. The fact that similar price changes among other firms follow a price change by one firm does not necessarily mean that tacit collusion exists. After all, in a perfectly competitive industry, economists expect prices to move together because all firms face similar changes in demand and the cost of inputs. As an example, imagine that a town has three gas stations. Without any way to communicate, all three will continually lower their prices in an attempt to capture the entire market, stopping only when price equals marginal cost. If the firms could cooperate, however, they would be better off if all set the price of gas at $0.20 above marginal cost. Each would have slightly lower sales but would have much higher revenue. Although explicit communication about prices is illegal, the firms might tacitly agree that whenever one station raises its prices, the other two will follow suit. In this way, all three can receive the benefits of oligopoly. The gas station that first raises its prices and that the other two follow is called the price leader.8

Law of Increasing Opportunity Costs

Once all factors of production (land, labor, and capital) are at maximum output and efficiency, producing more of one good requires giving up an increasing amount of the other good

Quiz: Which action should policymakers take as a long-run response when both inflation and unemployment increase?

Policymakers must choose to target just one aspect of the crisis since no fiscal policy solution addresses both Data shows that in the long run there is not a long-run trade-off between inflation and unemployment that holds true.

Allocative Efficiency

Producing goods and services demanded by consumers at a price that reflect the marginal cost. Economists evaluate market outcomes based on their allocative efficiency. Through the interaction of supply and demand, market prices adjust to move the market toward equilibrium. Once reached, there will be no tendency for the market quantity to change. Economists use the concept of allocative efficiency to assess whether this resting quantity is the optimal quantity. That is, could society be better off if a different quantity were produced? A market is efficient when it gets as much benefit as possible from its scarce resources, and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.

Aggregate Demand Curve

Shows the total spending on domestic goods and services at each price level The AD-AS model demonstrates the conditions that determine output and prices and changes in output and prices over time.1 This lesson looks at the first component: aggregate demand. In economics, demand is the amount of a good or service that consumers are willing and able to purchase at various prices during a specified period, other things remaining constant. Looking at this through a broader lens, aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. AD reflects the relationship between aggregate expenditure on final goods and services and the general price level.1 The term "aggregate" means total, and as such, the individual consumer or an individual product is no longer the focus. The focus of Aggregate Demand is the country's economy as a whole. Aggregate demand is determined by several factors, including the price level of goods. Recall that a price level is an index number such as the consumer price index (CPI), which measures the average price of the things people buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.1 The following image presents an aggregate demand (AD) curve. The horizontal axis shows real GDP, and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level lead to a lower quantity of total spending.1

Quiz: When analyzing economic problems, especially when confronted with models of choice, economic models use simplifying assumptions to let them focus on choice. Which simplifying assumption is important for analyzing consumer behavior?

Specific prices The consumer must know the price of each good being considered, and the prices must be fixed so the decision is not clouded by things like quantity discounts, price changes, negotiation, and so on.

Unattainable Production Level

Suppose you needed to make five scrapbooks and bake 20 dozen cookies to take to the local bazaar. If you plot that point, you will see it is above the line at Point L. You do not have enough resources to make that combination of outputs. It takes one hour to make one scrapbook and one hour to make four dozen cookies. To produce five scrapbooks and 20 dozen cookies would take 5 + 5 hours = 10 hours, and you only have eight. An output combination of five scrapbooks and 20 dozen cookies is not currently attainable given your scarce resource of time.`

Other Supply Shocks

The AS curve can also shift due to shocks to the supply of input goods or labor. For example, an unexpected early freeze could destroy a large number of crops, a shock that would shift the LRAS and SRAS curves to the left since there would be fewer agricultural products available at any given price. Similarly, shocks to the labor market can affect aggregate supply. An extreme example might be an overseas war that required a large number of workers to cease their ordinary production to fight for their country, such as what happened during World War II. In this case, SRAS and LRAS would both shift to the left because there would be fewer workers available to produce goods at any given price.3 The AD-AS model can convey several interlocking relationships between the three macroeconomic goals of growth, unemployment, and low inflation. Every model is a simplified version of the deeper reality and, in the context of the AD-AS model, the three macroeconomic goals arise in ways that are sometimes indirect or incomplete.4

Other Ways to Break Down Unemployment Rates

The BLS also gives information about the reasons for unemployment, as well as the length of time individuals have been unemployed. For example, the first table here shows the reasons for unemployment and the percentages of the currently unemployed that fall into each category. The next table shows the length of unemployment. For both of these, the data are from January 2017.1

Federal Reserve Policy Tools

The Fed has four main policy tools: setting reserve requirements, operating the discount window, conducting open market operations, and paying interest on reserves. A brief description of each of the four policy tools is provided here. Reserve requirements—Commercial banks are required to hold a certain proportion of their deposits in reserves and not lend them out. This proportion is called the reserve requirement and is controlled by the Fed. By changing the reserve requirement, the Fed can impact the amount of money available for lending, and, by extension, spending and investment. An increase in the required reserve ratio means that the bank must hold additional reserves instead of lending them out. This will decrease the money supply. A decrease in the required reserve ratio will increase excess reserves, encouraging banks to lend and increasing the money supply. Open market operations—When it undertakes open market operations, the Fed buys or sells securities such as Treasury notes or mortgage-backed securities from its member banks to increase or decrease the money supply available for banks to loan, thus affecting the interest rates (Amadeo, 2019). Decisions about open market operations are made by the FOMC, which meets every six weeks. When there is an open market purchase of government bonds, the Fed transfers bank reserves to the seller's bank to pay for these assets, crediting the seller's account. As the bank now has more reserves than it had before, it can lend out more money, and the money supply increases. If the FOMC authorizes the sale of government securities, the Fed sells its financial assets on the open market, and reserves are transferred from the buyer's bank back to the Fed. This reduces the amount of money that a bank may loan out, and the total money supply falls. This process works because the central bank has the authority to bring money in and out of existence. It is the only point in the whole system with the unlimited ability to produce money. Interest on reserves—By paying banks interest on their reserves, the Fed encourages banks to hold reserves rather than make loans. This reduces the money supply. To increase the money supply, the Fed lowers the interest paid on reserves, providing banks an incentive to make loans.

Natural Rate Hypothesis

The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this relationship in the long run? According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment or the hypothetical unemployment rate if aggregate production is at the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line. The natural rate of unemployment theory, also known as the nonaccelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to the NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. To get a better sense of the long-run Phillips curve, consider the example shown next. Assume the economy starts at Point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This is shown as a movement along the short-run Phillips curve to Point B, which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms to produce more output to meet rising demand, and unemployment will decrease. However, due to the higher inflation, workers' expectations of future inflation changes, which shifts the short-run Phillips curve to the right from unstable equilibrium Point B to the stable equilibrium Point C. At Point C, the rate of unemployment has increased back to its natural rate, but inflation remains higher than its initial level. The reason the short-run Phillips curve shifts is due to the changes in inflation expectations. Workers, who are assumed to be wholly rational and informed, will recognize their nominal wages have not kept pace with inflation increases (the movement from A to B), so their real wages have decreased. As such, in the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate to keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers (the movement from B to C). Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run leads to higher inflation and no change in unemployment in the long run. The NAIRU theory was used to explain the stagflation phenomenon of the 1970s when the classic Phillips curve could not. According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve and increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not affected, leading to high inflation and high unemployment.2

The World Trade Organization

The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995. It is designed to enable international trade while reducing unfair practices. In many ways, the WTO is more complicated than other international trade agreements because it incorporates a variety of smaller agreements into a broader framework. The WTO includes upwards of 60 different agreements alongside 159 official members and 25 observers. The WTO also provides and oversees a framework for resolving trade disputes among member nations.2 The core concept of the WTO is the most-favored-nation (MFN) rule, which states that each WTO member must be charged the lowest tariffs that an importer places on any country. For example, if the U.S. charges Brazil a 5% tariff on imported clothes and this is the lowest tariff it has placed on any country in the WTO, all other WTO members must also be charged a 5% tariff on imported clothes.2 Every nation in the WTO is given the same deal as the nation with the most favorable deal. The WTO is essentially a comprehensive trade agreement between hundreds of nations from every part of the globe. However, most international trade agreements stem from geographic proximity. NAFTA (replaced by the USMCA) is a trilateral agreement between the United States, Canada, and Mexico designed to minimize any trade or investment barriers between any of these countries. Trade agreements are designed to benefit all nations who participate. Generally speaking, the United States has benefited from a trade surplus for services, while Canada and Mexico have benefited from a trade surplus for goods.2

Total Costs

The amount a firm pays for producing and selling its products Total cost is the amount the firm pays for producing and selling its products. Recall that production requires the firm to convert inputs to outputs. Firms influence their costs when they choose to produce a certain quantity of output and select a production process. The production process defines how inputs are combined to make an output. Each input used increases the firm's cost. The sum of all those costs is total cost. The total cost is made up of fixed and variable costs. The total cost increases as production increases while the average total cost decreases initially as production increases. This is because the fixed cost is allocated over more output units until it reaches a point of diminishing marginal returns due to the congestion effect.

Absolute Advantage

The capability to produce more of a given product using less of a given resource than a competing entity , which focused on the ability of a country to produce more of a good than another nation.2 A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low-cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower labor costs. The United States has some of the most fertile farmland in the world, making it easier to grow corn and wheat locally than in many other countries. Guatemala and Colombia have climates uniquely suited for growing coffee. Chile and Zambia have some of the world's most productive copper mines. As some have argued, geography is destiny. Chile will provide copper, Guatemala will produce coffee, and they will trade. When each country has a product the other needs and it can be produced with fewer resources in one country over another, it is easy to imagine all parties benefiting from trade. However, as you will see, thinking about trade just in terms of geography and the absolute advantage is incomplete.

Calculating the Concentration Ratio

The concentration ratio approach can help clarify some of the confusion over deciding when a merger might affect competition. For instance, if two of the smallest firms in a hypothetical market for repairing automobile windshields merged, the four-firm concentration ratio would not change, which implies that there is not much worry that the degree of competition in the market has notably diminished. However, if the top two firms merged, then the four-firm concentration ratio would become 46 (i.e., 26 + 8 + 6 + 6). While this concentration ratio is modestly higher, the four-firm concentration ratio would still be less than half, so such a proposed merger might barely raise an eyebrow among antitrust regulators.

Externalities

The cost or benefit that affects a party who did not choose to incur that cost or benefit. Externalities prevent decision makers from experiencing either the true costs or true benefits of their decisions. Externalities are either positive or negative depending on the nature of the impact on the third party. If those parties imposing a negative externality on others had to take the broader social cost of their behavior into account, they would have an incentive to reduce the production of whatever is causing the negative externality. Pollution is an example of a negative externality. Manufacturing plants emit pollution, which impacts individuals living in the surrounding areas. In the case of a positive externality, the third party is obtaining benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, markets tend to underproduce output because suppliers do not consider the additional benefits to others. If the parties that are creating benefits for others can somehow be compensated for these external benefits, they would have an incentive to increase production. An example of a positive externality would be a competitor figuring out ways of adapting and copying an underlying idea without having to pay the R&D costs incurred by the innovator.

Law of Diminishing Marginal Returns

The decrease in the marginal output of a production process as the amount of a single factor of production is incrementally increased, while the amounts of all other factors of production stay constant Based on the law of diminishing marginal returns, the variable cost rises at an increasing rate as firms increase the output.

Quiz: To address environmental concerns, Congress is considering a bill that would increase the price of electricity generated by coal. Increasing the price of electricity creates a problem for low-income households.

The government needs to answer, "For whom to produce?" in this scenario.

Consequences of Levying a Tariff

The graph below shows an example of the U.S. lumber market. The domestic equilibrium price and quantity are $1,000 per board feet and 40 million board feet, respectively. In this case, the world price, or PW, is substantially lower than the domestic price. While this is not always the case, there is no incentive to import if the PW is greater than the domestic price. (This model assumes that imports are identical to domestic products in every respect except for price.) With access to imports with prices as low as $400, American consumers will purchase significantly more lumber. Their quantity demanded will increase to 70 million units (30 million more than the domestic equilibrium). These consumers are significantly better off with the new access to cheaper lumber. Domestic producers, on the other hand, lose significant profits from the imports. Whereas before they supplied 40 million board feet of lumber at $1000, now they can only supply 10 million board feet at $400. This is because many domestic firms are no longer able to compete with foreign production and will either leave the market or decrease production. With domestic production of 10 million and total consumption of 70 million, 60 million board feet of lumber are imported from other countries.

Quiz: What does the Phillips curve show economists and government policymakers?

The inverse relationship of inflation and unemployment in the short run The inverse relationship of inflation and unemployment in the short run is the definition of the Phillips curve.

The Law of Diminishing Marginal Returns and Variable Costs

The law of diminishing marginal returns causes the variable costs to rise at an increasing rate as the firm increases its output. To understand this, suppose there are no diminishing marginal returns, and each additional lumberjack hired results in five additional trees felled per hour. If each lumberjack receives a wage of $25 per hour, every additional tree felled costs $5. Because more labor is used, the variable cost rises with more output, but it rises at a constant rate. In the short run, under the law of diminishing marginal returns, rather than adding the same number of felled trees, each successive lumberjack hired adds a smaller amount of output. It requires increasingly larger amounts of labor to produce additional cut trees. Labor is costly, so variable cost not only rises with more output but rises at an increasing rate. For a firm, increasing variable costs reduces the profitability of additional units of output and is an essential factor in a firm's short-run output decisions.

Barriers to Entry

The legal, technological, or market forces that may discourage or prevent potential competitors from entering a market. Barriers to entry are obstacles that make it challenging to enter a market controlled by a single firm or a few large firms. The term can refer to hindrances a firm faces in trying to enter a market or industry. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.2 Barriers to entry can be natural or artificial. Natural barriers exist because of the characteristics of the industry. Examples include the following: 1. The need for capital, such as equipment, building, and raw materials 2. The increase in efficiency of production as the number of goods being produced increases due to economies of scale 3. Ownership or control of a natural resource that limits availability to competitors Artificial barriers to entry exist because existing companies have strategically created them to protect against the competition, the government has created them to protect existing firms, or for another societal goal. Examples of artificial barriers include the following: 1. Patents give a firm the legal right to stop other firms from producing a product for a given period and thus restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and service marks may represent a kind of entry barrier for a particular product or service if one or a few well-known names dominate the market. 2. Government regulation may prevent new firms from entering. For example, cities often limit the number of short-term rentals in a neighborhood. 3. Individuals face barriers in trying to gain entrance to a profession—such as education or licensing requirements. 4. Large incumbent firms may have existing customers who are loyal to established products. The presence of established strong brands within a market can be a barrier to entry in this case. Firms create loyalty programs to prevent customers from switching to competing firms such as frequent flyer miles.

Price Floor

The lowest legal price a commodity can be sold at. Price floors are used by the government to prevent prices from being too low. A price floor is a price control that limits how low a price can be charged for a product or service. Generally, floors are set by governments, although groups that manage exchanges can set price floors as well. The purpose of a price floor is to protect producers of a certain good or service. By establishing a minimum price, a government seeks to promote the production of the good or service and ensure that the producers have sufficient resources to go about their work. A price floor will only impact the market if the floor is set above the market equilibrium price. A low price floor does not limit the market's movement toward equilibrium, and therefore has no impact. The product is sold at the equilibrium price both before and after the floor is imposed. When the floor is above the equilibrium price, normal price adjustment is prevented. This can be demonstrated using the following table. In the table, the market reaches equilibrium at a price of $3. Imposing a price floor that makes it illegal to charge less than $2 for the product has no effect on the market. Firms would still sell their products for $3. To be effective, the price floor must be set above the equilibrium price. In the case presented here, the price floor must be above $3 to alter the market outcome. Setting a price floor above the equilibrium price creates a surplus and causes inefficiency. At the higher price, there will be a higher quantity supplied and a lower quantity demanded than at the equilibrium price. Without the price floor, market price would fall, eliminating the surplus. With the price floor, adjustment cannot happen so the surplus is sustained. To see an example, look at the previous table. Suppose the price floor is set at $4. Though the floor allows firms to charge more than $4, market forces will push the price down as much as possible. At the price of $4, consumers want to purchase 20 units per month. Suppliers are willing to bring 40 units per month to the market. This creates a surplus of 20 units per month. Prices are not able to fall, so this surplus will persist. As with the price ceiling, price floors produce inefficient outcomes. In this case, it is consumers who restrict the number of transactions with their unwillingness to buy at the higher price. Rather than trading 30 units of the good, only 20 units are traded when a $4 price ceiling is in place. Both consumers and producers lose the benefits from those potential trades. It is considered a market failure when potential benefits are left unrealized.

The Pattern of Cost Curves

The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Such a company might be paid by consumers directly, or perhaps hospitals or healthcare practices might subscribe something on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website. And increasing the output further could require a purchase of additional computer space. For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and carry some rakes and shovels. Still, other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine maintenance of the equipment. Marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment. Even though every firm is different, the general shape of the cost curves will typically be the same, they may be elongated or exaggerated in some way, but the law of diminishing returns will always kick in. Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs and then using these calculations as a basis for the average total cost, the average variable cost, and the marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself.

Quiz: A property owner has 500 acres of flat land and has been approached by two different businesses. One business wants to drill for oil, and the other wants to raise cattle.

The property owner needs to answer, "What to produce?" in this scenario.

Quiz: A consumer buys a bed for $1,000. The bed is assembled in the United States, but the manufacturer used $200 worth of materials that were imported from another country. In addition, the manufacturer used $300 of materials that were bought from suppliers in the United States. How is the value of the bed counted in gross domestic product (GDP) for the United States using the expenditure approach?

The purchase price of $1,000 is counted in consumption expenditures, and $200 of the material imported is subtracted from net export expenditures. The $1,000 includes the value of all intermediate goods used to make the bed. However, to account for the $200 of value that was imported, net exports decrease by that value.

Price Elasticity of Demand

The responsiveness of the quantity demanded to a change in price, in percentage terms; calculated by taking the percentage change in the quantity demanded divided by the percentage change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in price of that good or service.

Short Run

The short run is a planning period over which the managers of a firm must consider one or more of their factors of production as fixed in quantity. The only way for the firm to increase the output is by using more of its variable inputs. There are limits to how much this can increase the output. In the short run, production is constrained by the productive capacity of the fixed input. Imagine a lumber company whose product is felled trees. Two inputs are used to cut down the trees: lumberjacks and two-person saws. Assume that there is only one saw and no way to get additional saws. The saw is a fixed input, and the firm is operating in the short run. One lumberjack is able to fell 4 trees using the saw. If a second lumberjack is added, the output increases to 10 trees. The marginal product of the second lumberjack is the additional output produced when that lumberjack is added. Since the output rose from 4 to 10 trees, the marginal product of the second lumberjack is 6 trees. Values for the marginal product are listed in the following table. The output increases again when a third and then a fourth lumberjack are hired. But as additional lumberjacks are added, having only one saw becomes increasingly restrictive. The lumberjacks spend more of their time standing around. As a result, each successive lumberjack adds less to total production than the previously added lumberjack. This is known as the law of diminishing marginal returns. According to this law, any time one input is fixed, adding additional units of the variable resources will result in smaller and smaller gains in the output. This is demonstrated in the following table where the marginal product of labor decreases as the third and fourth lumberjacks are added: In the short run, there is at least one input that cannot be changed. This is a fixed input. Fixed costs are costs that do not change with the level of production. Firms have fixed costs in the short run. In the short run, firms experience the law of diminishing marginal returns. The marginal product of labor decreases as additional units are added to the fixed input.

Quiz: An industry is operating in an inelastic range of the market demand curve. What happens to the total revenue in the industry if the market supply increases?

The supply curve shifts to the right, and the equilibrium price decreases. Due to the inelastic response, this would result in a relatively small change in quantity to a larger change in price and would cause a decrease in total revenue in the industry.

Lesson Summary

This lesson discussed equilibrium in a market using the AD and AS curves. It also explained the driving forces that move the market toward equilibrium and the changes that occur to cause the equilibrium to shift. Key points to remember are the following: The intersection of the AS and AD curves shows the equilibrium level of real GDP and the equilibrium price level in the economy. In the short run, equilibrium can occur when real GDP is below potential GDP and a recessionary gap exists. In the long run, decreases in wages will move the economy toward the full employment equilibrium. In the short run, equilibrium can occur when real GDP is above potential GDP, and an inflationary gap exists. In the long run, increases in wages will move the economy toward the full employment equilibrium. Short-run variations in unemployment are caused by the business cycle as the economy expands and contracts. Over the long run, in the United States, the unemployment rate typically hovers around 5%. Inflation fluctuates in the short run. Higher inflation rates typically occur either during or just after an economic boom. A shift in AD to the right will lead to a higher price level and inflation. A shift in AD to the left will lead to a lower price level and unemployment. A wide array of economic events and policy decisions can affect AD and AS, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity. The AS curve illustrates the total quantity of output that firms will produce and sell at different price levels. The AS curve slopes upward because, as the price level of outputs increases, firms have a strong incentive to produce more goods to yield higher profits. Both production and price can shift the SRAS curve. The LRAS curve is vertical. In the long run, the quantity of goods and services supplied depends on the availability of the factors of production, not on the overall level of prices. The AD curve illustrates the quantity of all goods and services demanded in an economy at any given price level. The AD curve slopes downward due to three effects: the wealth effect, the interest-rate effect, and the foreign price effects. Any situation or policy that raises consumption, investment, government purchases, or net exports at a given price increases AD. The opposite is true as well. The intersection of the AD curve and the AS curve shows the equilibrium level of the real GDP and the equilibrium price level in the economy. The AD-AS model can be used to show the relationships between the three macroeconomic goals of growth, unemployment, and inflation.

Underutilization of Resources

Trade-offs are not necessary when output is inefficient. Any point inside the frontier represents underutilization or inefficient use of resources.

Lesson Summary

Two methods were used in this lesson to determine the monopoly power of an industry: the concentration ratio and the HHI. The concentration ratio measures the share of the total sales in an industry of the top four to eight firms. If the top four firms' market shares were measured and had a score of less than 50%, a proposed merger would not draw the attention of antitrust authorities. The HHI, as it is often called, is calculated by summing the squares of the market share of each firm in the industry. Both of these calculations share the weakness that an assumption is made that the market is well defined and that the competitive environment is consistent across the market. All businesses face two realities: No one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Every day, firms make decisions about how much to produce, how much profit they make, and whether to stay in business or not, among many others. Industries differ from one another in terms of the number of sellers in a specific market, how easy or difficult it is for a new firm to enter, and the type of products that are sold. This is referred to as the market structure of the industry. At one end of the spectrum are the perfectly competitive markets, and at the other are monopolies. Producers in competitive markets make no economic profit in the long run, and their only option is to produce or get out. As price takers, firms in a perfectly competitive market only have control over the quantity of goods produced. The vast majority of markets are imperfectly competitive. In these markets, firms are price makers with little influence in a monopolistic market composed of many sellers to much greater influence in a monopoly with a single seller. Firms attempt to differentiate their products in order to have some influence over price. They make these differences known through the power of advertising. Firms that work hard to gain large shares of the market are strongly influential, with only a few competitors in an oligopoly to no competitors in a monopoly. Firms in an oligopolistic market are conflicted between competing with others to gain profits or collaborating as in a monopoly. Greed can lead some firms to unfairly utilize this power and attempt to gain profit by lobbying or using other social services to receive a special advantage or privilege that is likely to net a higher economic profit than was earned. Apart from those in a perfectly competitive market, all firms must be on guard and look for the next possible blockbuster product from their competitors.

Balanced Budget

When the government spends exactly the same amount as it receives in a given year.

Quiz: Country A and Country B both produce butter and toys. Country A can produce either 5,000 pounds of butter or 10,000 toys. Country B can produce either 20,000 pounds of butter or 4,000 toys. Currently, Country A is producing 2,000 pounds of butter and 6,000 toys. Country B is producing 10,000 pounds of butter and 2,000 toys. What is the change to world production if these countries engage in free trade?

An increase of 2,000 toys and 8,000 pounds of butter Each country should do what they are best at doing. Toy production increases from a combined 8,000 toys to 10,000 toys and butter production increases from a combined 12,000 pounds to 20,000 pounds of production.

Accounting Profit versus Economic Profit

Economists and accountants calculate profits differently. Their processes differ because they have different purposes for using profit information. Accountants want to know exactly how much profit the firm earned so they can answer questions about things like taxes and cash flows. An economist wants to know if the firm's owners are satisfied with the return they receive from the business. Knowing whether the return is sufficient allows an economist to assess the stability of the market and to predict the entry or exit of new firms. In order to meet these different goals, economists and accountants include different types of costs in their profit calculations. Economists use a total cost measure that reflects the business owner's opportunity cost. That is, it considers the value of all resources used, even if these resources are owned by the business and don't receive a specific payment. This means that economists include both explicit and implicit costs when calculating the total cost. For accountants, the total cost includes only the explicit cost. Accounting profit differs from economic profit by the amount of the implicit cost. Formulas for accounting profit and economic profit can be written as follows: Accounting Profit = Total Revenue - Explicit Cost Economic Profit = Total Revenue - Explicit Cost - Implicit Cost The primary goal of any firm is to earn a profit. Economists and accountants measure profit differently. To determine the accounting profit, accountants subtract explicit costs from revenue. Economists take it one step further by subtracting the implicit (opportunity) costs in addition to the explicit costs. Profit depends on the production decisions of firms. A firm's options are limited by fixed resources in the short run. Costs reflect the firm's decisions about input usage and output level.

The Costs of Inflation

Economists generally regard a relatively low, stable level of inflation as desirable. When inflation is stable and expected, the economy is generally able to adjust easily to slowly rising prices. However, inflation does have some economic costs, especially when it is high or unexpected. The costs of inflation include menu costs, shoe leather costs, loss of purchasing power, and the redistribution of wealth. 1. Menu Costs: The cost to a firm resulting from changing its prices. In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. With high inflation, firms must change their prices often to keep up with economy-wide changes, and this can be a costly activity explicitly, as with the need to print new menus, and implicitly, as with the extra time and effort needed to change prices constantly. 2. Shoe Leather Costs: The cost of time and effort that people spend trying to counteract the effects of inflation. This refers to the cost of time and effort that people spend trying to counteract the effects of inflation, such as holding less cash, investing in different currencies with lower levels of inflation, and having to make additional trips to the bank. The term comes from the fact that more walking is required (historically, although the rise of the internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly. A significant cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were less or no inflation. 3. Loss of purchasing power:

Consumer Price Index (CPI)

A measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases Although there are several different price indices, the most cited measure of inflation in the United States is the consumer price index (CPI). The CPI is the average price of the goods and services typically purchased by consumers. Government statisticians at the U.S. Bureau of Labor Statistics (BLS) calculate the CPI based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. When the BLS calculates the CPI, their first task is to decide on a basket of goods that is representative of the purchases of the average household. They do this by using the Consumer Expenditure Survey, a national survey of about 7,000 households, which provides detailed information on spending habits. Statisticians divide consumer expenditures into eight major groups, which in turn they divide into more than 200 individual item categories. The BLS currently uses 1982-1984 as the base period. The eight major categories in the CPI are as follows: 1. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks) 2. Housing (renter's cost of housing, homeowner's cost of housing, fuel oil, bedroom furniture) 3. Apparel (men's shirts and sweaters, women's dresses, jewelry) 4. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance) 5. Medical care (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) 6. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions) 7. Education and communication (college tuition, postage, telephone services, computer software and accessories) 8. Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses) For each of the 200 individual expenditure items, the BLS chooses several hundred very specific examples of that item and looks at the prices of those examples. The BLS statistically selects specific products, sizes, and stores to reflect what people buy and where they shop. The basket of goods in the CPI thus consists of about 80,000 products, that is, several hundred specific products in over 200 broad-item categories. Statisticians rotate about one-quarter of these 80,000 specific products of the sample each year and replace them with a different set of products. The next step is to collect data on prices. Numerous samples are used to collect the data on prices, including various surveys such as the Consumer Expenditure Survey. After the pricing information is collected, prices are weighed by the importance of the item in consumer spending patterns, including geographical areas and retail establishments. The following graph shows the weighting of CPI components of the eight categories used to generate the CPI. Housing is the highest at 42.7%. The next highest category, food and beverage at 15.3%, is less than half the size of housing. Other goods and services and apparel are the lowest at 3.4% and 3.3%, respectively. In recent years, the statisticians have paid considerable attention to a subtle problem: The change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living because the cost of living represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction. To understand the distinction, imagine that over the past 10 years the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living changed? If you do not necessarily purchase the identical fixed basket of goods every year, an inflation calculation based on the cost of that fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality and new goods bias. When the price of a good rises, consumers tend to purchase less of it and seek substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, whereas goods with falling prices tend to become more important. Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were totally inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people switch to other fruit choices and the average price of food does not change much at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a consumer's true cost of living because it does not take into account that the person can substitute away from goods whose relative prices have risen. The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals and if a box of the cereal costs 5% more. It would be misleading to count the entire resulting higher price as inflation because the new price reflects a higher quality (or at least different) product. Ideally, a person would like to know how much of the higher price is due to the quality change and how much of it is just a higher price. The arrival of new goods creates problems with the accuracy of measuring inflation. The reason people buy new goods is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality and new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer's true cost of living because it does not account for how improvements in the quality of existing goods or the invention of new goods improves the standard of living. The BLS, which is responsible for computing the CPI, must deal with these difficulties in adjusting for the substitution of goods and quality changes.1

the factors market

A market in which companies buy the factors of production or the resources they need to produce their goods and services

Monopoly: Market Power

.Barriers to entry are the reason monopolies exist. These sources of monopoly power can take many forms. A natural monopoly exists because the costs of production or the fixed costs are so high that only one firm provides the output. Having only one firm provide the output minimizes overall costs to society. (Utilities typically fall into this category.) An example is the water company in a city. It would be inefficient for two companies to build a complex series of pipes and then pump water through these pipe networks. It would be costly for the community to have two water companies, each with its pipe network. Governments tend to regulate these natural monopolies to keep prices down for consumers. A governmental monopoly, such as the U.S. Postal Service, exists because the government runs the business and only authorizes one seller. A technological monopoly exists due to a patent that gives only one seller the right to use the manufacturing method, an invention, or a type of technology. A geographic monopoly, such as professional sports teams, exists because there are no other producers or sellers in that region Primary Goal: All firms maximize profit. Barriers to entry or exit: There are high barriers to enter or exit in the market. Market Composition: Single Seller Types of Goods: Unique Product Pricing: Firms can set the price.

Market interactions are complex, but this four-step process offers a simple way to analyze the effect of a change in a nonprice factor on equilibrium:

1. First, draw the demand and supply curves for the market. Identify the original equilibrium price and quantity. 2. Second, decide whether the first effects of this event will be felt by consumers or producers. It can be helpful to consider whether the event changes the cost of production. If so, this event will cause a supply shift. If the event changes consumers' willingness or ability to buy, there will be a shift in demand. 3. Third, decide whether the curve shifts to the right or to the left. A rightward shift in either curve is an increase, and a leftward shift is a decrease. Draw in the new demand or supply curve. 4. Fourth, use the supply and demand diagram to show how the shift affects the equilibrium price and quantity. Identify the new equilibrium and show how the new price and quantity differ from their original values. When using the supply and demand framework to think about how an event will affect the equilibrium price and quantity, proceed through the following four steps: (1) sketch a supply and demand diagram to think about how the market looked like before the event; (2) decide whether the event will affect supply or demand; (3) decide whether the effect will increase or decrease the curve you decided on in Step 2 and draw the appropriate shifted supply or demand curve; and (4) compare the new equilibrium price and quantity to the original ones.

There are some general rules about what determines the price elasticity of demand:

1. Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. 2. Necessities tend to have inelastic demands, whereas luxuries have elastic demands. 3. The elasticity of demand in any market depends on how market boundaries are drawn. Narrowly defined markets (e.g., ice cream) tend to have more elastic demand than broadly defined markets (e.g., food) because it is easier to find close substitutes of narrowly defined goods. 4. Goods tend to have more elastic demand over longer time horizons. 5. Goods tend to have more elastic demand over longer time horizons. 6. The portion of income that a good takes up also affects its elasticity. A new car would take up a lot of income, so new cars tend to have a more elastic demand.

Microeconomics vs. Macroeconomics

1. Microeconomics, which focuses on the actions of individual agents within the economy, like households, workers, and businesses. 2. Macroeconomics, which looks at the economy as a whole. It focuses on broad issues such as the growth of production, number of unemployed people, inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects but rather complementary perspectives on the economy. The micro decisions of individuals and businesses are influenced by whether the macroeconomy is healthy. Example: if the overall economy is healthy and growing, Paradigm Toys can hire more workers to increase their toy production before the Christmas season because they have confidence their products will sell. In turn, the performance of the macroeconomy ultimately depends on the microeconomic decisions made by individual households and businesses.1 For instance, when firms like Paradigm Toys hire more workers, the workers can contribute to economic health by buying more products. Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the entire economy, focusing on goals like growth in the standard of living, unemployment, and inflation.

As with elasticity of demand, there are numerous factors that directly impact the elasticity:

1. Number of producers: Ease of entry into the market. Markets that are easy to enter will be more elastic, as it will be easier to increase or decrease production. 2. Availability of resources: If a company can easily get the resources or inputs it needs for production, then it can respond relatively quickly to changes in the market. On the other hand, if a company uses a very scarce resource, increasing production may be very difficult making its supply much more inelastic. A very scarce resource can also result in quickly increasing production costs, affecting a company's ability to increase production. 3. Technology: The more quickly a company can be innovative or incorporate new technology, the better able they are to adjust production. Technology also tends to increase production efficiency and reduces costs, which allows for more flexibility in production changes. 4. Flexibility: It is also a big factor. This can come in terms of spare capacity, ease of storage, easy of switching between products, and length of the production period. If a firm has spare capacity, the ability to easily store the good it produces, or a short length of production, it is easy to change production. Such firms will have a more elastic supply. 5. Time: The ability to produce many goods changes over time. For example, increasing the supply of housing in the short run is difficult, but building housing in the long run is relatively easy. The longer it takes for something to be produced, the more inelastic the supply is in the short run and the more elastic it is in the long run.

Three conditions that generate inefficient market outcomes:

1. Price Controls 2. Imperfect Information 3. Externalities Each of these conditions impedes the smooth functioning of the market. In each case, the market-generated equilibrium quantity will not be efficient.

Every economic system must be able to answer the three basic economic questions:

1. What to produce? 2. How it will be produced? 3. For whom the goods or services are produced? Individuals, organizations, governments, and countries must make decisions about how, what, and for whom to produce.

Firm

A commercial or for-profit organization, business, government, or individual in the business to maximize profit; an organization that combines inputs of labor, capital, land and raw or finished component parts to produce outputs

Imports

A commodity, article, or service brought in from abroad for sale are defined as purchases of goods or services by a domestic country from a foreign economy. The domestic purchaser of the good or service is called an importer. Imports and exports are critical for many economies, and they are the defining financial transactions of international trade. Due to the economic importance of imports, countries enact specific laws, barriers, and policies to regulate international trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, the price of a good or service will decrease while the quantity consumed will increase. On a national level, in most countries, international trade represents a significant share of the GDP. International trade has a significant economic, social, and political importance in many countries. Imports provide countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and services within its own borders. Imports are generally less expensive than domestic production despite additionally imposed costs, taxes, and tariffs. However, the factors of production, such as capital and labor, are usually more mobile domestically than internationally. It is common for countries to import goods rather than a factor of production; for example, instead of importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor. On a business level, companies take part in direct imports, which occur when a significant retailer imports goods that are designed locally from an overseas manufacturer. The direct import program allows the retailer to bypass the local supplier and purchase the final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.

Mergers Continued

A corporate merger occurs when two formerly separate firms combine to become a single firm. When one firm purchases another, it is called an acquisition. An acquisition may not look just like a merger since the newly purchased firm may continue to be operated under its former company name. However, both mergers and acquisitions lead to the unification of two formerly separate firms now under common ownership and common decision-making, and so they are commonly grouped. Since a merger combines two firms into one, it can reduce the extent of competition between firms. The U.S. government approves most proposed mergers. In a market-oriented economy, firms have the freedom to make their own choices. Private firms generally have the freedom to 1. expand or reduce production, 2. set the price they choose, 3. open or close new factories or sales facilities, 4. hire workers or lay them off, and 5.start selling new products or stop selling existing ones. If the owners want to acquire a firm or be acquired or to merge with another firm, this decision is just one of many that company owners are free to make. In these conditions, the managers of private firms will sometimes make mistakes. They might close down a factory that would have turned out profitable. They might start selling a product that ends up losing money. A merger between two companies can sometimes lead to a clash of corporate personalities that makes both firms worse off. However, the fundamental belief behind a market-oriented economy is that firms, not governments, are in the best position to know if their actions will lead to attracting more customers or producing more efficiently.1

Traditional Economy

A economic system that relies on customs, history, and time-honored beliefs. Tradition guides economic decisions such as production and distribution. A system where individuals make decisions based on traditions, beliefs, and customs. The traditional economic system is an economy based on customs handed down through generations. This type of system was common throughout human history, and it remains prevalent in much of the world today. Traditional economies are mostly based on fishing, hunting, gathering, and agriculture. In many cases, bartering and trading goods and services are used instead of currency. This type of economic system is active in the developing world in places like Latin America, Africa, Asia, and the Middle East. There are five key characteristics of a traditional economy: 1. It is centered around families or tribes. 2. It exists in a hunter-gatherer and nomadic society. 3. Trade is heavily dependent on bartering rather than money. 4. It only produces what is needed, and a surplus is very rare. 5. It eventually changes from purely trade to the use of some type of currency. There are several advantages to a traditional economy such as the following: 1. There is little competition or friction among members of the society. 2. People's roles and contributions are well understood. 3. It can be more sustainable than a technology-based economy. A traditional economy also has the following disadvantages: 1. It is exposed to environmental changes and weather patterns. 2. It is vulnerable to market or command economies, which consume and deplete the resources of traditional economies. Traditional: This system is based on culture and rituals handed down through generations. It is usually present in small, remote communities where members contribute equally towards one goal

Reserve Requirement Continued

A first method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which is the percentage of each bank's deposits legally required to hold either as cash in its vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend. In early 2015, the Fed required banks to hold reserves equal to 0% of the first $14.5 million in deposits, then hold reserves equal to 3% of the deposits up to $103.6 million and 10% of any amount above $103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the $103.6 million dividing line is sometimes raised up or lowered down by a few million dollars. In practice, the Fed rarely uses large changes in reserve requirements to execute monetary policy. A sudden demand that all banks increase their reserves would be extremely disruptive and challenging for them to comply with while loosening requirements too much would create a danger that banks would be unable to meet withdrawal demands.5

Price Supports or Price Floor or Subsidy

A government incentive in the form of financial aid or support extended to an economic sector (or institution, business, or individual) generally with the aim of promoting economic and social policy Price floors are sometimes called a subsidy, or price supports, because they prevent a price from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and therefore farm incomes fluctuate, sometimes widely. Even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings. Imposing the price floor is sufficient if the only goal of the policy is to keep the price of an agricultural product high. However, usually the broader goal of the policy is to benefit agricultural producers. On its own, a price floor cannot do this. High prices reduce the number of goods consumers are willing to buy, thus creating a surplus. To ensure that the producers benefit, governments support the high prices by entering the market and buying the surplus product. The high income areas of the world, including the United States, Europe, and Japan, are estimated to spend roughly $1 billion per day in supporting their farmers. According to the common agricultural policy reform passed in 2013, the European Union (EU) will spend about €60 billion per year, US$67 billion per year (with the November 2016 exchange rate), or roughly 38% of the EU budget, on price supports for Europe's farmers from 2014 to 2020. Government purchase of the excess agricultural supply redistributes benefits and generates inefficiency. The price floor is like a guarantee that farmers will receive a certain price for their crops. Farmers benefit from the policy, but taxpayers and consumers of food pay the costs. As with price ceilings, price supports distort the transactions that would have otherwise occurred and create market failure. In this case, too many exchanges take place between buyers and sellers. Consumers stop buying when the price exceeds the amount they are willing to pay. Government purchases are not limited in this way. Buying continues even when the value of the product falls below the product's cost. This is an inefficient allocation of resources. Numerous proposals have been offered for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. Either because this is viewed by the population as supporting the traditional rural way of life or because of the lobbying power of the agribusiness industry.1Removing these price controls so that prices and quantities can adjust to their equilibrium level would increase the economy's efficiency.2

Rent Control Laws

A government-mandated maximum price, or a rent ceiling, on what landlords may charge tenants. Rent control is an example of a price ceiling. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws. These price ceilings usually work by stating that landlords can raise rents by only a certain maximum percentage each year. Some of the best examples of rent control occur in urban areas such as New York, Washington, DC, or San Francisco. When faced with rising rents, consumers, who are also potential voters, may unite behind a political proposal to hold down the price. Imagine that an increase in demand for housing has recently increased the price of an apartment in a certain city. Perhaps a change in tastes made the city a more popular place to live. Perhaps locally based businesses are expanding, bringing higher incomes and more people into the area. The equilibrium price is currently $1,000 per month. Unfortunately, for many people, housing is not affordable at this price. In response to the problem, the city government passes a rent control law to keep the price at $800 for a typical apartment. Though this restricts the price, it does not change the underlying demand and supply conditions. In the table below, the quantity supplied at a price of $800 is 15,000 rental units, but the quantity demanded is 20,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing. One of the ironies of price ceilings is that although the policy is intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be at the market rent of $1,000 (17,000 rental units). In this example, rent control was enacted in an attempt to keep prices low for those who would need the product. Rather than solving the problem, the policy redistributes benefits and generates an inefficient outcome. The price ceiling causes suppliers to reduce the quantity of apartments on the market, creating a shortage. Those who manage to purchase the product at the lower price will benefit, but many will be left without any housing. Sellers of the product struggle more and may try to improve the profitability of their rental properties by reducing maintenance, allowing the properties to deteriorate. The rent control policy also blocks some transactions that buyers and sellers would have been willing to make. In this example, 2,000 additional apartments would have been rented at the equilibrium price. These transactions would have benefited renters by providing housing and would have benefited sellers by generating profits. These benefits are lost when the economy produces an inefficient quantity. In a very real sense, it is like money thrown away that benefits no one. The price control is blocking some suppliers and demanders from transactions they would both be willing to make. This is considered a market failure.2

The Phillips Curve

A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession, inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at a greater risk for inflation. Phillips analyzed 60 years of British data and did find that trade-off between unemployment and inflation, which became known as a Phillips curve During the 1960s, the Phillips curve was seen as a policy menu. A nation could choose low inflation and high unemployment or high inflation and low unemployment, or anywhere in between. Fiscal and monetary policy could be used to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the trade-off between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted. The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation or an unhealthy combination of high unemployment and high inflation. Perhaps most important, stagflation was a phenomenon that could not be explained by traditional Keynesian economics.1 Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the oil crisis of the mid-1970s, which first brought stagflation into everyone's vocabulary. The second is changes in people's expectations about inflation. In other words, there may be a trade-off between inflation and unemployment when people expect no inflation; but when they realize inflation is occurring, the trade-off disappears. Both supply shocks and changes in inflationary expectations cause the aggregate supply curve, and thus the Phillips curve, to shift. In short, a downward-sloping Phillips curve should be interpreted as valid for short-run periods of several years, but over more extended periods when aggregate supply shifts, the downward-sloping Phillips curve can shift so unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).

Adjustable-Rate Mortgage (ARM)

A loan a borrower uses to purchase a home in which the interest rate varies with market interest rates

Quiz: Dairy producers have recently experienced a sharp decrease in demand for their product. Which factor explains this decrease?

A lower price for a substitute product leads to a decrease in demand.

Monopolistic Competition

A market composed of multiple firms selling differentiated products in a market with a low barrier to entry

A Monopolistic Competition Market

A market composed of multiple firms selling differentiated products in a market with a low barrier to entry Monopolistic competition involves the competition of many firms against each other to sell products that are distinctive in some way. Examples include stores that sell different styles of clothing, restaurants, grocery stores that sell a variety of food, and even products like golf balls beer that may be somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States competing for buyers, but each of them has something that sets them apart from the others in some way. When products are distinctive in this way, each firm has a mini-monopoly on its particular style or flavor or brand name. The term "monopolistic competition" captures this mixture of mini-monopoly and tough competition. In a monopolistic competition market, many firms compete against each other. Firms are said to be in monopolistic competition when the following conditions occur: 1. Many firms produce similar but differentiated products. 2. Many buyers are available to buy the product, and many sellers are available to sell the product. 3. There are low barriers to entry and exit from the market. Primary Goal: All firms maximize profit. Barriers to Entry or Exit: There are no barriers to entry or exit. Market Composition: A large number of firms. Types of Goods: All firms produce a similar but slightly differentiated product. Pricing: All firms have a slight degree of market power to set the price. Market Power: Limited price setting power. Long-run Economic Profit: No Efficiency: Less allocatively and productively efficient than perfectly competitive. Benefits to Society:Differentiation creates diversity, choice, and utility.

Monopolies: Profit

A monopoly exists when there is only one producer and many consumers. Monopolies are characterized by a lack of economic competition to produce a good or service and a lack of viable substitute goods. As a result, the single producer has control over the price of a good. In other words, the producer is a price maker that can determine the price level by deciding what quantity of a good to produce.1 A monopoly can also be defined as a firm that can ignore the economic actions of other firms or a firm that can retain an economic profit in the long run. Consider a monopoly firm, comfortably surrounded by barriers to entry so that it faces no competition from other producers. How will this monopoly choose its profit-maximizing quantity of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to total revenues minus total costs. The pattern of costs for the monopoly can be analyzed within the same framework as the costs of a perfectly competitive firm—that is, by using total cost, fixed cost, variable cost, marginal cost, average cost, and average variable cost. However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm.1 A perfectly competitive firm acts as a price taker, so total revenue is calculated by taking the given market price and multiplying it by the quantity of output that the firm chooses. A monopolist cannot charge any price for its product, and demand for the firm's product constrains the price. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve: downward sloping. Since a monopolist faces a downward-sloping demand curve, the only way it can sell more output is by reducing its price. Selling more output raises revenue, but lowering the price reduces it. Thus, the effect on total revenue is not clear. However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total cost curves. After all, the firm does not know exactly what would happen if it were to alter production dramatically. However, a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs. This is because it has had experience with such changes over time and because modest changes are easier to extrapolate from its current experience. A monopolist can use the information on marginal revenue and marginal cost to seek out the profit-maximizing quantity. A monopolist can determine its profit-maximizing quantity by analyzing the marginal revenue and marginal cost of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit.10 Once the profit-maximizing quantity is determined, firms use the information they have about consumer demand to find the highest price consumers would be willing to pay for that quantity.

Flat-Bottom LRAC

A more frequent case is illustrated in the flat-bottom LRAC, where there is an extended range of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at the same average cost. Given that the market will demand 1 million dishwashers per year at a price of $500, this market might have as many as 200 producers (i.e., 1 million dishwashers divided by firms making 5,000 each) or as few as 50 producers (1 million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. But firms that produce below 5,000 units or more than 20,000 will be unable to compete because their average costs will be too high. Thus, if there is an industry where almost all plants are the same size, it is likely that the LRAC curve has a unique bottom point, as in a clear minimum point. However, if the LRAC curve has a wide flat bottom like the following figure, then firms of a variety of different sizes will be able to compete with each other.1

Negative Externalities

A negative externality is a cost that results from an activity or transaction and falls on a person who had no role in the transaction generating the cost. Negative externalities cause overproduction in the market, creating inefficiency. Firms make production decisions based on their private costs, not the social cost of production. For example, when a firm considers whether to open a new factory, it will think about things like the wages it will pay to workers, the cost of energy, and the cost of materials. These are all expenses that fall directly on the firm. They are considered private costs and included in the decision-making process. However, the cost of the factory is not limited to the firm's private costs. Local residents might experience healthcare costs from drinking water polluted by the factory. Or, the factory may run 24 hours a day, creating noise that prevents local residents from sleeping. These costs are considered external costs. They are not considered by the firm when making decisions because they are not paid by the firm. An economically efficient decision would take both private and external costs into account. The sum of these costs is called the social cost. Because social costs are higher than private costs when a negative externality is present, a business owner is likely to approve production that is inefficient. A comparison of the private costs to the expected benefits of a project might indicate that the project is profitable. The firm will most likely move ahead with production. Doing that same comparison, but accounting for externalities by using social costs rather than private costs, might indicate the project will result in a loss. This indicates that the project should not move forward. Because market decisions are based on private costs, production on more than the socially efficient level occurs. In these cases, government intervention is necessary to help price negative externalities. Governments can either use regulation (e.g., outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things: First, these regulations recover funds to help fix the damage caused by negative externalities. See how this can be applied to Daniel Miller. After buying a used car, Daniel discovered that his car did not meet certain environmental regulations to be on the road. Due to the high levels of harmful air pollutants that vehicles produce, the local government enacted legislation to have all vehicles emissions tested and repaired to particular safety standards. Daniel had to pay a fee to correct the negative externality produced by his used car. Second, these regulations help put a financial price on externalities. The business has to add the cost of regulation to its private costs. This is called internalizing the externality. Ideally, the regulation makes the firm's private costs equal to the social cost. Businesses can then avoid producing products whose social costs exceed the financial return. Markets overproduce when a negative externality is present, generating inefficient outcomes. Government intervention in markets with negative externalities can discourage actions that create costs for others by imposing costs on production.

Understanding Costs

A product's cost depends on the inputs required to make the product and on the price of those inputs. Firms don't determine the price of inputs, but they do decide which inputs to use. To make the most profit, firms want to choose a combination of inputs to produce the desired quantity of output for the lowest possible cost. Consider the following example: It is dawn in Shanghai, China. Already, thousands of Chinese are out cleaning the city's streets using brooms. On the other side of the world, night falls in Washington, DC, where the streets are also being cleaned, but by a handful of giant street-sweeping machines driven by a handful of workers. The difference in method is not the result of greater knowledge of modern technology in the United States—the Chinese know perfectly well how to build street-sweeping machines. It is a production decision based on costs in the two countries. In China, where wages are relatively low, an army of workers armed with brooms is the least expensive way to produce clean streets. In Washington, where labor costs are high, it makes sense to use more machinery and less labor.3 As described in this example, firms make input choices to minimize costs. The set of possible input combinations from which a firm can choose depends on the decision's planning period. Two planning periods are used in economics—the long run and the short run. If, as part of a 10-year plan, a firm is considering the best possible way to produce its product, there are no restrictions on what input combinations are possible. Planners are free to consider ideal options regarding things like building size, the number of trucks, or the number of accountants. All inputs are variable. Economists call the time frame in which all inputs are variable the long run. In the long run, when all inputs are variable, all costs will be variable too. If instead a business owner is considering the best way to adjust inputs in order to deal with a weekend rush, the options will be fewer. Many inputs will already be determined, and there will be no time to make changes. Those productive resources that cannot be changed are known as fixed inputs. The time frame in which some of the firm's inputs are fixed is called the short run. With both fixed and variable inputs, firms will have both fixed and variable costs in the short run. Economists usually consider labor a variable input and capital a fixed input. At any time, a firm will be making both short-run and long-run choices. Decisions that can be implemented over the next few weeks are likely to be short-run choices. Long-run choices, where managers consider changing every aspect of their operations, can take many years to implement.

A Straight-Line Production Possibilities Frontier

A production possibilities frontier (PPF), sometimes called a production possibilities curve (PPC), identifies all possible combinations of two goods or services that can be produced within the given resources and technology when the resources are fully and efficiently used per unit time. The PPF shown in the following figure is a straight line with a constant slope. A constant slope is seen when the factors of production are homogeneous. In this example, the first hour is just as productive as the eighth hour. This makes it possible to produce four dozen cookies for each hour dedicated to cookie baking or one scrapbook for each hour dedicated to scrapbooking. Homogeneous resources are unusual, so in most cases the PPF is not linear.

Substitutes

A substitute is a good that can be used in place of another good. Lowering the price of a substitute decreases demand for the other product. Consider the relationship between tablets and laptop computers. In recent years, the price of tablet computers has fallen, leading to an increase in the quantity demanded of tablets. How does a decrease in the price of a tablet affect demand for a laptop? People substitute away from laptops as they become relatively more expensive. Demand for laptops decreases, which is shown as a leftward shift of the demand curve for laptops. A higher price for a substitute good has the reverse effect. Changes in expectations about future prices or other factors that affect demand—While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. These changes in demand are shown as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price.1

Voluntary Export Restrictions

A trade restriction on the quantity of a good that an exporting country is allowed to export to another country Voluntary export restrictions are a form of trade barrier through which foreign firms agree to limit the number of goods exported to a particular country. They became prominent in the United States in the 1980s when the U.S. government persuaded foreign exporters of automobiles and steel to limit their exports to the United States. Although such restrictions are called voluntary, they typically are agreed to only after pressure is applied by the country whose industries they protect. The United States, for example, has succeeded in pressuring many other countries to voluntarily accept quotas limiting their exports of goods ranging from sweaters to steel. A voluntary export restriction works precisely like an ordinary quota. It raises prices for the domestic product and reduces the quantity consumed of the goods or services affected by the quota. It can also increase the profits of the firms that agree to the quota because it raises the price they receive for their products.

Time Deposits

Account that the depositor has committed to leaving in the bank for a certain period of time in exchange for a higher rate of interest; also called certificate of deposit

Lesson Summary

Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. It includes all four components of the expenditure side of GDP: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M).1 Nearly all AD curves share the fundamental similarity that they slope downward from left to right. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand.1 The wealth effect holds that as the price level increases, the buying power of money is depleted to some extent by inflation. The interest rate effect means that as prices for outputs rise, the same purchases will cost more money or need credit. This pushes interest rates higher, which reduces borrowing by businesses for investment and by households for purchases—thus reducing consumption and investment spending. The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world, which tends to reduce exports and increase imports.1 An increase in any of the components of AD will shift the AD curve to the right. An increase in AD means that a higher amount of total spending would occur at every price level. A decrease in any of the components of AD will shift the AD curve to the left. A decrease in AD means that at least one of these components decreased so a lesser amount of total spending would occur at every price level.1 When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, firms spend more on investment. Economists associate a rise in confidence with higher consumption and investment demand, which will lead to an outward shift in the AD curve.2

Short-Run Aggregate Supply

Aggregate supply (AS) is the output of all final goods and services businesses produce at any given price level, all other conditions held constant. The short-run aggregate supply (SRAS) curve reflects the positive relationship between the quantities of goods and services businesses are willing to produce and prices. The SRAS curve is based on the following key assumptions: 1. Prices of the factors of production—including the money wage rate for labor—are constant. 2. The stock of capital equipment—the buildings and equipment used in the production process—and the technology of production are constant. The fixed nature or "stickiness" of input prices generates a positive relationship between real GDP supplied and the price level. This stickiness means that the number of dollars paid to a worker (nominal wage) or the number of dollars paid for a resource (nominal cost) does not change as the selling price of the product changes. Instead, with no change in nominal input costs, real input costs fluctuate with changes in the price level. Wages provide a good example of this stickiness. Often workers sign long-term contracts for a particular money wage. Throughout the contract, nominal wages do not change. However, even though employees receive the same number of dollars in each paycheck, their buying power falls if the overall price of goods and services in the market increases during their contract. This decrease in buying power is a decrease in real wages. Although it is difficult for the employee, for the employer it means that paying employees takes a relatively smaller share of revenues. Firms make decisions about what quantity to supply based on the profits they expect to earn. They determine profits, in turn, by the price of the outputs they sell and by the prices of the inputs, like labor or raw materials, that they need to buy. A decrease in real wages makes production more profitable and increases output. In general, when input prices are fixed, an increase in the general price level reduces the firms' real input costs, encouraging them to produce more output. When market prices fall with no corresponding drop in input prices, real input costs increase, reducing profits and leading to a decrease in output. As a result, there is a positive relationship between the quantity of real GDP supplied and the price level. This relationship can be depicted using an AS curve.

The Aggregate Supply Curve

Aggregate supply is illustrated using the AS curve. A sample AS curve is shown in the following diagram. The diagram's horizontal axis shows real GDP—that is, the level of GDP adjusted for inflation—and the goal is to look at actual production, which is what real GDP measures. The vertical axis shows the price level, which measures the average price of all goods and services produced in the economy. Remember that the price level is different from the inflation rate. The price level is an index number, like the CPI, whereas the inflation rate is the percentage change in the price level over time.2 For the AS curve, as the price level rises, real GDP rises as well. Why? The price level on the vertical axis represents prices for final goods or services bought in the economy. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while all else is held equal, like technology, labor productivity, and the prices of inputs like labor and energy. If firms across the economy face a situation where the price level of what they produce and sell is rising but their costs of production are not rising, then the lure of higher profits will induce them to expand production at those higher prices. In other words, the AS curve shows how producers, as a group, will respond to an increase in the price level. 2

The Herfindahl-Hirschman Index

An approach to measuring the market concentration by adding the square of the market share of each firm in the industry A four-firm concentration ratio is a simple tool, which may reveal only part of the story. For example, consider two industries that both have a four-firm concentration ratio of 80. However, in one industry, five firms each control 20% of the market. In the other industry, the top firm holds 77% of the market, and all the other firms have 1% each. Although the four-firm concentration ratios are identical, it would be reasonable to worry more about the extent of competition in the second case—where the largest firm is nearly a monopoly—than in the first. Another approach to measuring industry concentration that can distinguish between these two cases is called the Herfindahl-Hirschman Index (HHI). The HHI, as it is often called, is calculated by summing the squares of the market share of each firm in the industry. Calculating the HHI Calculate the HHI for a monopoly with a market share of 100%. Because there is only one firm, it has a 100% market share. The HHI is 1002 = 10,000. For an extremely competitive industry, with dozens or hundreds of extremely small competitors, the value of the HHI might drop as low as 100 or even less. Calculate the HHI for an industry with 100 firms that each has 1% of the market. In this case, the HHI is 100(12) = 100.1 Smooth as Glass Repair Company 16% of the market The Auto Glass Doctor Company 10% of the market Your Car Shield Company 8% of the market Seven firms each have 6% of the market 42% of the market, combined Eight firms each have 3% of the market 24% of the market, combined Comparing the Concentration Ratio and the HHI In this case, the HHI is 162 + 102 + 82 + 7(62) + 8(32) = 744. Notice that the HHI gives greater weight to large firms. Compare one industry where five firms each have 20% of the market with an industry where one firm has 77%, and the other 23 firms have 1% each. The two industries have the same four-firm concentration ratio of 80. However, the HHI for the first industry is 5(202) = 2,000. The HHI for the second industry is much higher at 772 + 23(12) = 5,952. It is also common for the HHI to be calculated using decimals instead of percentages. For the previous example, it would be 0.162 + 0.12 + 0.082 + 7(0.062) + 8(0.032) = 0.0744. Both versions contain the same information, so the choice of which calculation to use is typically preferential. Note that the near-monopolist in the second industry drives up the HHI measure of industrial concentration. In the 1980s, the Federal Trade Commission (FTC) followed these guidelines: If a merger would result in an HHI of less than 1,000, the FTC would probably approve it. If a merger would result in an HHI of more than 1,800, the FTC would probably challenge it. If a merger would result in an HHI between 1,000 and 1,800, then the FTC would scrutinize the plan and make a case-by-case decision. However, in the past several decades, the antitrust enforcement authorities have moved away from relying as heavily on measures of concentration ratios and HHIs to determine whether a merger will be allowed. They instead carried out more case-by-case analysis on the extent of competition in different industries.

Mixed Economy

An economic system in which both private enterprise and a degree of state monopoly (usually in public services, defense, infrastructure, and basic industries) coexist. A system where businesses make decisions based on consumer demand, but the government makes decisions in terms of regulations, consumer safety, and environment. A mixed economy features a combination of traditional, command, and market economies to varying degrees. In a mixed economic system, decisions are made based on consumer demands. However, there is government involvement in making decisions about consumer safety, environmental, and other regulations. For example, Paradigm Toys does business in the U.S., which has a mixed economic system. When making decisions about production, the firm uses cost information to decide which inputs to use, but Paradigm also needs to consider the safety of those inputs to the children using their products. In the U.S., consumer agencies provide guidelines for toy production and distribution while local and federal governments enforce stringent safety regulations. Consumer guidelines can affect the demand for a product, while regulations can sometimes lead to higher production costs. This in turn affects the firm's profitability. As with other economic systems, mixed economies have both advantages and disadvantages. Mixed economies have the following advantages: 1. Goods and services are distributed to where they are needed the most; therefore, prices are set by supply and demand. 2. Competition incentivizes innovation and improves the quality of products and services. 3. Goods and services are more available and accessible to those who are willing to pay. 4. The role of the government is expanded to help ensure access for the underprivileged. Mixed economies also have disadvantages such as the following: 1. The disadvantages of a market economy emerge when there is too much emphasis on the goals of a particular market decision maker. 2. There could be too much or not enough freedom of choice for individuals and organizations. 3. The government may take its expanded role too far and limit competition, thus discouraging innovation and quality. 4. Businesses may influence the government to provide taxpayer funds to help them when they take too much risk. Mixed: Market concepts are prevalent, but elements of other economies are also present, such as government regulations to ensure safety and fairness. Most countries conform to a mixed economy.

Elasticity

An economics concept that measures responsiveness of one variable to changes in another variable. This law of demand specifies the direction of the response, but it does not provide a measure for the strength of the response. To understand this, economists use the concept of elasticity. Elasticity measures the responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball, and the second item is a brick. Which will bounce higher? Obviously, the tennis ball. You would say that the tennis ball has greater elasticity. Understanding customers' responsiveness to changes in price is very important to firms. For a firm considering a price increase, it is essential to have an idea of the number of sales that may be lost as a result of the change. Elasticity can identify if consumers will react strongly with many opting not to buy or if the reaction will be minimal.

Economic Growth

An increase in the availability of inputs or technological advancement will shift the production possibilities frontier outward, increasing potential outputs of both goods simultaneously. A shift caused by technological improvement identifies the additional output generated by increased productivity. There is a wide variety of technological advances that have driven productivity upward. Innovation has generated both incremental advances and large leaps in productivity. Significant advancement has been made in these categories: 1. Energy: Historically, animals and humans were the primary energy input for the generation of products. Using humans and animals for energy was extremely expensive and time-consuming relative to more modern ways to power things and has been improved on dramatically over time. Electricity, heat, steam, water, solar, and a wide variety of other energy capturing methodologies have dramatically increased efficiency while making working hours available. 2. Trade: Trade has been a part of human history for nearly as long as civilizations knew of one another, bartering being the central component of human interaction. The improvement of trade venues such as boats, cars, planes, and trains has enabled rapid increases in trade quantity and efficiency. Similarly, industrial machinery using similar vehicles has enabled mass increases in scale and efficiency, particularly in agriculture. 3. Communication: The internet and mobile communications have rapidly expedited the transmission of knowledge, data, information, and networking. This increased ability to transmit information has resulted in a massive increase in synergy across the world, as well as the development of economic learning and development. 4. Process design: Increases in technological systems are generally considered to be a tangible innovation but are not limited to such. Improvements in how things are done are often just as useful. Henry Ford is a classic example of this, innovating the assembly line to maximize the efficiency of the production process through the strategic implementation of labor roles. Technological advances, an increase in resource quality or quantity, and an increase in trade can shift the production possibilities frontier outward, making what was previously unattainable attainable. An inefficient outcome occurs when a circumstance such as excessive unemployment results in a country producing less than it could from its available resources. If the source of inefficiency is eliminated, production can be increased.

Substitution Bias

An inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living because it does not take into account that the person can substitute away from goods whose prices rise considerably

Quotas Explained Further

Another barrier to trade is an import quota, which places a limit on the amount of a good that may enter a country. In the short run, a tariff will reduce the profits of foreign exporters of a good or service.3 There are two main types of import quota: the absolute quota and the tariff-rate quota. An absolute quota is a limit on the number of specific goods that may enter a country during a specified period. Once the quota has been fulfilled, no additional goods may be imported into the country. An absolute quota may be set globally, in which case, goods may be imported from any country until the goal has been reached. An absolute quota may also be set selectively for certain countries. As an example, suppose an absolute, global quota for pens is set at 50 million. The government is setting a limit that only 50 million pens can be imported in total. If there were a selective, absolute quota, only 50 million pens would be able to be imported, but this total would be divided among exporting countries. The domestic country might only import 10 million pens from Country A, 25 million pens from Country B, and 15 million pens from Country C. Collectively, the total imports equal 50 million pens, but the number of pens from each country is set. A tariff-rate quota is a two tier quota system that combines characteristics of tariffs and quotas. Under a tariff-rate quota system, an initial quota of a good is allowed to enter the country at a lower duty rate. Once the initial quota is met, imports are not stopped; instead, more of the good may be imported but at a higher tariff rate. For example, under a tariff-rate quota system, a country may allow 50 million pens to be imported at a low tariff rate of $1 each. Any pen that is imported after this first tier quota has been reached would be charged a higher tariff, say $3 each.

The Law of Increasing Opportunity Costs

As the economy produces more guns than previously, it must start giving up more and more butter. This property is called the law of increasing opportunity costs. Calculating the opportunity cost will be covered in Lesson 8. For now, notice the trend. This relationship will also work the other way. If you instead work from Point I back to Point A, the opportunity costs of producing additional butter (as opposed to producing additional guns) will start small and get larger as more units of butter are produced.

Shifts in Long-Run Aggregate Supply

As you consider each of the determinants of LRAS, remember that those nonprice factors that cause an increase in LRAS will shift the curve outward and to the right, and those nonprice factors that cause a decrease in LRAS will shift the curve inward and to the left. In the long run, the most important factor shifting the LRAS curve is productivity growth. Productivity is how much output can be produced with a given quantity of labor or capital. This can be measured as output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output. Historically, the real growth in GDP per capita in an advanced economy like the United States has averaged about 2% to 3% per year, but productivity growth has been faster during certain extended periods like the 1960s and the late 1990s through the early 2000s or slower during periods like the 1970s. Changes in an economy's productivity can result from an increase in the number of scarce resources, such as immigration or foreign investment, improvements in the quality of resources, such as through better education and training, or increases in technology. Local and state governments and the federal government subsidize education and research and development partly because of their role in long-run economic growth. When there is an increase in productivity, the ability to produce increases and the LRAS curve shifts to the right. Additionally, a higher level of productivity shifts the SRAS curve to the right because, with improved productivity, firms can produce a greater quantity of output at every price level. Every time there is a shift in the LRAS curve, the SRAS curve will also shift and in the same direction because what affects LR production also affects SR production. The following figure shows an increase in the LRAS curve and the corresponding change in SRAS. The LRAS curve shifts to the right from LRAS0 to LRAS1 and the SRAS follows from SRAS0 to SRAS1. The equilibrium shifts from E0 to E1. Note that with increased productivity, workers can produce more; thus, full employment corresponds to a higher level of potential GDP.

Barriers to Exit

Barriers to exit are obstacles in the path of a firm that wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it from doing so. If the barriers to exit are significant, a firm may be forced to continue competing in a market, as the costs of leaving may be higher than those incurred if they continue competing in the market. The factors that may form a barrier to exit include the following: 1. High investment in nontransferable fixed assets that is particularly common for manufacturing companies that invest heavily in capital equipment, which is specific to one task 2. A large number of employees, employees with high salaries, or contracts with employees who stipulate high severance payments that may cause a firm to face high costs if it wishes to leave the market 3. Contract contingencies with suppliers or buyers and any penalty costs incurred from cutting short agreements.

Money Creation

Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks can create money. To understand this, imagine that you deposit $100 at your bank. The bank is required to keep $10 as reserves but may lend out $90 to another individual or business. This loan is new money; the bank created it when it issued the loan. When that $90 loan is spent, it is likely that the recipient will deposit the money in a checking account. The money creation process repeats. The bank holds 10% of the deposit and loans out the rest. If the full $90 is deposited, the bank is required to hold $9 but can loan out $81. With this loan, the money supply increases by an additional $81. The money creation process can repeat until there are no excess reserves available to loan. New loans create money, but when a loan is repaid, that money disappears from the economy until the bank issues another loan. Fractional reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, banks also have an incentive to loan out as much money as possible and keep only a minimum buffer of reserves, as they earn more on these loans than they do on the reserves. Mandating a reserve requirement helps ensure that banks can meet their obligations.

Average Fixed Cost

Begin exploring Oliver's average costs by looking first at his average fixed cost. Oliver pays a total of $38,000 per year (or $122 per day) for rent, insurance, and rental equipment. These costs are fixed. As Oliver produces more output, these fixed costs are spread out across a larger number of ornaments. Average fixed costs decline as more output is produced. The average fixed cost of one worker producing 16 ornaments is as follows: $122 total fixed cost / 16 ornaments = $7.63 average fixed cost per ornament. The average fixed cost of two workers producing 40 ornaments is as follows: $122 total fixed cost / 40 ornaments = $3.05 average fixed cost per ornament. Average fixed cost = Total fixed cost / Output AFC = TFC / Q

Problems with Defining a Market

Both the four-firm concentration ratio and the HHI share some weaknesses. First, they begin from the assumption that the "market" under discussion is well defined, and the only question is measuring how sales are divided into that market. Second, they are based on an implicit assumption that competitive conditions across industries are similar enough that a broad measure of concentration in the market is enough to decide the effects of a merger. These assumptions, however, are not always correct. In response to these two problems, the antitrust regulators have been changing their approach in the last decade or two. Defining a market is often controversial. For example, Microsoft in the early 2000s had a dominant share of the software for computer operating systems. However, in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. A narrowly defined market will tend to make concentration appear higher, whereas a broadly defined market will tend to make it appear smaller. There are two especially important shifts affecting how markets are defined in recent decades: One centers on technology and the other on globalization. These two shifts are interconnected. With the vast improvement in communications technologies, including the development of the internet, a consumer can order books or pet supplies from all over the country or the world. As a result, the degree of competition many local retail businesses face has increased. The same effect may operate even more strongly in markets for business supplies where business-to-business (B2B) websites can allow buyers and suppliers from anywhere in the world to find each other.1

Price Elasticity and Total Revenue

Businesses use price elasticity of demand to help with pricing decisions. These decisions are difficult because firms realize that by changing their price, they also change their total revenue (TR). This is the amount paid by buyers and received by sellers of the good. It is calculated as follows: Total Revenue = Price X Quantity TR = P X Q How does total revenue change as price changes? If demand is inelastic, an increase in price causes an increase in total revenue. This occurs because the percentage change in the quantity demanded will be much smaller than the percentage change in price. You obtain the opposite result if demand is elastic: An increase in price causes a decrease in total revenue. For a good with an elastic demand, the percentage change in the quantity demanded will be much larger than the percentage change in price. The following examples demonstrate this relationship between elasticity and total revenue. Based on the previous calculation, coffee has a price elasticity of 0.25 and is inelastic. Suppose the price of coffee is $2 per cup and increases to $3 per cup. In response, the quantity demanded falls from 100 to 90 cups of coffee. You can calculate the total revenue for coffee before and after the price change: Before: TR = P × Q = $2 × 100 = $200 After: TR = P × Q = $3 × 90 = $270 In this case, the increase in price led to an increase in total revenue. This outcome depends on the balance of two opposite forces. Increasing the price of coffee tends to push revenues up because the firm is collecting a larger payment for each cup of coffee. But consumers purchase a smaller quantity of coffee at higher prices, and the decrease in sales pushes revenues down. Since coffee has an inelastic demand, the increase in price is greater than the decrease in the quantity demanded percentage wise. The revenue-raising effect of a price increase dominates the impact of falling quantity, and total revenue increases. This relationship between total revenue and price is depicted in the following image. The arrows show the changes in price and the quantity demanded. Notice the larger arrow is under price since that changed by the largest percentage. Total revenue moves in the same direction as price for an inelastic good. For an elastic good, the opposite is true. The change in the quantity demanded is much larger than the change in price in percentage terms. So, an increase in price will lead to a decrease in total revenue. For example, you learned earlier that restaurant meals are elastic—the percentage change in the quantity demanded is greater than the percentage change in price. Say that the average price of a restaurant meal increased from $15 to $17, and, in response, the quantity demanded fell from 100 to 72 meals. Calculating the total revenue before and after the price change gives you the following: Before: TR = P × Q = $15 × 100 = $1500 After: TR = P × Q = $17 × 72 = $1224 As before, the increase in price tends to push revenue up because customers pay more for each meal. However, in this example, consumers are responsive to the change in price, and the cost of lost sales outweighs the benefits of the price increase. Total revenue falls. The following image depicts the relationship between price and revenue. When price elasticity of demand is elastic, total revenue will move in the opposite direction of the price change.

Changes in Demand

But economic change is inevitable, and as these changes occur, the original demand curve will no longer fit the economy. Luckily, the demand and supply model has the flexibility to adapt to these changes. To understand the mechanism for adapting to change, focus on a single variable that influences demand: income. Consumers' responses to changes in income depend on whether the good being evaluated is a normal or an inferior good. For normal goods, as incomes rise, consumers increase their buying. Higher incomes lead to more spending on housing, cars, vacations, healthcare, and coffee. Consider your own buying. Is there a product you would like to buy more of if you had the income to afford it? Whatever the product, if you buy more of it as your income increases, the good is considered normal. As incomes rise, consumers decrease their buying of inferior goods. A used car is an example of an inferior good. As consumers' incomes rise, fewer people choose used cars and instead buy new cars.

Demand Deposits

Checkable deposit in banks that is available by making a cash withdrawal or writing a check

Taxes

Collecting taxes is necessary to fund the activities of the government. However, taxes are also a fiscal policy tool. They affect AD by changing personal disposable income and therefore affecting consumption (C). They also influence investment spending (I). Taxes imposed on firms affect the profitability of investment decisions and therefore affect the levels of investment firms will choose. Increasing taxes leads to a decrease in AD, whereas a decrease in taxes raises AD.

Principle 9: Printing too much money causes prices to rise

Consistently rising prices for goods and services results in inflation. This economic phenomenon is directly related to excessive government-printed currency circulating. The more a government prints money, the less the money is worth, thus making goods and services more expensive. Principles of Economics Eight to Ten: How the Economy Works as a Whole

Total Production after Comparative Advantage

Combined, Golden and Maple have increased their butter production by 500 pounds (5,000 - 4,500), and they have increased their gun production by 2,000 guns, from 10,000 to 12,000 guns. Further, imagine that Golden and Maple decide to trade guns for butter at a 1:1 exchange. Maple will trade 2,000 pounds of butter for 2,000 guns. This means that Golden now has 10,000 guns (12,000 produced - 2,000 traded) and 2,000 pounds of butter (0 produced + 2,000 traded). On the other hand, Maple now has 3,000 pounds of butter (5,000 produced - 2,000 traded) and 2,000 guns (0 produced + 2,000 traded). The resulting distribution is seen by Points F and G in the following graphs.

Mergers

Combining two companies into a single larger company

Quiz: Principle 7: Governments sometimes have the ability to better market outcomes.

Companies face regulation when they create a monopoly in their industry. Principle 7 is about how governments can influence markets positively or negatively.

Perfectly Competitive Firms: No Market Power

Competitive markets are characterized by many buyers and sellers in the market. An action by one seller or one buyer will not significantly impact the market price. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. Therefore, each firm individually in a perfectly competitive market does not have any significant market power or ability to set the price. The result is that the industry as a whole produces the optimum level of output for society. For this reason, a firm operating in a perfectly competitive market is known as a price taker because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market, which is determined by the intersection of the market supply and demand curves. All sellers in the market sell an identical or homogeneous product, and buyers do not care from which seller they purchase their goods. A perfectly competitive firm will not sell below the equilibrium price, either. Why would they when they can sell all they want at a higher price? Examples of a perfectly competitive market are agricultural markets such as small roadside produce markets and small organic farms.1 In the real world, few markets are perfectly competitive because their products are not standardized. Primary Goal: All firms maximize profit. Barriers to Entry or Exit: There are no barriers to entry or exit. Market Composition: A are number of small firms Types of Goods: All firms produce a homogenous or identical commodity. Pricing: All firms are price takers since consumers have no preference for one good over another. Market Power: Price Taker Long-Run Economic Profit: No Efficiency: Both allocatively and productively efficient Benefits to Society: Low price and high quantity

Contractionary Fiscal Policy

Contractionary fiscal policy is used when the economy is experiencing an inflationary gap. To reduce the problems caused by high inflation, the government can cut government spending, raise taxes, or do a combination of both. Reductions in government spending lead directly to reductions in aggregate demand. Increasing taxes also reduce aggregate demand, but does so by decreasing disposable income, which leads to a reduction in consumer spending. This is illustrated in the following graph. At the initial E0 equilibrium, real GDP exceeds potential GDP, creating an inflationary gap. A contractionary fiscal policy reduces AD, shifting the curve from AD0 to AD1. The policy closes the inflationary gap, reducing the price level and reducing GDP. By reducing government spending and increasing taxes, contractionary fiscal policy can reduce a government deficit or generate a budget surplus. A surplus occurs when tax revenues exceed government spending. Under these circumstances, contractionary fiscal policy can pay government debt in addition to reducing inflation.2

De Beers Consolidated Mines

Control over natural resources that are critical to the production of a good is another source of monopoly power. Single ownership over a resource gives the owner of the resource the power to raise the market price of a good over marginal cost without losing customers to competitors. In other words, resource control allows the controller to charge economic rent. This is a classic outcome of imperfectly competitive markets. A classic example of a monopoly based on resource control is De Beers. De Beers Consolidated Mines was founded in 1888 in South Africa as an amalgamation of several individual diamond mining operations. De Beers had a monopoly over the production of diamonds for most of the 20th century. It used its dominant position to manipulate the international diamond market and convinced independent producers to join its monopoly. In instances when producers refused to join, De Beers flooded the market with diamonds similar to the ones they were producing. De Beers also purchased and stockpiled diamonds produced by other manufacturers to control prices through supply. The De Beers model changed at the turn of the 21st century when diamond producers from Russia, Canada, and Australia started to distribute diamonds outside of the De Beers channel. De Beers' market share fell from as high as 90% in the 1980s to 35% in 2019.

Spillovers or Externalities

Costs of consumption or trade that spill over onto other parties. Private markets are an efficient way to put buyers and sellers together to determine what goods are produced, how they are produced, and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. But what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller? Externalities occur all the time because economic events do not occur within a vacuum. As an example, consider a club promoter who wants to build a night club right next to your apartment building. You and your neighbors will be able to hear the music in your apartments late into the night. In this case, the club's owners and attendees may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or external to the exchange is called an externality. These can also be called spillovers Externalities can be negative or positive. If you need to get up early for work and cannot sleep because of the loud music, the club creates a negative externality. The club imposed a cost on you, an external agent to the market interaction. If you stay up late and love to dance, you might consider the loud music a positive externality. These occur when the market interaction of others presents a benefit to nonmarket participants. An externality occurs when an exchange between a buyer and a seller has an impact on a third party who is not part of the exchange. An externality can have a negative or positive impact on the third party.

Quiz: Country A has given export subsidies to certain preferred domestic producers who export their goods. Which policy is used by Country B to directly address this action?

Country B will impose a countervailing duty. The idea of the duty is that it is only imposed if it is determined by customs that the product received a subsidy and thus lowered its price below the world price. This duty would be enough to counter the subsidy's effect on the price.

The Demand Curve

Deciding how much money to hold involves choices about how to allocate wealth. How much wealth should be held as money and how much as other assets? For a given amount of wealth, the answer to this question depends on the relative costs and benefits of holding money versus other assets.2 Assume there are only two ways to hold wealth: as money in a checking account or as a less liquid, interest-bearing asset. There are two reasons people hold money. The first is to purchase goods and services. This is called the transactions demand for money. Next, people hold money as an asset because of its liquidity. This is sometimes considered the precautionary demand for money because the money is often being held to protect against future contingencies. In holding money for these purposes, an individual gives up the interest that would have been earned if the money had been used to purchase an interest-bearing asset. Think of the interest rate as the opportunity cost or price of holding money. The demand for money is a result of the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. When interest rates are high, the opportunity cost of holding money is high and the quantity of money demanded will be low. When interest rates are low, little is sacrificed when holding money, so the quantity of money demanded is high. There is a negative relationship between the interest rate and the quantity of money demanded. This is illustrated by the downward slope of the money demand curve (DM) in the following graph. Demand for money increases when price levels rise or when income goes up. An increase in demand shifts the money demand curve to the right. If either price level or income decline, demand for money decreases, moving the curve to the left.

Quiz: What is the first step in a contractionary monetary policy?

Decrease the money supply The money supply must decrease in a contractionary monetary policy.

Lesson Summary

During a period of recession, increased government spending and lower taxes will increase aggregate demand. During a period of inflation, decreased government spending and increased taxation will decrease aggregate demand. An expansionary fiscal policy encourages an increase in economic activity as businesses increase production, hire more workers, and increase investment. More workers have more income to spend on goods and services, which increases aggregate demand. A contractionary fiscal policy slows down economic activity as businesses decrease production and lay off workers. Workers have less money to spend on goods and services, and aggregate demand decreases. A change in government purchases directly affects aggregate demand (AD) through government spending (G). A change in taxes affects aggregate demand (AD) through a change in consumer spending (C) or business investment (I).

Calculating the Price Elasticity of Demand

Economists calculate the price elasticity of demand as the percentage change in the quantity demanded divided by the percentage change in price: e^d= % change in the quantity demanded / % change in price Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign to the percentage change in price. This means that the elasticity of demand is technically a negative number. However, for the purposes of this example, only the positive or absolute value of the number will be considered. Given that a larger price elasticity of demand implies a greater responsiveness of the quantity demanded to price.1 Look at a couple of examples to see how the concept of elasticity and the number work together. In the first example, consider eating out at restaurants. Assume the price of restaurant meals increased by 10%. In response, the quantity demanded of restaurant meals decreased by 23%. What is the elasticity of demand for restaurant meals? e^d = 23% / 10% = 2.3 The elasticity of demand for restaurant meals is 2.3. Since this number is greater than 1, you can say that the price elasticity of demand for restaurant meals is elastic. When a good is elastic, consumers are responsive to the change in price and alter their buying behavior by a percentage greater than the change in price. Looking at the numbers in this specific example, notice that the quantity demanded fell by 2.3% for every 1% increase in price. The percentage change in the quantity demanded is greater than the percentage change in price. Hence, the good is elastic. Now, look at the market for coffee. If the price of coffee increased by 10% and, in response, the quantity demanded fell by 2.5%, what is the elasticity of demand for coffee? e^d = 2.5% / 10% = 0.25 In this case, the elasticity of demand is less than 1, making coffee an inelastic good. When a good is inelastic, consumers respond only weakly to a change in price. Here, in response to a 1% increase in price of coffee, consumers reduce their coffee buying by only 0.25%. The percentage change in quantity falls by less than the percentage change in price. This is true for all inelastic goods. Businesses use elasticity to inform their pricing decisions. This measure helps firms predict how sales will change in response to a price change. For example, what if Chevrolet is thinking of increasing the prices of their vehicles by 5%? You know from the law of demand that an increase in price will decrease the quantity demanded for the good, but by how much? Chevrolet does some research and learns that the elasticity of demand for their vehicles is 4.0 (Anderson, McLellan, Overton, & Wolfram, 1997). They can use this to determine how much quantity demanded is likely to fall if they increase price by 5%. 4.0 = % change in the quantity demanded / 5% Multiple both sides by 5% 5% X 4.0 = = % change in the quantity demanded 20% = = % change in the quantity demanded This tells Chevrolet that if they choose to increase the price of their vehicles by 5%, they can expect the quantity demanded of their vehicles to fall by about 20%. Knowing the elasticity of demand for your products can be very helpful when making pricing decisions for your business.

Implicit and Explicit Costs

Economists consider two types of costs when calculating profit: implicit and explicit. Explicit costs are payments made to cover the firm's bills and are sometimes called out-of-pocket costs. Examples of explicit costs include the wages paid to a firm's employees and the rent a firm pays for its office. Implicit costs are more subtle but just as important. They represent the opportunity cost of using resources already owned by the firm. Often these resources are contributed by the firm's owners. There are four primary sources of implicit cost: forgone wages, forgone interest, depreciation, and normal profit. 1. Forgone wages are used to measure the value, or opportunity cost, of the time owners dedicate to supporting their business. In using their time, they give up the opportunity to earn money in a different job. 2. Forgone interest is the opportunity cost of using the owner's money for the business. When people us all of their savings to start a business, they sacrifice the interest this money would have earned. 3. Depreciation is the cost to the firm of using its own capital. The firm's physical assets lose value from its use in production. Depreciation measures the opportunity cost associated with this wear and tear. 4. Normal profit is the return to the entrepreneur for taking risks and making decisions. There is no formal salary associated with the challenge of entrepreneurship. Instead, the owner expects to be rewarded with profit. Economic profit evaluates owners' return relative to their other opportunities. When economic profit is positive, a business is earning a larger return than it could expect to earn by pursuing any available alternative. A negative economic profit indicates that a more rewarding option is available. Zero economic profit means that the business is paying all its bills and providing the owner with a return that is just as good as the available alternative. Unlike zero accounting profit, zero economic profit is considered a good outcome. Imagine you work at the local hardware store for $10 an hour. You notice that a popular musician is coming to town and decide to take the day off to sell merchandise at the concert. You spend $300 purchasing inventory. On the day of the concert, you earn $375 through your sales. Did you make a profit? According to an accountant, the answer is yes. The difference between your total revenue and your explicit cost is $75. Economists answer this question differently. There is an implicit cost to working at the concert rather than at the hardware store. This cost should be considered in order to understand whether your decision to sell merchandise at the concert was beneficial. At $10 an hour, you could have earned $80 during your 8-hour shift. When these forgone wages are subtracted, you have an economic loss of $5. You would have been $5 better off by going to work at the hardware store. Economic profit evaluates your return relative to your other opportunities.

Calculating the Unemployment Rate

Economists define the unemployment rate as the number of unemployed persons divided by the number of persons in the labor force (not the overall adult population). Thus, the calculation for unemployment is the following: Unemployment rate =Unemployed people / Total labor force × 100 As an example, examine the following table and graph. These data show the three-way division of the sixteen-and-over population. In January 2017, about 62.9% of the adult population was in the labor force, people either employed or without a job but looking for work. Those in the labor force are divided into the employed and the unemployed. Note that the unemployment rate is not the percentage of the total adult population without jobs but rather the percentage of adults who are in the labor force but do not have jobs and are actively looking. The following steps show how to calculate the unemployment rate using data from the previous table. Step 1. Divide the number of unemployed people by the total labor force. This expresses the unemployment rate as a decimal. Step 2. Multiply by 100 to express as a percentage. The calculation is shown here. Common practice is to round to one decimal place. Unemployment rateUnemployment rate===7.635 million unemployed159.716 million in labor force=0.04780.0478×1004.8%

Circular Flow Diagram

Economists use a model called the circular flow diagram to depict the interaction of economic actors in the macroeconomy. In the basic version of the diagram, there are two principal actors: firms and households. The model illustrates how transactions between households and firms in both the goods and the factors markets direct the flow of goods and the flow of inputs. You can also see the flow of money that goes along with these transactions. The diagram is an abstraction of the economy. The idea is that households spend money on goods and services produced by businesses, which enables businesses to purchase labor and other inputs from households. In continuation, these households use the money earned to purchase goods and services from the businesses. Thus, the interactions move in a circular motion. In the real world, there are many different markets for goods and services and markets for many different types of labor and other factors of production. The circular flow diagram simplifies this to make the picture easier to grasp. However, details can easily be added to this basic model to introduce more real-world elements like financial markets, governments, and interactions with the rest of the world (imports and exports, for example). This lesson will explore an expanded version of the circular flow model in which these components are considered.

Underemployed

Employed in a job that offers fewer work hours than desired

Quiz: Why is technology an important part of entrepreneurship?

Entrepreneurs use technology to best organize production. New ideas and technologies must be applied by an entrepreneur.

Diseconomies of Scale

Features that lead to an increase in average costs as a business grows beyond a certain size. The long-run average cost of producing each individual unit increases as total output increases. Finally, the right-hand portion of the LRAC curve that runs from output level Q4 to Q5 shows a situation where average costs rise as the level of output and the scale rises. This occurs when a firm scales inputs up by a certain factor and generates an increase in output that is smaller than that factor. For example, if the firm's output increases by a factor of one and a half when inputs are doubled, the firm exhibits diseconomies of scale. A firm or a factory can grow so large that it becomes challenging to manage. This results in unnecessarily high costs as many layers of management and bureaucracy try to communicate with workers and with each other and as failures to communicate lead to disruptions in the flow of work and materials. Firms that shrink their operations are often responding to finding themselves in the diseconomies region, thus moving back to a lower average cost at a lower output level. Not many oversized factories exist in a market economy. With their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.

Quiz: The market price of a product is lower than the average total cost to produce the product. Which outcome stems from this type of market?

Firms will leave the market. This happens in a perfectly competitive market. When the price drops below the average total cost, firms will leave the market.

Describe deficits and debts in the federal budget.

For two weeks in October 2013, the U.S. federal government shut down. Many federal services, like the national parks, closed and 800,000 federal employees were furloughed. Tourists were shocked, and so was the rest of the world: Congress and the president could not agree on a budget. Inside the U.S. Capitol Building, Republicans and Democrats argued about spending priorities and whether to increase the national debt limit. Each year's budget, which is over $3 trillion of spending, must be approved by the Congress and signed by the president. Two-thirds of the budget is entitlements and other mandatory spending, which occur without congressional or presidential action once the programs are established. Tied to the budget debate was the issue of increasing the debt ceiling—how high the U.S. government's national debt can be. The House of Representatives refused to sign on to the bills to fund the government unless they included provisions to stop or change the Affordable Care Act. As the days progressed, the United States came very close to defaulting on its debt.1 In this lesson, you will learn about the federal debt. Using historical comparisons, this lesson provides context for evaluating the burden of the debt. It also examines the federal deficit, looking at annual budgets and the relationship between taxes and spending. Data offer insight into changes in the deficit and their connection to macroeconomic fluctuations.

What Is Fiscal Policy?

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes with a goal to fight inflation or decrease unemployment Fiscal policy is the use of government spending and taxation to influence the economy.1 The United States Constitution gives Congress the financial control, making it responsible for enacting fiscal policy. The president can influence the process and has veto power, but Congress must author and pass the necessary bills (Amadeo, 2019). Through these bills, Congress sets its fiscal policy objectives by changing the level of taxation or by changing the level of government spending in various sectors of the economy. Governments use fiscal policy to influence the level of aggregate demand in the economy to achieve the economic objectives of price stability, full employment, and economic growth. Fiscal policy works by changing buying behavior within the different components of aggregate demand. Levels of consumption, investment, government spending, and net exports can each be affected by changes in taxes and government spending. In the United States, monetary policy is the responsibility of the Federal Reserve. A bank takes deposits and loans out of part of them to generate an interest income. To stabilize the interest rate and prevent inflation, the Fed uses tools such as fractional reserve requirements, discount rates, open market operations, and interest on reserves to affect the supply of money. The primary goal of the Fed is to control inflation. Once inflation is under control, the Fed then works to close recessionary gaps. An expansionary monetary policy is utilized in times of recession to increase the supply of money available for lending and to drive down the interest rate. With a lower interest rate, businesses and individuals may feel more comfortable borrowing money to expand their businesses and hire employees. These employees will then spend their wages, which multiplies the effect of the expansionary policy. In times of inflation, a contractionary monetary policy is used to create the opposite effect. Fiscal policy is the use of taxes and government spending to influence economic conditions. Congress has the primary responsibility for setting fiscal policy. To address inflation, Congress would use a contractionary fiscal policy, reducing government spending, and increasing taxes. To address unemployment, Congress would use an expansionary fiscal policy, increasing government spending and reducing taxes. Government spending is made up of discretionary spending and transfer payments. When government spending exceeds the amount of taxes collected, a federal deficit is the result. With the exception of the late 1990s, the federal government has had policies resulting in deficit spending. An aging population that will withdraw more transfer payments than the working generations will contribute brings concerns for a worsening financial picture for the level of government debt in the future. Examination of data on inflation and unemployment suggests that in the short run, there is a trade-off between these variables—increases in unemployment lead to decreases in inflation and vice versa. Under these conditions, both fiscal and monetary intervention can successfully affect policy targets. However, in the long run, the inverse relationship between inflation and unemployment does not hold. Instead, unemployment tends to return to its natural rate, independent of the inflation rate. This suggests that policy interventions that work in the short run will prove less effective in the long run.

Establishing accurate methods for gauging the performance of the economy is an essential component of macroeconomics:

How large is the United States' economy? Economists typically measure the size of a nation's overall economy using its gross domestic product (GDP). GDP is the market value of all final goods and services produced within a country in a year. Measuring GDP involves counting the production of millions of different goods and services, such as smartphones, cars, music downloads, computers, steel, bananas, college education, and all other new goods and services that a country produced over a period of time and summing them into a total value. This task is straightforward: Take the quantity of everything produced, multiply it by the price at which each product is sold, and add up the total. In 2018, the United States' GDP totaled $20.58 trillion, the largest GDP in the world. Each of the market transactions included in GDP must involve both a buyer and a seller. An economy's GDP can be measured either by the total dollar value of what is purchased in the economy or by the total dollar value of what the country produces.1

Long Run Costs Example

How long does it take to reach the long run? This is a trick question. The long run refers to a planning period, not a moment in time. The appropriate duration of the planning period depends on the specifics of the firm in question—it is not a precise time frame. If you have a one-year lease on your factory, then the long run is any period longer than a year since, after a year, you are no longer bound by the lease. For some industries, the long run is the time it takes to build new factories and purchase new machinery. For any industry, the business owner is simultaneously in the short run and in the long run. Decisions need to be made about things that happen today, tomorrow, and next week. In making these decisions, the manager is operating in the short run. At the same time, decisions are made to chart the direction of the firm. In making these choices, the manager is acting in the long run. In planning for the long run, the firm compares alternative production technologies (or processes). In this context, technology refers to all alternative methods of combining inputs to produce outputs. The firm searches for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits if total revenues remain unchanged. Moreover, each firm fears that if it does not seek out the lowest-costing methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.

For whom to produce it:

If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means the good or service will not be available to someone else. For example, representatives of the poorest nations on earth often complain that the energy consumption per person in the United States is 17 times greater than the energy consumption per person in the world's 62 poorest countries. Critics argue that the world's energy should be more evenly allocated. Should it? That is a "for whom" question.

Quiz: When will a country consider imposing import quotas?

If it is concerned about increasing levels of domestic production By limiting the amount of imports, the price levels and profits of domestic producers are increased leading to more domestic production.

A Farmer's Market: An Example of a Perfectly Competitive Market

Imagine you have an acre of land, and you would like to grow and sell tomatoes at the local farmer's market for some additional income. Theoretically, anyone can grow tomatoes, and every tomato is like every other tomato. Customers know everything they need to know when buying tomatoes. With this information, customers buying tomatoes will look for the lowest price and buy from that vendor. As a seller, you can easily access the going price of tomatoes in the local farmer's market. You consider the price of seed, fertilizer, water, and the value of your time to determine the cost of producing tomatoes. You then compare your cost to the market price. If your average total cost is less than the market price, you will enter the market. If your average total cost is higher than the market price, you will not enter the market. In the long run, as other potential tomato growers enter a competitive market in which a profit can be made, the supply of tomatoes will increase more than the demand, which will drive the price down. If the price is now below average total cost, you leave the market. Others will do the same. Eventually, supply will decrease, and the price will go back up. This process continues as the price of tomatoes fluctuates slightly above and then slightly below the minimum of the average total cost.

Ad Valorem Tariffs

Import tax based on a fixed percentage of the assessed commercial value of imported goods Ad valorem tariffs are tariffs based on a percentage of the value of each item.3 In 2019, the United States levies a 2.5% ad valorem tariff on imported automobiles. Thus, if $100,000 worth of automobiles are imported, the U.S. government collects $2,500 in tariff revenue. In this case, $2,500 is collected whether two $50,000 BMWs or ten $10,000 Hyundais are imported.

Oligopoly: Returns to Scale

In an oligopoly market structure, a few large firms dominate the market. Each firm recognizes that every time it takes action, it will provoke a response among the other firms. These actions, in turn, will affect the original firm. Each firm therefore recognizes that it is interdependent with the other firms in the industry. This interdependence is unique to the oligopoly market structure. In perfect competition and monopolistic competition, an assumption is made that each firm is small enough that the rest of the market will ignore its actions.2 Consider a firm like Apple in the smartphone market. Apple can affect demand and price, and other firms have to react to them. Compared to a farmer at a farmer's market who needs only to concern herself with her costs and the market price, firms in oligopoly markets are as concerned with the behavior of other firms as they are of the consumer. The existence of oligopoly requires that a few firms gain significant market power, preventing other, smaller competitors from entering the market. One source of this power is economies of scale. Economies of scale imply that larger firms will face lower average costs than smaller firms because they can take advantage of added efficiency at higher levels of production. Monopolies and oligopolies often form when an industry has economies of scale at relatively high output levels. When a few large firms already exist in this type of market, any new competitor will be smaller and therefore have higher average costs of production. This will make it difficult to compete with already established firms. Therefore, the oligopoly firms have a built-in defense against new competition. Take the example of the cell phone industry in the United States. As of the third quarter of 2018, Verizon, AT&T, Sprint, and T-Mobile together controlled 98.62% of the U.S. cell phone market. Providing cell service requires very large upfront expenditures to establish a network of towers. This large fixed cost creates economies of scale in the cell phone service industry. The per-unit cost of providing cellular access to 100,000 people is more than twice the per-unit cost of providing cellular access to 200,000 people. Any new entrant into the cell phone market will either need to pay one of the larger companies for access to its already existing network or try to build a network from scratch. Both options result in higher costs, higher prices, and difficulty in competing with the major networks.2 Oligopolies usually exist when fixed costs are extremely large and act as a barrier to entry.

Comparative Advantage Continued

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost over another. The country with the lowest opportunity cost will be the low-cost producer in the case of free trade and will set the world price (Mankiw, 2018). Some countries, especially developing countries with little technology and capital, may not have an absolute advantage in producing any goods or services. David Ricardo, a great British political economist, developed the concept of comparative advantage in the early nineteenth century (Torelli, 2013). Ricardo reasoned that even if a country had the absolute advantage in the production of all products, specialization and trade could still occur between two countries. Specialization refers to the tendency of countries to specialize in certain products, which they trade for other goods rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good from another country. The traders decide on whether they should export or import goods depending on comparative advantages.5 Specialization, according to comparative advantage, results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more or better resources or discovering improved production techniques.

The Law of Supply

In economics, supply is the amount of a product that producers are willing and able to bring to the market at a series of possible prices during a specified time period if all other factors are being held constant. In general, there is a positive relationship between the price of a good and the quantity that the producer is willing to supply. If a supplier believes that it can sell the product for a higher price, it will want to make more of the product. Therefore, as the price of a good or service increases, suppliers increase the quantity available for purchase—the quantity supplied. The positive correlation between price and the quantity supplied (Qs) is based on the potential increase in profitability that occurs with an increase in price. If all else is being held constant, suppliers will be able to increase their return per unit of a good or service as the price for the item increases. However, just like with demand, there are several factors that can affect a seller's willingness or ability to produce and sell a good. Economists call this positive relationship between price and the quantity supplied the law of supply.1 According to the supply schedule, when the price of coffee is $6 per pound, the quantity supplied of coffee is 30 million pounds in a month. Just like you saw with demand and the quantity demanded, the terms supply and quantity supplied are distinct and cannot be used interchangeably. Supply refers to the entire set of possible price-quantity combinations that exist when all other things are constant. Quantity supplied, as stated previously, is the specific quantity producers are willing to sell at a particular price. If the price of coffee increases from $6 to $8 per pound, the quantity that companies are willing to sell increases from 30 to 40 pounds of coffee. The quantity supplied increases because companies are able to profit more at higher prices. The positive relationship between price and the quantity supplied is known as the law of supply. It states that if all else is equal, as the price increases, the quantity supplied will also increase; or, as the price falls, the quantity supplied will also fall.

Keynesian Policies during Periods of Recession and a Booming Economy

In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a Goldilocks level of aggregate demand: looking for not too much, not too little, but for what is just right. In this model, the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment or direct increases in government spending that would shift the aggregate demand curve to the right. When the economy is operating above potential GDP, unemployment is low, and inflationary pressures are a concern, a contractionary fiscal policy is recommended. Governments should use tax increases or government spending cuts to shift aggregate demand to the left. Notice that these policies rely on a trade-off between inflation and unemployment and are designed to address a single problem at a time. One set of policies addresses the problem of inflation, while the other addresses the problem of unemployment. Historical experience with the Phillips curve identifies some situations in which these characteristics of fiscal policy make it unable to address market problems effectively. During a supply shock, both inflation and unemployment increase. There is not a fiscal policy answer to that situation. Instead, policymakers set priorities and target a single aspect of the crisis. Next, data suggests that in the long run, the trade-off between inflation and unemployment does not hold. People adjust their inflation expectations, and unemployment returns to its full-employment levels. This indicates that fiscal intervention can be successful in the short run but in the long run will not impact the level of unemployment.

LRAC and the Number of Firms in the Market

In the examples up to this point, the quantity demanded in the market is quite large (1 million) compared with the quantity produced at the bottom of the LRAC curve (5,000, 10,000, or 20,000). In such a situation, the market is set for competition between many firms. But what if the bottom of the LRAC curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower? Imagine that the total quantity of dishwashers demanded in the entire market at that price of $500 is only 30,000. Looking at the right-hand graph in the following figure, you can see that the minimum number of dishwashers a firm must make in order to achieve an average cost of $500 is 10,000 units (point R). In this situation, the total number of firms in the market would be three. Alternatively, looking at the same graph, suppose the total quantity demanded for the product is only 10,000 dishwashers at a price of $500. In this situation, the market may well end up with a single firm—a monopoly—producing all 10,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 10,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The relationship between the quantity at the minimum point of the LRAC curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum point of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum point of the LRAC, a few firms will compete. If the quantity demanded in the market is less than the quantity at the minimum point of the LRAC, a single-producer monopoly is a likely outcome.1

Gaining from Trade

In the previous example, you used the PPF to calculate opportunity cost to determine which nation has a comparative advantage in producing guns and butter. To see the power of comparative advantage in international trade, continue with the same example. Imagine that Golden is currently producing at Point A (8,000 guns, 2,000 pounds of butter) and Maple is producing at Point D (2,000 guns, 2,500 pounds of butter). What is total production in this simple world? Total world production=(8,000+2,000) guns+(2,000+2,500) lb of butter = 10,000 guns+4,500 lb of butter

Difficulties with Monetary Policy

In the real world, an effective monetary policy faces several significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: The central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy or doing nothing. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars; then it takes time for these changes to filter through the rest of the economy. Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves above the legally mandated limit. For example, during a recession, banks may be hesitant to lend because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans. When many banks choose to hold excess reserves, an expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession because they recognize that firms' sales and employees' jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during a profound recession, an expansionary monetary policy may have little effect on either the price level or the real GDP. The problem of excess reserves does not affect a contractionary policy. Central bankers have an old saying that monetary policy can be like pulling and pushing on a string: When the central bank pulls on the string and uses a contractionary monetary policy, it can raise interest rates and reduce aggregate demand. However, when the central bank tries to push on the string of an expansionary monetary policy, the string may sometimes just fold up limp and have little effect because banks decide not to loan out their excess reserves. However, an expansionary policy usually does have real effects as well.

Expansionary Fiscal Policy

In times of recession, expansionary fiscal policy can be used to reduce unemployment, increase output, and move the economy toward a full-employment equilibrium. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two. As government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right. A reduction in taxes will leave more disposable income and cause consumption to increase, also shifting the aggregate demand curve to the right. An increase in government spending combined with a reduction in taxes will also shift the aggregate demand curve to the right. This can be seen in the following graph as the shift of AD0 to AD1.3 By stimulating aggregate demand, an expansionary fiscal policy increases output, closing the recessionary gap. In instances of recession, government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. The government could stimulate a great deal of new production with a modest expenditure increase if the people who receive this money use most of it for consumption. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in spending and so on, in a circle.2 The effects of fiscal policy can be limited by crowding out. Direct crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Indirect crowding out can occur if government spending exceeds tax revenues, an expansionary policy that leads to a budget deficit. The government borrowing needed to fund the deficit can raise interest rates, limiting private investment.2

Inflationary Pressures in the AD-AS Model

Inflation measures the rate of increase in the price level. Although not explicitly identified by the AD-AS model, it can be interpreted based on changes in the equilibrium price level. Higher inflation rates have typically occurred either during or just after economic booms: For example, the most significant spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called deflation—during the Great Depression. Even during the relatively short 1991-1992 recession, the inflation rate declined from 5.4% in 1990 to 3% in 1992. During the 2001 recession, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007-2009, the inflation rate declined from 3.8% in 2008 to -0.4% in 2009. Although some countries have experienced bouts of high inflation that lasted for years, in the U.S. economy, since the mid-1980s, inflation does not seem to have had any long-term trend to be substantially higher. Instead, it has stayed in the 1% to 5% range annually. The AD-AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing up the price level. In the first of the figures that follow, there is a shift of aggregate demand to the right. The new equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy must overuse resources to increase production, leading to a rise in the price level. Inflation can also arise from a supply shock. This situation is depicted in the preceding graph. The economy is at E0, a long-run equilibrium, when a supply shock occurs, which makes it suddenly more expensive or more difficult to produce. The oil price shock of the early 1970s is an excellent example of this type of supply shock. Due to an Organization of Petroleum Exporting Countries (OPEC) embargo, the price of oil nearly doubled between 1973 and 1974. As an essential input, the increase in the price of oil raised production costs, causing a leftward shift of the AS. This shift in AS is shown as the movement from SRAS0 to SRAS1. A new equilibrium is reached at E1. At this new equilibrium, prices are higher and output lower than at E0. Supply shocks are considered particularly difficult for the economy because they raise both inflation and unemployment. Economists use the term "stagflation" to identify the specific problem of simultaneous inflation and recession.

The Equilibrium Interest Rate

Interest rates adjust to bring the money market to an equilibrium at which the supply of money is equal to the demand for money. In the previous graph, when the supply of money is SM, equilibrium is reached at an interest rate of r. The Fed can affect this interest rate by changing the supply of money. An increase in the money supply shifts the money supply curve from SM to SM1. This leads to a reduction in the interest rate from r to r1. To raise the interest rates, the Fed reduces the money supply. On the graph, this action causes the supply curve to shift from SM to SM2 and leads to an increase in the interest rate from r to r2. By controlling the money supply, the Fed can alter the underlying conditions in the money market to change the interest rate. The interest rate is the pathway through which changes in the money supply affect the market for goods and services.

International Trade

International trade is a vital part of the economy, and its importance has been growing over time. There have been three primary reasons for this increase in importance: a reduction in the cost of transportation and communication, advancement in technology, and decreased trade barriers. First, there have been significant reductions in the cost of transportation and communication. It is now much cheaper for a company to not only operate internationally and trade with foreign partners, but also exchange information between potential buyers and sellers. Second, technological advances have made international production and trade easier to coordinate. More efficient telecommunications, from the first transatlantic telephone cable in 1956 to the introduction of the internet in the 1980s and 1990s, have allowed companies to exchange goods more efficiently and lower the costs of international integration. Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also contributed to the rise in international trade.1 Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of international monetary management has shaped the relationship between the world's major industrial states and has resulted in a much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after World War II, the Bretton Woods Conference set up regulations for the production of individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade. This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed exchange rates, the goal of more open economies and free international trade remained.

Describe international trade.

International trade is the exchange of goods and services across national borders. You engage in international trade every time you buy goods that are produced in a foreign country, whether you buy them in a local store or have them shipped to you directly. What benefits do you get from your ability to purchase goods from anywhere in the world? Lower prices and a greater selection are fantastic benefits for consumers. Competition drives down prices and can push domestic firms to become more efficient. In this lesson, you will learn about why nations trade. People who are living in countries that are open to trade benefit from the importing and exporting of goods and services. Ensuring that this trade is fair and that each nation involved plays by the rules is a challenge. You will learn about the role the World Trade Organization (WTO) plays in overseeing and facilitating the trade process. There is also disagreement about the right level of imports and exports for a nation, which is called the ideal balance of trade. Governments, producers, and consumers all have different perspectives on trade, and you will explore these views as they relate to the value of free trade.

Debt-to-GDP Ratio

It is essential to clarify the difference between the deficit and the debt. The deficit is not the debt. The difference between the deficit and the debt lies in the time frame. The government deficit (or surplus) refers to what happens with the federal government budget each year. The government debt is accumulated over time; it is the sum of all past deficits and surpluses. If you borrow $10,000 per year for each of the four years of college, you might say that your annual deficit was $10,000, but your accumulated debt over the four years is $40,000. The following figure shows the ratio of debt to GDP since 1940. Until the 1970s, the debt-to-GDP ratio revealed a relatively clear pattern of federal borrowing. The government had large deficits and raised the debt-to-GDP ratio in World War II. However, from the 1950s to the 1970s, the government ran either surpluses or relatively small deficits, and so the debt-to-GDP ratio drifted down. Significant deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt-to-GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt-to-GDP ratio higher—with a big jump when the recession took hold in 2008-2009.

Perfect Competition in the Long run

It is impossible to precisely define the line between the short run and the long run with a stopwatch, or even with a calendar. It varies according to the specific business. Therefore, the distinction between the short run and the long run is more theoretical. In the short run, firms cannot change the usage of fixed inputs, whereas in the long run, the firm can adjust all factors of production. Over the long run, if firms in a perfectly competitive market are earning positive economic profits, more firms will enter the market, which will shift the market supply curve to the right. As the supply curve shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will decrease until they become zero. A firm is willing and able to produce when it earns zero economic profit because economic profit includes opportunity costs. The firm will cover both its implicit and explicit costs, including the time invested by its owners. When the price is less than average total cost, firms are making a loss (see the previous formula). Over the long run, if firms in a perfectly competitive market are earning negative economic profits, more firms will leave the market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As the price goes up, economic profits will increase until they become zero. In the long run, companies that are engaged in a perfectly competitive market earn zero economic profits.4 It is important not to confuse zero economic profit with zero accounting profit. Recall that economic profit includes your opportunity cost of production. Zero economic profit means that you could not do any better doing something different.

Quiz: A country is producing capital and consumption goods, and its resources and technology are fixed in quantity and quality. The country wants to expand production of both capital and consumption goods without changing its resources or technology. When is this goal possible?

It is possible if there are underutilized resources, so the production point moves to the frontier. This shows that a production point under the production possibility frontier would result if some resources were not in use. As resources engage in production, the production point moves to the frontier.

Factor of Production: Labor

Labor is the human effort that can be applied to production. People who work to repair tires, pilot airplanes, teach children, or enforce laws are all part of the economy's labor. People who would like to work but have not found employment—who are unemployed—are also considered part of the labor available to the economy. In some contexts, it is useful to distinguish the two forms of labor. The first is the human equivalent of a natural resource. It is the natural ability an untrained, uneducated person brings to a production process. But most workers bring far more. The skills a worker has as a result of education, training, or experience that can be used in production are called human capital. Students are acquiring human capital. Workers who are gaining skills through experience or training are acquiring human capital. The amount of labor available to an economy can be increased in two ways. One is to increase the total quantity of labor, either by increasing the number of people available to work or by increasing the average number of hours of work per time period. The other is to increase the amount of human capital possessed by workers. Sustained, long-term economic growth comes from increases in worker productivity. Human capital is one of the determinants of how productive workers are. Typically, the higher the average level of education in an economy, the higher the accumulated human capital and labor productivity. Another very important factor that determines labor productivity is technological change. Technological change is a combination of invention—advances in knowledge—and innovation, using that advance in a new product or service. For example, the transistor was invented in 1947. It allowed people to miniaturize the footprint of electronic devices and use less power than the tube technology that came before it. Innovations since then have produced smaller, better transistors that are ubiquitous in products as varied as smartphones, computers, and escalators. The development of the transistor has allowed workers to be anywhere with smaller devices. These devices can be used to communicate with other workers, measure product quality, or do any other task in less time, improving worker productivity. Labor requires payment in the form of wages for hourly workers and salaries for executives. Land requires payment from a business to use the space needed for producing a good or service. Labor is the human effort that can be applied to the production of goods and services. Labor's contribution to an economy's output of goods and services can be increased by either increasing the quantity of labor or increasing human capital.

Consequences of Quotas

Like other trade barriers, quotas restrict international trade and thus have consequences for the domestic market. In particular, quotas restrict competition for domestic commodities, which raises prices and reduces the selection. Raising prices and reducing selection hurts the domestic consumer, who must spend more for the good or reduce their consumption. On the other hand, this very action benefits the domestic producer, who may see an increase in profits due to the increase in both the price and domestic production. Usually, the increase in producer profits is not enough to offset the loss to consumers, so the economy experiences a loss overall. Quotas may also foster harmful economic activities. Import quotas may promote administrative corruption, especially in countries where import quotas are given to selected importers. There are incentives to give the quotas to importers who can provide the most favors or the largest bribes to government officials. Quotas may also encourage smuggling. As quotas raise the price of domestic goods, it becomes profitable for some to try and circumvent the quota by bringing in goods illegally or above the quota.

Patterns of Unemployment

Look at how unemployment rates have changed over time and how various groups of people are affected by unemployment differently. The following graph shows the historical pattern of U.S. unemployment since 1955. When looking at this data, several patterns stand out: 1. Unemployment rates fluctuate over time. During the deep recessions of the early 1980s and of 2007-2009, unemployment reached roughly 10%. For comparison, during the 1930s Great Depression, the unemployment rate reached almost 25% of the labor force. 2. Unemployment rates in the late 1990s and into the mid-2000s were rather low by historical standards. The unemployment rate was below 5% from 1997 to 2000, near 5% during almost all of 2006-2007, and 5% or slightly less from September 2015 through January 2017 (the latest date for which data are available as of this writing). The previous time unemployment had been less than 5% for three consecutive years was three decades earlier, from 1968 to 1970. 3. The unemployment rate never falls all the way to zero. It almost never seems to get below 3%—and it stays that low only for very short periods. 4. The timing of rises and falls in unemployment matches fairly well with the timing of upswings and downswings in the overall economy, except that unemployment tends to lag changes in economic activity, especially so during upswings of the economy following a recession. During periods of recession and depression, unemployment is high. During periods of economic growth, unemployment tends to be lower. 5. No significant upward or downward trend in unemployment rates is apparent. This point is especially worth noting because the U.S. population more than quadrupled from 76 million in 1900 to over 324 million by 2017. Moreover, a higher proportion of U.S. adults are now in the paid workforce because women have entered the paid labor force in significant numbers in recent decades. Women composed 18% of the paid workforce in 1900 and nearly half of the paid workforce in 2017. However, despite the increased number of workers as well as other economic events like globalization and the continuous invention of new technologies, the economy has provided jobs without causing any long-term upward or downward trend in unemployment rates.1

Macroeconomics

Macroeconomics is the branch of economics that studies the structure and performance of the overall economy. The scale of this analysis creates a unique challenge. It is difficult to evaluate overall economic performance when each person is only able to witness a small segment of the economy. If asked about how well the economy is doing, a person with a well-paying job in a thriving industry is likely to say it is performing very well. If asked the same question, a person in the same town who just lost his or her job will answer differently. To gain a sense of the big picture, macroeconomists rely on data, using it to provide measurements for economic activity. This module introduces three of the most commonly cited measurements of macroeconomic performance: gross domestic product (GDP), unemployment, and inflation.1 The module begins by looking at the circular flow diagram. This model reduces the complexity of macroeconomic interactions by mapping the market interactions between the primary macroeconomic actors. From this you learn to identify important economic actors, understand the roles they play, and recognize the institutions they interact with. This overview provides a context for understanding the usage and meaning of the measurements discussed in subsequent lessons. For each of the measurements discussed, you will learn the variable's definition and see how it is calculated. These lessons will develop your understanding of the strengths, weaknesses, and usage of each of these critical macroeconomic measurements.

An Oligopoly Market

Many purchases that individuals make at the retail level are produced in oligopolies. An oligopoly market structure exists when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly include the auto industry, cable television, and commercial air travel. In an oligopoly market, only a few large firms compete against each other. An oligopoly exists when the following conditions occur: 1. A few large firms produce identical or differentiated products. 2. Firms are considered price makers. 3. Buyers have incomplete knowledge. 4. Barriers to entry and exit from the market exist. While some oligopoly industries make standardized products—tools, copper, and steel pipes, for example—others make differentiated products: cars, cigarettes, soda, and cell phone manufacturers. Product differentiation is not necessary for the existence of an oligopoly, but if a firm can successfully engage in product differentiation, it can more easily gain market power and dominate at least part of the industry. Primary Goal: All firms maximize profit Barriers to entry or exit: There are barriers to entry or exit in the market Market Composition: Three to five firms dominate the market. Types of Goods: May have differentiated or homogeneous products. Pricing: Firms can set prices.

Oligopolies and Society

Many real-world oligopolies prodded by economic changes, legal and political pressures, and the egos of their top executives go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market. When firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.9 When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. However, oligopolies are often buffeted by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods. Therefore, oligopolists do not typically produce at the minimum of their average cost curves. When oligopolists lack vibrant competition, they may also lack incentives to provide innovative products and high-quality service. The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Market Power: Price Setter Long-Run Economic Profit: Yes Efficiency: Less allocatively and productively efficient than both perfect and monopolistic competitive. Benefits to Society: Innovation

Choices of Production Technology

Many tasks can be performed with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages or invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets or invest in a computerized record-keeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts or invest in motorized vehicles. Firms often face a choice between buying many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate. In short, capital and labor can often substitute for each other. Consider the example of a private firm that is hired by local governments to clean up public parks. Three different combinations of labor and capital for cleaning up a single average-sized park appear in the following table. The first production technology is heavy on workers and light on machines while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines. Production Technology Options Production technology 1 uses the most labor and least machinery. Production technology 3 uses the least labor and the most machinery. The following table outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery. Example A shows the firm's cost calculation when wages are $40 and the machine's costs are $80. In this case, technology choice 1 is the least expensive production technology. In example B, wages rise to $55 while the cost of machines does not change, in which case technology 2 is the least expensive production technology. If wages keep rising to $90 while the cost of machines remains unchanged, then technology 3 clearly becomes the least expensive form of production, as shown in example C. This example shows that as the labor input becomes more expensive, firms will attempt to reduce their usage of that input and instead shift to other inputs that are relatively less expensive. When a multinational employer like Coca-Cola or McDonald's sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that employ few workers and rely more heavily on capital. However, the same employer is likely to use production technologies that include more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.1 It also explains why fast-food restaurants would transition to self-service or kiosk ordering as the cost of labor increases.

Positive Externalities and Social Benefits

Market competition can provide an incentive for discovering new technology because a firm can earn higher profits by finding a way to produce products more cheaply or create products with characteristics that consumers want. As Gregory Lee, CEO of Samsung, said, "Relentless pursuit of new innovation is the key principle of our business and enables consumers to discover a world of possibilities with technology." An innovative firm knows that it will usually have a temporary edge over its competitors and thus an ability to earn above normal profits before competitors can catch up. In certain cases, however, competition can discourage new technology, especially when other firms can quickly copy a new idea. Consider a pharmaceutical firm deciding to develop a new drug. On average, it can cost $800 million and take more than a decade to discover a new drug, perform the necessary safety tests, and bring the drug to market. If the research and development (R&D) effort fails—and every R&D project has some chance of failure—the firm will suffer losses and could even be driven out of business. If the project succeeds, the firm's competitors may figure out ways of adapting and copying the underlying idea without having to pay the costs themselves. As a result, the innovative company will bear the much higher costs of the R&D and will enjoy at best only a small, temporary advantage over the competition. In certain cases, however, competition can discourage new technology, especially when other firms can quickly copy a new idea. Consider a pharmaceutical firm deciding to develop a new drug. On average, it can cost $800 million and take more than a decade to discover a new drug, perform the necessary safety tests, and bring the drug to market. If the research and development (R&D) effort fails—and every R&D project has some chance of failure—the firm will suffer losses and could even be driven out of business. If the project succeeds, the firm's competitors may figure out ways of adapting and copying the underlying idea without having to pay the costs themselves. As a result, the innovative company will bear the much higher costs of the R&D and will enjoy at best only a small, temporary advantage over the competition.

Lesson Summary

Market structure is determined by the number and size of firms in a market, by entry conditions, and by the extent of product differentiation. The major types of market structures include the following: A monopoly is an industry structure where a single firm produces a product for which there are no close substitutes. Monopolists are price makers. Barriers to entry and exit exist, and to ensure profits, a monopoly will attempt to maintain them. Oligopoly is a market structure in which there are a few firms producing products that range from similar to highly differentiated. Each firm is large enough to influence the industry. Barriers to entry exist. Monopolistic competition is a market structure in which there are a large number of firms, each having a small portion of the market share and slightly differentiated products. There are close substitutes for the product of any given firm, so competitors have slight control over price. There are relatively insignificant barriers to entry or exit, and success invites new competitors into the industry. Perfect competition is a market structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.

the goods and services market

Market where households purchase consumable items and businesses sell their wares. The market includes stores, the internet, and any other place where consumer goods and services are exchanged. Goods and Services Market—The exchange of products between buyers and sellers takes place in the goods and services market. Looking at the arrows pointing toward the market, you can see that each of the economic actors in the economy is a buyer of products. Expenditures from these four sources combine to create the total or aggregate demand for goods in the economy. These four expenditure streams are described below. 1. Consumer spending (consumption): The acquisition of goods and services by individuals or families This includes the value of all expenditures by households on final goods and services. Households' consumption spending depends on their disposable income, the income households have available to them after all taxes have been paid to the government and all transfers have been received. Households allocate their disposable income to either buying consumption goods or saving. Consumption includes the purchase of things like cars, food, medical care, and education. 2. Investment (Business Spending): Investment refers to the purchase of new capital goods: new commercial real estate and equipment, residential housing construction, and inventories. This refers to the purchase of goods and services that, in one way or another, help produce more output in the future. Firms borrow from the financial market to fund their investment spending. Investment includes the purchase of things like trucks, computers, desks, or buildings. 3. Government Spending: All government consumption, investment, and transfer payments. This includes all purchases of goods and services by the federal, state, and local governments. To fund its purchases, government can tax its citizens or borrow from the financial market. If the government spends more than it gathers in taxes, it must borrow from the financial markets to make up for the shortfall. When the government is running a deficit, there is a flow of money to the government sector from the financial markets. When the government runs a surplus, there is a flow of money to the financial markets from the government sector. Expenditures by the government may go to build roads, purchase military equipment, or fund research. 4. Net Exports: The difference between the monetary value of exports and imports. This is equal to exports minus imports and measures the expenditure flows associated with the rest of the world. Exports are goods and services produced in one country and purchased by households, firms, and governments of another country. Imports are goods and services purchased by households, firms, and governments in one country but produced in another country. Exports add to the overall level of spending on domestic products, and imports decrease total spending on domestic products. Oil purchased from Saudi Arabia is an import. Soybeans sold to China is an export. Money and financial assets also flow between countries as countries borrow from each other and invest in each other.

Lesson Summary

Markets range from perfectly competitive to monopolies. Each market type has benefits and drawbacks. Only the truly competitive markets result in a situation where marginal costs equal marginal benefits (MC = MB). All other markets charge a higher price than the cost of the production inputs. The process of advertising helps firms distinguish their products in hopes of justifying a higher price. The process of rent-seeking allows firms to gain wealth that is not warranted. Perfectly competitive market: Many suppliers produce uniform goods in a market with little to no barriers to entry. Each firm must accept the market price and is, therefore, a price taker. Competition means that economic profits cannot be sustained in the long run. Production, in the long run, will be at the minimum of the average total cost curve. Equilibrium production takes place where price = marginal revenue = marginal cost = minimum of the average total cost. A perfectly competitive market is the most efficient market structure. Monopolistic competition: Many suppliers provide differentiated goods in a market with few barriers to entry. Individual firms face a downward-sloping demand, so the quantity they produce will affect the price. Because of this, the price charged will be greater than the marginal cost. Low barriers to entry will encourage competition that drives economic profits to zero in the long run. In equilibrium, the price will equal the average total cost; however, unlike a competitive market, production will not be at the minimum of the average total cost curve. Thus, price = average total cost > marginal revenue = marginal cost. A monopolistic market is less efficient than a perfectly competitive market. Oligopoly: Few firms produce goods with few good substitutes. Barriers to entry are high, and firm strategies are interdependent. Long-run profits can be sustained if firms can successfully collude, but some incentives would cause firms to break that collusion. In most cases, production takes place where price > average total cost > marginal revenue = marginal cost. An oligopoly is less efficient than either a perfectly competitive market or a monopolistic competitive market. Monopoly: Single firms produce goods with no close substitutes. Barriers to entry are insurmountable. Long-run profits are sustained. Equilibrium production can take place where price > average total cost > marginal revenue = marginal cost. A monopoly is the least efficient market structure. Perfectly competitive market: The products are identical or homogeneous, and everyone knows that they are. This knowledge makes a marketing campaign or advertising a waste of time and money. However, industry-wide marketing campaigns can raise demand for the whole industry. In other market structures, advertising can differentiate a firm's product. Rent-seeking: It can disrupt market efficiencies and allow an imbalance of information access to give some participants in the market an advantage over others. Rent-seeking includes using political means to seek an economic advantage.

Gross Domestic Product GDP

Measures the value of economic activity within a country. Strictly defined, GDP is the sum of the market values, or prices, of all final goods and services produced in an economy during a period of time. Firms supply the goods and services desired by these four buyers. Prices adjust with changes in the demand and supplies of these goods and services. The purchase of goods and services creates a flow of money to suppliers of the products. This flow of payments is shown in the diagram by the darker blue arrow going from the goods and services market to the firms. It is the sum of the expenditures listed above and is the total value of production in the economy. The total flow of money into the firm sector equals the gross domestic product (GDP).

Monetary Policy

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand: Business investment will decline because it is less attractive for firms to borrow money. Even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than it is to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for expensive items like houses and cars. This decrease in consumption and investment will lead to a decrease in aggregate demand, shifting the curve to the left, shown in the following figure on Panel (b). The new equilibrium occurs at a lower price and lower GDP. Conversely, a loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for expensive items. At lower interest rates, businesses are more likely to invest in capital expenditures and consumers are more likely to purchase expensive items. Similarly, at lower interest rates, both businesses and individuals are less likely to hold money in savings or other financial investments. This increase in consumption and investment will therefore increase aggregate demand, shifting the curve to the right; shown in the following figure on Panel (a). The new equilibrium occurs at a higher price and higher GDP.5

Functions for Money

Money has four primary functions. It is used as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. This money is then used to buy shoes. To serve as a medium of exchange, money must be very widely accepted as a method of payment in the markets for goods, labor, and financial capital. Second, money must serve as a store of value. In a barter system, the shoemaker risks having his or her shoes go out of style, especially if he or she keeps them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money. Third, money serves as a unit of account, which means that it is the ruler by which other values are measured. For example, an accountant may charge $100 to file your tax return. That $100 can purchase two pairs of shoes at $50 per pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs. Finally, another function of money is that it must serve as a standard of deferred payment. If it is usable today to make purchases, it must also be acceptable to make purchases today that will be paid in the future. Loans and future agreements are stated in monetary terms, and the standard of deferred payment is what allows you to buy goods and services today and pay in the future. So, money serves all these functions—it is a medium of exchange, store of value, unit of account, and standard of deferred payment.2

Lesson Summary

Money is accepted as a means of payment and can facilitate efficient transactions. It is used as a medium of exchange, a store of value, and a unit of account. Different measurements of the money supply include forms of money that are less liquid than cash and checkable deposits. Under a fractional reserve system, banks make loans that lead to increases in the money supply. The Fed uses its tools—required reserve ratio, discount rate, open market operations, and interest rates on reserves—to control the money supply. M1 money is cash, checkable deposits, and traveler's checks. M2 money includes M1 money in addition to other types of deposits. Commodity-backed money has value because it is backed up with gold or silver. Fiat money has value because users believe that it does. Banks earn profits by making loans, which means they are motivated to loan out as much money as possible. A fractional reserve system requires a percentage of money to be retained in the bank. When a deposit is made at a bank, the bank can lend out all of the deposit except the required reserve ratio. Loans that are made to individuals or firms will likely be deposited in other accounts, which creates more money. The Fed can change the amount of money available by changing the reserve requirement, changing the discount rate, changing the interest rate on reserves, or buying and selling securities. Increasing the reserve requirement, increasing the discount rate, increasing the interest rate on reserves, and selling securities decrease the money supply and vice versa. Banks may hold excess reserves; customers may withdraw cash, and individuals and firms may not spend their entire loan. All of these decrease the amount of money that can be created.

Monopolies and Competitive Markets—the Two Extremes

Monopolies and perfectly competitive markets mark the extremes in regard to market structure. Monopolistically competitive markets and oligopolies are situated between these two extremes. There are a few similarities between monopolies and competitive markets, both of which minimize cost and maximize profit. However, there are noticeable differences between the two market structures, including the number of firms, product differentiation, and barriers to entry. These differences will lead to additional differences in price, quantity, profits, and efficiency, which will be the topics of the next lesson.

Quiz: A utility company is the only electricity provider in its market. The local government allows the company to determine prices and has created regulations that make it difficult for competitors to enter the market. What type of market is this company working in?

Monopoly A monopoly has a single firm that sells a product and is able to determine the price. There are high barriers for other firms to enter the market.

Understanding the Unemployment Rate

Newspaper or television reports typically describe unemployment as a percentage or a rate. For example, it might have been reported that from August 2009 to November 2009, the U.S. unemployment rate rose from 9.7% to 10%, but by June 2010, it had fallen to 9.5%. At a glance, the changes between the percentages seem small. However, remember that the U.S. economy has about 160 million adults (as of the beginning of 2017) who either had jobs or were looking for them. A rise or fall of just 0.1% in the unemployment rate of 160 million potential workers translates into 160,000 people, which is roughly the total population of a city like Syracuse, New York; Brownsville, Texas; or Pasadena, California. Large rises in the unemployment rate mean large numbers of job losses. In November 2009, during the worst part of the recession, about 15 million people were out of work. By January of 2017, even with the unemployment rate at 4.8%, about 7.6 million people who would like to have jobs were out of work.1

The unskilled labor market wage rate equilibrium is $7 per hour. Legislators are considering imposing a $20 per hour minimum wage. Will this action help unskilled workers who want to work more hours?

No, since this will motivate employers to hire fewer workers for less hours. A dramatic increase in wages due to the minimum wage of $20 will create a surplus in the market, and the number of hours worked would decrease.

The Labor Force

Not everyone without a job should be counted as unemployed. For example, children are not counted as unemployed. Similarly, people who are retired are not counted as unemployed. Many full-time college students have only a part-time job, or no job at all, but it seems inappropriate to count them as unemployed. Some people are not working because they are rearing children, ill, on vacation, or on parental leave. The point is that the adult population is not just divided into employed and unemployed. A third group exists: people who do not have a job and are not interested in having a job. This group also includes those who may want a job but who have become discouraged and quit looking due to their inability to find suitable employment. People who are not working and are not actively looking for work are considered out of the labor force.

Calculating Implicit Costs

Oliver Patel is considering leaving his position as a software engineer in order to open a business selling stained glass ornaments and windows. Evaluating his potential accounting profit and his potential economic profit can provide insight into his decision. Oliver expects to earn $200,000 per year once he gets established in his stained glass business. To run his business, Oliver will need a storefront and an assistant. He has found the perfect store location in a local artisan's mall, which rents for $30,000 per year. An assistant could be hired for $22,000 per year. If these figures are accurate, would Oliver's stained glass store be profitable? Step 1: First, calculate the known explicit costs. Store rental: $30,000 Assistant's salary: +$22,000 Total explicit costs: $52,000 Step 2: Subtracting the explicit costs from the revenue gives the accounting profit. Revenues: $200,000 Explicit costs: - $52,000 Accounting profit: $148,000 Based on these projections, Oliver earns an accounting profit of $148,000 per year. However, these calculations consider only explicit costs. To open a store, Oliver would have to quit his current job, where he is earning an annual salary of $100,000. Leaving his current position would be an implicit cost. Step 3: Subtract both the explicit and implicit costs to determine the true economic profit: Economic Profit = Total Revenues - Explicit Costs - Implicit Costs Economic Profit = $200,000 - $52,000 - $100,000 = $48,000 If he decides to leave his current job and open his store, Oliver will experience an economic profit of $48,000 per year. His return will exceed what he can earn from his next best alternative. This does not necessarily mean Oliver will open his own business. Individuals incorporate many different factors into their decision-making. However, because he expects a positive economic profit, Oliver is more likely to leave his current job.

Tariffs Continued

One barrier to international trade is a tariff. A tariff is a tax imposed by a government on imported or exported goods. It is also known as customs duties.3 The average tariff on dutiable imports in the United States (i.e., those imports on which a tariff is imposed) is about 4%. Some imports have much higher tariffs. For example, as of December 2019, the U.S. tariff on imported frozen orange juice is 35 cents per gallon, which amounts to about 40% of the value. The tariff on imported canned tuna is 35%, and the tariff on imported shoes ranges between 2% and 48%. Protective tariffs make imported products less attractive to buyers than domestic products. The United States, for instance, has protective tariffs on imported poultry, textiles, sugar, and some types of steel and clothing. In March of 2018, the Trump administration added tariffs on steel and aluminum from most countries. On the other side of the world, Japan imposes a tariff on U.S. cigarettes that makes them cost 60% more than Japanese brands. U.S. tobacco firms believe they could get as much as a third of the Japanese market if there were no tariffs on cigarettes. With tariffs, they have under 2% of the market. Tariffs can be classified based on what is being taxed: Import tariffs are taxes on goods that are imported into a country. They are more common than export tariffs. Export tariffs are taxes on goods that are leaving a country. Taxing exports may be done to raise tariff revenue or restrict the world supply of a good. Tariffs may also be classified by their purpose: Protective tariffs are tariffs levied to reduce imports of a product and protect domestic industries. Revenue tariffs are tariffs levied to raise revenue for the government. Tariffs can also be classified on how the duty amount is valued: Specific tariffs are tariffs that levy a flat amount on each item that is imported. For example, a specific tariff would be a fixed $1,000 duty on every imported car, regardless of how much the car cost. Ad valorem tariffs are tariffs based on a percentage of the value of each item.3 In 2019, the United States levies a 2.5% ad valorem tariff on imported automobiles. Thus, if $100,000 worth of automobiles are imported, the U.S. government collects $2,500 in tariff revenue. In this case, $2,500 is collected whether two $50,000 BMWs or ten $10,000 Hyundais are imported. Compound tariffs are tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might consist of a fixed $100 duty plus 10% of the value of every imported car. Generally speaking, the average tariff rates are less than 20% in most countries, although they are often quite a bit higher for agricultural commodities. In most developed countries, average tariffs are less than 10% and often less than 5%. On average, less-developed countries maintain higher tariff barriers, but many countries that have recently joined the WTO have reduced their tariffs substantially to gain entry.6

Quiz: A consumer is deciding between shopping in-store or online for a personalized sweater that will require the consumer to identify size, type of image, and style of stitching desired without seeing the final product before production. All purchases are final. Which venue will present the greatest level of uncertainty for the consumer?

Online retail venue Since the consumer would not be able to try on the sweater, feel the clothing material, or see the fabric, the online consumer may face more purchase risk when using an online retailer than if the consumer was able to see the material in the store.

Principle 2: The cost of something is determined by what you give up to get it

Opportunity Cost: The next best alternative that is given up when a choice is made. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. Example: When buying the new car, the person will give up other goods or services that she would have bought with that money if she had not purchased the car. Principles of Economics One to Four: How People Make Decisions

Using Fiscal Policies to Shift the Aggregate Demand Curve

Over the course of the business cycle, an economy deviates from its full-employment equilibrium, experiencing periods of expansion that create inflation and periods of recession that cause unemployment. Often these fluctuations are caused by changes in AD. Panel (a) of the following graph depicts a short-run, demand-driven expansion. The economy starts at equilibrium E0. An increase in aggregate demand shifts the curve rightward from AD0 to AD1. A new equilibrium is established at E1. At this equilibrium, real GDP (Y1) exceeds potential GDP (Y*), creating an inflationary gap. This is not a long-run equilibrium. Given time, changes in the labor market will bring output back to Y*. The question is, how long will that take? Does everyone want to wait? Consider these questions in the context of a recession. Panel (b) shows the impact of a decrease in AD. As buying falls, the curve moves from AD0 to AD1. At the E1 equilibrium, real GDP (Y1) is below the potential GDP (Y*). The economy is in a recession, and unemployment is high. As in the inflation case, you can expect that eventually wage adjustment in the labor market will bring the economy back to full employment but may not be able to say how long that might take. Before the Great Depression, economists' answer to each of these situations was to simply wait for markets to adjust, suggesting that, in the long run, the economy would return to full employment. It was after witnessing the devastating effects of the Great Depression that John Maynard Keynes's frustration with this advice led him to rewrite macroeconomic theory. Stating that "In the long run we're all dead," Keynes (1923, p. 80) argued for active policy responses by the public sector to stabilize output over the business cycle. Keynes advocated countercyclical fiscal policies (policies that acted against the tide of the business cycle). Countercyclical fiscal policies mean deficit spending and decreased taxes when an economy suffers from a recession and decreased government spending and higher taxes during boom times.

The Results of Free Trade

Overall, when a country trades and becomes an exporter of a good or service, domestic producers are better off and domestic consumers are worse off. This is because domestic consumers will typically pay a higher price than they would previously as the price of a good or service rises in a country that has a comparative advantage for producing that good or service. Domestic producers will produce more because of their new foreign demand. Overall, the gains for the winners from trade exceed the losses of the losers When a country imports goods and services, it is because the domestic cost of production is higher than the world price. As a result, domestic consumers are better off as they can take advantage of the lower world price, and domestic producers are worse off due to lower production and prices. Once again, the economic well-being of a nation is increased because the benefits to the winners exceed the cost to the losers Economists have studied free trade extensively, and although it creates winners and losers, the overall consensus is that free trade generates a significant net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the United States should eliminate any remaining tariffs and trade barriers. Economics professor N. Gregory Mankiw explained that "Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards"

Principle 1: Everyone faces tradeoffs

People must decide what they are willing to give up to get what they need or want. Example: Consider a person who needs a car. She may want a brand-new, expensive car, but her income is limited. If she spends most of her paycheck on the expensive car, she will have to forego other wants or needs. She could buy a less expensive car and have more money left to meet her other wants or needs. Since people must choose, they inevitably face tradeoffs in which they must give up things they desire to get other things they desire more. Principles of Economics One to Four: How People Make Decisions

Protectionism and Jobs

Protectionism certainly saves jobs in the specific industry being protected but, for two reasons, it costs jobs in other unprotected industries. First, if consumers are paying higher prices to the protected industry, they inevitably have less money to spend on goods from other industries, so jobs may be lost in those other industries. Second, if the protected product is sold to other firms so other firms must now pay a higher price for a key input, then those firms will lose sales to foreign producers who do not need to pay the higher cost. Lost sales translate into lost jobs. The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries. Therefore, the United States International Trade Commission, in its study of barriers to trade, predicts that reducing trade barriers would not lead to an overall loss of jobs. Protectionism reshuffles jobs from industries without import protections to industries that are protected from imports, but it does not create more jobs. Moreover, the costs of saving jobs through protectionism can be very high. A number of different studies have attempted to estimate the cost to consumers in higher prices per job saved through protectionism. The table below shows a sample of results compiled by economists at the Federal Reserve Bank of Dallas. Saving a job through protectionism typically costs much more than the actual worker's salary. For example, a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel industry would cost $199,000 per job saved. In other words, those workers could have been paid $100,000 per year to be unemployed, and the cost would only be half of what it is to keep them working in the textile and apparel industry. This result is not unique to textiles and apparel (Federal Reserve Bank of Dallas, 2002).

Reasons for Quotas

Quotas are often implemented for similar reasons as other trade barriers. Often quotas and other trade barriers are instituted to protect the following: Domestic industries and employment: By reducing the number of imports, domestic suppliers must produce more to meet domestic demand. By producing more, the suppliers must hire more domestic workers, increasing employment. Additionally, setting quotas to reduce foreign competition allows domestic "infant industries"—young, small industries—to grow and mature to a competitive level. Countries against unfair trade practices: Setting a quota helps protect a domestic economy from unfair trade practices such as dumping, pricing of imports below production cost. By restricting imports, quotas minimize the impact of such activities. National security: Import quotas discourage imports and encourage domestic production of goods that may be necessary to the security of the country. By protecting and encouraging the growth of these defense-related industries, a country will not have to be dependent on imports in the event of a war.3

Quiz: An economist wants to compare the standard of living between different countries. Which measure should be used for this purpose?

Real GDP per capita Real GDP per capita provides an estimation of inflation adjusted GDP for each citizen. This is a reasonable measure for standard of living.

Scarcity and Consumption

Scarcity is relevant to consumer behavior because consumers have limited incomes. Given a specific budget, each person can only buy those goods that fit within that budget. Consider this example: Suppose William has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers he eats for lunch. Burgers cost $2 each, and bus tickets are $0.50 each. While this example is similar to a real-life consumer decision, it does not feel entirely realistic. This is intentional. Economic models rely on simplifying assumptions to let them focus on specific aspects of an interaction or choice. Several simplifying assumptions are used when analyzing consumer behavior: 1. Two goods: In this example, William chooses between burgers and bus tickets. Though in life, William makes choices between many different goods, including additional goods in the analysis does not significantly add to an understanding of William's choices. It would, however, make this example much more difficult to graph. For this reason, a simplifying assumption is imposed that William's options are limited to only two goods. 2. Specific prices: William knows the price of each good, and those prices are fixed. Unlike real life, there are no quantity discounts or surprise price changes during the week. 3. Specific budget: William knows exactly the amount of money he has available to get himself to work and purchase lunch. This amount remains fixed. 4. Specific period: Both the budget and the period for its use must be stated. William's budget is $10. Without knowing if that money needs to last him for a month, a week, or a day, you would have little sense of how constrained his options are. In this example, William's budget covers a week of purchases.

Principle 10: Society faces a short-run trade-off between inflation and unemployment

Society faces a short-run trade-off between inflation and unemployment—Most economists agree that there is a relationship between inflation and unemployment. To lower inflation, the government may reduce the amount of money in the economy. This, in turn, reduces the amount of money people spend. Less spending means fewer goods and services being bought, ultimately leading to less production and more unemployment. Principles of Economics Eight to Ten: How the Economy Works as a Whole

Quiz: What are the major policy tools used to direct fiscal policy?

Taxes and spending Congress creates legislation that raises and lowers both of these in response to the health of the economy and other factors.

The Herfindahl-Hirschman Index (HHI) is calculated using the sum of the squares of the market share of each firm in an industry. Then the Federal Trade Commission (FTC) historically uses the results to decide whether there is an antitrust concern. Which statement accurately describes how the FTC determined the presence of a concern in the 1980s?

The FTC would try to halt a merger if the merger would put the HHI over 1,800. An HHI between 1,000 and 1,800 would draw scrutiny, and a result over 1,800 would likely be halted.

Lesson Summary

The Fed is tasked with the responsibility for maintaining stable prices and maximum employment. It pursues these goals using monetary policy. Using different tools, the Fed alters the supply of money in the economy, changing interest rates. This change in interest rates affects aggregate demand and leads to changes in price and output. An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit to below what it otherwise would have been and raises interest rates, seeking to hold down inflation. Interest rates are determined by the interaction of money demand and money supply in the money market. Rates adjust to bring the market to an equilibrium at which the quantity of money demanded and the quantity of money supplied is balanced. The Fed targets the rate for federal funds by adjusting the money supply using open market operations, changing the required reserve, and manipulating the discount rate. When these policies are ineffective, additional measures such as quantitative easing and interest on reserves may be used. An expansionary policy, such as a purchase of government securities by the Fed, tends to push interest rates down, increasing investment and aggregate demand. A contractionary policy, such as a sale of government securities by the Fed, pushes interest rates up, investment down, and the aggregate demand curve to the left. During a period of recession, an expansionary monetary policy is used. During a period of inflation, a contractionary monetary policy is used.

The Discount Rate

The Fed was founded in the aftermath of the Financial Panic of 1907 when many banks failed as a result of bank runs. As mentioned earlier, banks make profits by lending out their deposits, and no bank, even those that are not bankrupt, can withstand a bank run. As a result of the Panic, the Fed was founded to be the "lender of last resort." In the event of a bank run, banks that were not bankrupt could borrow as much cash as they needed from the Fed's discount window to quell the bank run. The interest rate banks pay for such loans is called the discount rate, which allows banks to borrow against their outstanding loans at a discount. Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Fed was initially intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed. As fewer loans are available, the money supply falls, and market interest rates rise—a contractionary policy. If the central bank lowers the discount rate it charges to banks, the process works in reverse—an expansionary policy. In recent decades, the Fed has made relatively few discount loans. Before a bank borrows from the Fed to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed, charging a higher discount rate than the federal funds rate, which is the rate that banks charge other banks for overnight loans. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations, discussed next, are a more precise and powerful means of executing any desired monetary policy. In the Federal Reserve Act, the phrase "...to afford means of rediscounting commercial paper" is contained in its long title. This was the primary tool for monetary policy when the Fed was created. This illustrates how monetary policy has evolved and how it continues to do so.

Monetary Policy Tools: The Reserve Ratio

The Federal Reserve Act of 1977 gave the Fed a dual mandate. It was tasked with the goal of maintaining both price stability and maximum sustainable employment. Actions taken by the Fed to pursue this mandate are known as monetary policy. A monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy. In contrast, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy, or tight monetary policy. A central bank has the following four tools to implement monetary policy in the economy: Changing reserve requirements Changing the discount rate Open market operations Interest on reserves In discussing how these tools work, it is useful to think of the central bank as a bank for banks—that is, each private-sector bank has its own account at the central bank.

Measuring Money

The Federal Reserve Bank (Fed) is responsible for monitoring the money supply in the United States. As the central bank, the Fed uses both its power to regulate banks and its ability to adjust the money supply to ensure the value of the fiat money in the United States. To do this, the Fed needs to know how much money is in the economy. This requires a definition of money. Cash in your pocket indeed serves as money. But what about checks or credit cards? Are they money, too? Economists offer several definitions of money based on liquidity. Liquidity refers to how quickly a financial asset can be used to buy a good or service. For example, cash is very liquid. Your $10 bill can be easily used to buy a hamburger at lunchtime. However, $10 that you have in your savings account is not so easy to use. You must go to the bank or an automatic teller machine (ATM) and withdraw that cash to buy your lunch. Thus, $10 in your savings account is less liquid. Money is defined from M0 to M4, but the Federal Reserve since 2005 has only published statistics on M1 and M2 money. M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler's checks. The M2 money supply is less liquid and includes M1 plus those classified as near money: savings and time deposits, certificates of deposits, and money market funds. M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that are not held by the U.S. Treasury, at the Fed, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his or her money on demand when a check is written or a debit card is used. These items together—currency and checking accounts in banks—make up the definition of money known as M1, which is measured daily by the Federal Reserve System. Traveler's checks are also included in M1 but have decreased in use over the recent past. In a broader definition of money, M2 includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an ATM or bank. Many banks and other financial institutions also offer a chance to invest in money market funds, where the deposits of many individual investors are pooled together and invested in a safe way, such as short-term government bonds. Another ingredient of M2 is the relatively small (less than about $100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1.4

Structure of the Federal Reserve

The Federal Reserve System was designed to maintain the central bank's independence, promote decentralized power, and be independent of Congress and the government. The justification for independence is that it allows the Fed to operate without being put under political pressure to take actions that may not be in the best long-term economic interest of the country. The presidentially appointed board of governors (or Federal Reserve Board) is an independent federal government agency located in Washington, D.C. Each governor serves a fourteen-year term. As of February 2018, the chair of the Board of Governors is Jerome H. Powell, who succeeded Janet Yellen. The Federal Open Market Committee (FOMC), comprised of the seven members of the Federal Reserve Board and five of the 12 Fed presidents, oversees open market operations, the principal tool of U.S. monetary policy. Twelve regional Feds are located in major cities throughout the nation, which divide the nation into twelve Fed districts. The Feds act as fiscal agents for the U.S. Treasury, and each has a nine-member board of directors. Numerous other private U.S. member banks own required amounts of nontransferable stock in their regional Feds. The Fed can be thought of as having both private and public organization characteristics, though it considers itself to be private. On the one hand, it works toward achieving public goals such as moderate inflation and low unemployment. It does not exist to make money. On the other hand, it is, by design, separate from the government. It operates independently and is not subject to political pressures directly, as Congress or the president is.

How Business Confidence Can Affect AD

The Organization for Economic Development and Cooperation (OECD) publishes a measure of business confidence included in the Business Tendency Surveys: A Handbook. The OECD collects business opinion survey data for 21 countries on future selling prices and on employment, among other business climate elements. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages, (The indicator dips below zero when the business outlook is weaker than usual.) (OECD, 2003). Neither of these survey measures is very precise. They can, however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past. Because economists associate a rise in confidence with higher consumption and investment demand, it will lead to an outward shift in the AD curve and a move of the equilibrium from E0 to E1. This shift in the AD curve leads to a higher quantity of output (from Y* to Y1) and a higher price level (from PL0 to PL1), as shown in the following graph. (The short-run AS and long-run aggregate supply curves will be explained below.)

The Phillips Curve and the Aggregate Demand Curve

The Phillips curve shows the inverse trade-off between rates of inflation and rates of unemployment in the short run. If unemployment is high, inflation will be low; if unemployment is low, inflation will be high. The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship between inflation, which affects the price level aspect of aggregate demand and unemployment, which is dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are closely related.

Comparative Advantage

The ability of a party to produce a particular good or service at a lower opportunity cost versus another

Market Power

The ability to control or raise prices above the marginal cost

Exports

The act of shipping goods and services from one country to another is defined as the act of shipping goods and services out of a country. In international trade, exporting refers to the selling of goods and services produced in the home country to people in other countries. The seller of the goods and services is referred to as the exporter. When exporters sell their goods to other countries, those goods must pass through customs authorities both at home and abroad where legal restrictions and trade barriers are enforced. When legal restrictions and trade barriers are lessened or lifted, the number of goods and services that are exported to other countries increases. Exporting goods and services has both advantages and disadvantages for countries involved in international trade. Exporting allows a producer to retain ownership of production and develop low-cost and differentiated products. Those producers will keep more of the profits from their sales than if they licensed the product to be made by a different company in another country. The disadvantages of exporting are mainly the result of manufacturers often having to sell their goods to importers. In domestic sales, manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face an extra layer in the chain of distribution, which takes a cut of the profits. To keep their prices competitive for international customers, manufacturers may have to offer lower prices to the importers than to domestic wholesalers to move their product and generate business.4

Marginal Cost Continued

The additional cost incurred from consuming an additional unit of something In addition to per-unit costs, firms also want to know how their costs will change if they alter their level of output, either increasing it by a small amount or decreasing it by a small amount. To assess this, firms calculate their marginal cost. This measure allows a company to evaluate how much it will be paying to produce one additional unit of output. It is not the cost per unit of all units being produced but only the cost of the next one (or next few). Marginal cost is calculated by dividing the change in the total cost by the change in quantity. Using the information in the table, notice that as the number of ornaments Oliver produces increases from 16 to 40, total costs rise from $202 to $282, or by $80. Thus, the marginal cost for each of those ornaments is calculated as follows: Marginal cost = $282-$202 / 40 ornaments-16 ornaments = $80 / 24 ornaments = $3.33 per ornament As the number of ornaments produced increases from 40 to 60 ornaments, total costs rise from $282 to $362, or by $80. Thus, the marginal cost for each ornament is calculated as follows: Marginal cost = $362-$282 / 60 ornaments-40 ornaments = $80 / 20 ornaments = $4 per ornament Marginal cost = Change in total costs / Change in output MC = ΔTC / ΔQ Marginal cost is calculated by dividing the change in the total cost by the change in output for each possible change in output. Marginal costs are typically rising. When the marginal cost is below the average total cost, the average total cost is falling. When the marginal cost is above the average total cost, the average total cost is rising.3

Budget Deficit and Surplus

The annual budget deficit or surplus is the difference between the tax revenue collected and government spending over a fiscal year, which starts October 1 and ends September 30 of the next year. The figure that follows shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, and, most recently, during the 2008-2009 recession. It is noticeable that after the mid-1970s, there is a bias toward deficit spending that cannot be explained by either recessions or wartime spending. Budget deficits that exist when the economy is at full employment are called structural deficits. These deficits are a result of the perennial political problems with raising taxes and cutting spending. Structural deficits are mainly the result of political decisions to spend more than the government takes in. The period of budget surplus occurring in the late 1990s stands out as an exception to this trend. Government spending as a share of GDP declined steadily through the 1990s as defense spending declined from 5.2% of GDP in 1990 to 3% in 2000. Simultaneously, federal tax collections increased, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Robust economic growth in the late 1990s fueled the boom in taxes. Longer-term U.S. budget forecasts that span a decade or more into the future predict enormous deficits. The higher deficits during the 2008-2009 recession have repercussions, and the demographics will be challenging. The primary reason is the "baby boom"—the exceptionally high birthrates that began in 1946, right after World War II and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation began to reach age 65. In the next two decades, the proportion of Americans over the age of 65 will increase substantially. The current level of the payroll taxes that support Social Security and Medicare will fall short of the projected expenses of these programs; thus, the forecast is for large budget deficits. A decision to collect more revenue to support these programs or decrease benefit levels would alter this long-term forecast.

Short-run Average Cost (SRAC) Curve

The average total cost curve in the short term. It shows the total of the average fixed costs and the average variable costs

Average Total Cost

The average total cost is the total cost divided by the quantity of output. If the total cost of producing 16 ornaments is $202, the average total cost to produce 1 ornament is as follows: $202 total cost / 16 ornaments = $12.63 average total cost per ornament If the total cost of producing 40 ornaments is $282, the average total cost to produce 1 ornament is as follows: $282 total cost / 40 ornaments =$7.05 average total cost per ornament Average cost curves are typically U-shaped, as the following graph shows. This shape reflects the influence of both average fixed and average variable costs. When the output is low, total costs are dominated by the fixed costs. As the output increases, the average total cost declines as the fixed costs are spread over an increasing quantity of output. As the output expands still further, the average cost begins to rise. This increase is driven by an increase in the average variable cost as the firm begins to experience diminishing marginal returns. In the graph, the right side of the average total cost curve is upward sloping. Average total cost = Total cost / Output = Fixed cost / Output + Variable cost / Output ATC = TCQ = FCQ + VCQ The average total cost is calculated by dividing the total cost by the total output at each different level of output. Average total costs are typically U-shaped on a graph.

Average Variable Cost

The average variable cost is calculated by dividing the total variable cost by the quantity of output. For example, the variable cost of labor for one worker ($80) producing 16 ornaments is $5. For two workers, the variable cost of labor ($160) producing 40 ornaments is $4. The average variable costs are as follows: $80 total variable cost / 16 ornaments = $5 average variable cost per ornament $160 total variable cost / 40 ornaments = $4 average variable cost per ornament Notice that the average variable cost initially decreases due to specialization. With more employees, tasks can be divided so that the employee who is an expert at cutting glass can focus on glass cutting and is not required to answer the phone. Specialization allows workers to become more proficient at their assigned task. It decreases the unproductive time between jobs and allows workers to develop new methods to more efficiently perform existing tasks. The average variable costs decrease as the firm takes advantage of specialization. This is shown by the downward slope of the average variable cost curve in the following graph. Eventually, as the output continues to increase, the average variable cost begins to rise. Additional workers add congestion to a workplace in which employees are all trying to use the same equipment. Too many workers may also increase the incidence of broken glass or injuries in the store. In the short run, average variable costs rise due to the law of diminishing marginal returns. This is illustrated in the graph by the upward sloping portion of the average variable cost curve. Average variable cost = Total variable cost / Output AVC = TVC / Q

Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period, measured in the currency of that economy. It is measured by finding the country's net exports. A positive balance of trade is known as a trade surplus since exports are greater than imports. A negative balance of trade is referred to as a trade deficit or, informally, a trade gap since imports are greater than exports. Factors that can affect the balance of trade include the following: the cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing economy; the cost and availability of raw materials, intermediate goods, and other inputs; the currency exchange rate; tariffs or restrictions on trade; nontariff barriers such as environmental, health, or safety standards; the availability of foreign currency with which to pay for imports; and prices of goods manufactured in the domestic country. In addition, the trade balance is likely to differ across the business cycle. In export-driven economies, a good economy means a better balance of trade as exports increase. However, in consumer-driven economies, a good economy means a worsening balance of trade as imports increase.

Monopolistic Competitive Market: Short Run

The demand curve for an individual firm is downward sloping in monopolistic competition. In contrast, a firm's demand curve in a perfect competition market is perfectly elastic. This is because firms have some market power due to the inability to perfectly substitute one product for another in the market perfectly. They can raise prices to a certain extent without losing all of their customers. In this type of market, these firms have a limited ability to dictate the price of their products; a firm is, to some degree, a price setter, not a price taker. The source of the market power is that there are differentiated products, so businesses focus on product differentiation or differences unrelated to price. By differentiating its products, firms in a monopolistic competitive market ensure that its products are imperfect substitutes for each other. As a result, a business that works on its branding can increase its prices without risking its consumer base.6 The consumers do confront marginally higher prices, but they also have a greater variety of choices given that differentiation. Monopolistically competitive companies will determine where marginal revenue equals marginal cost and then use the demand curve to determine at which price they can sell the indicated quantity. Because the individual firm's demand curve is downward sloping, reflecting market power, the price these firms will charge will exceed their marginal costs.6Monopolistic competitive markets can lead to significant profits in the short run if the price is greater than the average total cost for the quantity at which the monopolistic competitive firm produces. If the price is less than the average total cost, then the firm will suffer a loss

Factor of Production: Capital

The first human beings produced food by picking leaves or fruit off a plant or by catching an animal and eating it. Very early on, however, they began shaping stones into tools, seemingly for use in butchering animals. Those tools were the first capital because they were made to produce other goods—food and clothing. Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all were used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also capital. Other examples are transportation equipment such as cars and trucks; facilities such as roads, bridges, ports, and airports; and buildings. These all help people produce goods and services. To be able to innovate and develop new tools and technology, organizations must invest in research and development (R&D), either alone or through partnerships and mergers. R&D is usually not expected to provide immediate profitability because it takes time to develop and implement new technologies. However, it helps firms stay ahead of competitors and earn long-term profits. The technological tools created by the advances achieved through R&D can be considered capital since they are used to produce other goods. Capital does not consist solely of physical objects. The score for a new symphony is capital because it will be used to produce concerts. Computer software that is used by business firms or government agencies to produce goods and services is capital. Capital may thus include physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria: 1. The resource must have been produced. 2. The resource can be used to produce other goods and services. One thing that is not considered capital is money. A firm cannot use money directly to produce other goods, so money does not satisfy the second criterion for capital. Firms can, however, use money to acquire capital. Money is a form of financial capital. Financial capital includes money and other "paper" assets (such as stocks and bonds) that represent claims on future payments. These financial assets are not capital, but they can be used directly or indirectly to purchase factors of production or goods and services. Capital requires payment of interest for using another's money to pay for things needed for producing a good or service. Capital is a factor of production that has been created for use in the production of other goods and services.

The Results of Trading

The first thing you should notice is that both countries are consuming outside of their PPFs. By producing what each nation has a comparative advantage in and trading with one another, both nations can achieve a material position that is impossible for them to reach by themselves. This unintuitive outcome is quite possibly the most important result in macroeconomics. This simple numerical example can be extended to many nations and many goods, but the fundamental result holds. If nations focus on what they have a comparative advantage in and trade with one another, everyone can benefit. Before moving on, consider the following important points: A nation should produce what it has a comparative advantage in producing. A nation has a comparative advantage in something if it has a lower opportunity cost in producing that good compared with other nations. If all nations focus on producing what they have a comparative advantage in producing, all nations can be benefit by trading. Because it is impossible to have a comparative advantage in everything, even very wealthy, productive, nations will have an incentive to trade with poorer nations.

How Consumer Confidence Can Affect AD

The following example involving consumer confidence had been developed to provide a more detailed look at how a particular factor can affect AD. Consumer confidence has a significant influence on economic markets. When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer confidence or business confidence drops, consumption and investment spending decline.2 The University of Michigan publishes a survey of consumer sentiment and constructs an index of consumer sentiment each month. The survey results are then reported online at University of Michigan's Surveys of Consumers, which breaks down the change in consumer confidence among different income levels. According to this index, consumer confidence averaged around 90 before the Great Recession, and then it fell to 63.7 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 value of 67.3 back to a level in the low 90s, including a 2019 value of 95.6, which economists consider a very healthy state. This survey is based off of a value of 100 when it was normalized in December 1966 (University of Michigan, 2019). Consumption is about 70% of spending, so changes in consumer confidence significantly affect aggregate demand.2

Shifts in the Supply Curve

The increase in the cost of beans causes the supply curve to shift from S0 to S1. The new curve is needed because S0, the original supply curve, no longer accurately reflects the quantity producers are willing to sell at each price. Showing the leftward shift from S0 to S1 allows you to see how companies alter production in response to higher costs. The supply curve moves left when there is a decrease in supply. The upward slope of the supply curve can make it difficult to determine whether a shift is an increase in supply or a decrease in supply. To help, focus on the horizontal movement of the curve. An increase in supply shifts the supply curve outward, or to the right, as the firm is willing to provide a larger quantity to the market at each price. A decrease in supply shifts the supply curve inward, or to the left, as the firm is willing to supply a smaller quantity of the good at each price. Nearly all supply curves share the fundamental similarity that they slope up from left to right.

Price Elasticity of Supply Equation

The law of supply states that a fall in the price of a good or service leads to a decrease in the quantity supplied. Similarly, the increase in price of a good or service leads to an increase in the quantity supplied. The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good. The supply of a good or service is said to be elastic if the quantity supplied responds substantially to changes in price, and it is said to be inelastic if the quantity supplied responds only slightly to changes in price. Elasticity of supply is calculated as the percentage change in the quantity supplied divided by the percentage change in price. This is written as follows: e^s = % change in the quantity supplied / % change in price Since the quantity supplied and price are directly related, elasticity of supply is always positive. Numbers are used in the examples that follow to show how the formula is applied and how the results are interpreted. Assume the price of housing increased by 10% and was expected to stay that high or increase. In response, companies started building housing, eventually increasing the amount of housing by 25%. The amount of time elapsed between the price change and the measurement of response is important. Builders are not able to respond instantly. A week after the price change, there is unlikely to be any additional housing produced. After one year, some response is likely to be apparent. With even more time, more growth in output will occur. In this example, ample time is allowed giving builders the opportunity to change their planned behavior. Given this condition, the value calculated is the long-run price elasticity of supply. e^s = % change in the quantity supplied / % change in price e^s = 25% / 10% = 2.5 The long-run price elasticity of supply for housing is 2.5, meaning that the supply of housing is elastic. Over time, home builders were responsive to the change in price, raising output by a larger percentage than that of the price change. In this case, the quantity supplied increased by 2.5% for every 1% increase in price. When supply is elastic, the change in the quantity supplied will always be greater than the change in price in percentage terms. Consider another example. The price of cotton increases by 10%, which leads to a short-run increase in the quantity supplied of 3%. What is the elasticity of supply? e^s = 3% / 10% = 0.3 In this example, the elasticity of supply is less than 1, meaning the short-run supply of cotton is inelastic. The quantity supplied is not very responsive to a change in price. Raising prices by 10% only leads cotton producers to add an additional 3% to output. For all supply inelastic goods, the change in the quantity supplied will always be less than the change in price in percentage terms. In each of these cases, time plays an important role in determining elasticity. For housing, the long-run supply is elastic when builders have flexibility and time to build the amount of housing desired. Similarly, for cotton, it makes sense that the short-run supply is inelastic. Cotton takes time to grow and then processes into a usable product. In the short term, increases in supply must come from the stored product, as you cannot instantly grow cotton.

Long-run average Cost (LRAC) Curve

The lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. The long-run average cost (LRAC) curve identifies the lowest possible average cost for any level of output. While in the short run, firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run—when all costs are variable—firms can choose to operate on any average cost curve. Thus, the LRAC curve is based on a group of SRAC curves, each of which represents one specific level of fixed costs. The following figure shows how the LRAC curve is built from a group of SRAC curves. Five SRAC curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra large factories, respectively. Although this diagram shows only five SRAC curves, presumably, there are an infinite number of other SRAC curves between the ones shown. This family of SRAC curves can be thought of as representing different choices for a firm that is planning its level of investment in fixed-cost physical capital—knowing that different choices about capital investment in the present will cause it to end with different SRAC curves in the future.1

The Relationship between the Marginal Cost Curve and the Average Cost Curve

The marginal cost curve is generally upward sloping because diminishing marginal returns implies that additional units are more costly to produce. A small range of increasing marginal returns can be seen in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which the marginal and average cost curves meet.3 The marginal cost curve intersects the average cost curve precisely at the bottom of the average cost curve. The reason the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where marginal cost crosses average total cost, then producing one more additional unit will reduce average costs overall—and the average total cost curve will be downward sloping in this zone. Conversely, if the marginal cost for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where marginal cost crosses average total cost, then producing a marginal unit will increase average costs overall. And the average total cost curve must be upward sloping in this zone. The point of transition, between where marginal cost is pulling average total cost down and where it is pulling it up, must occur at the minimum point of the average total cost curve. This idea of the marginal cost "pulling down" or "pulling up" the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs, and higher marginal costs pull them up.3

Discount Rate

The minimum interest rate set by the Federal Reserve for lending to other banks

Open Market Operations

The most common monetary policy tool in the United States is open market operations. These occur when the central bank sells or buys U.S. Treasury bonds (government securities) to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer as the federal funds rate is the interest rate that commercial banks charge when making overnight loans to other banks. As such, it is a very short-term interest rate, but one that reflects credit conditions in financial markets very well. The Fed, as well as other banks, individuals, and financial institutions such as brokerage companies and pension funds, all hold government securities. Buying and selling these securities changes the amount of reserves banks have available to lend, which in turn changes the money supply and the federal funds rate, often just referred to as the interest rate. An expansionary policy involves an open market purchase of government securities, increasing the funds available for banks to lend, lowering the interest rate. A contractionary policy is when the Fed conducts an open market sale of government securities. This decreases the amount of funds available for the bank to lend, which will cause the interest rate to rise. A change in the interest rate occurs because, as the amount of reserves the bank has available to lend changes, the supply of money in the economy will change as well. The more money is pushed into the economy, the higher the supply of money will be, lowering the interest rate. As money is removed from the economy, the supply of money falls and the interest rate rises. Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations. Financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop as well. When the federal funds rate rises, other interest rates rise, too.

Stabilization Policies

The nation's institutions play a crucial role in the long-term growth and the short-term stability of its economy. This module explores the roles played by two of the most important institutions in the United States: the central bank and the federal government. For each of these institutions, the module provides a basic explanation of the functioning of the organization, including identification of the primary decision makers, descriptions of the tools available to influence the economy, and a review of the institution's policy goals. The module examines the response of these institutions to economic fluctuations, considering both the potential benefits and pitfalls of their interventions. The Federal Reserve Bank (Fed) is the central bank for the United States. Established in 1913 under the Federal Reserve Act, the Fed's structure includes both centralized and decentralized elements. This allows them to answer to both the federal government and the needs of banks and their customers across the nation. With its ability to adjust the money supply, the Fed plays a powerful role in maintaining price levels, setting interest rates, and influencing exchange rates. When the Fed takes action to influence economic conditions by altering the money supply, it is using monetary policy. This module links the monetary policy actions of the Fed to existing macroeconomic conditions, examining the Fed's decision-making and its implications for businesses and individuals. With the power to tax, spend, and set rules, the government can affect the course of long-term economic development and influence short-run economic conditions. Though this is true to different degrees for all levels of government, this module focuses on the federal government. Generally, government priorities are not set primarily based on economic considerations. The long list of government priorities may include jobs, national security, education, healthcare, or infrastructure. However, when the federal government exercises its abilities to tax and spend -+to pursue economic objectives, it is called fiscal policy. In this module, you will examine the impact of different fiscal policies on macroeconomic conditions. You will also consider the limitations affecting the ability of fiscal policy to correct economic problems. Understanding the topics covered in this module is critical to your role as a citizen. Stewardship of these institutions requires that you understand their functioning and their missions. As you will see, there are clear benefits to the judicious use of both fiscal and monetary policies. They may be used to help increase employment, limit inflation, fund recovery from national emergencies, and provide public goods and services. However, these policies can be overused or inappropriately implemented. Policy actions that are not timely, targeted, and temporary can generate negative economic outcomes. The module will provide foundational knowledge to help you better evaluate the economic impact of policy proposals offered by institutional leaders.

Lesson Summary

The national debt is the sum of all past national deficits minus any surpluses. All levels of government have budgets, which include the revenue the government expects to receive and the expenses it expects to pay. Policy decisions, unexpected disasters, and other circumstances can make it challenging to stay within the budget. The amount the government overspends in a year is a budget deficit. A cumulative accounting of all government deficits and surpluses has resulted in significant government debt. Over the last 50 years, government purchases fluctuated around 20% of U.S. GDP. The bulk of federal revenues comes from income and payroll taxes. The government budget balance is the difference between government revenues and government expenditures. The national debt is the sum of all past federal deficits minus any surpluses. The benefits of running a budget deficit include stabilizing the economy during business cycles, enabling large scale infrastructure investments, and provide funding for wars. The concerns of running a budget deficit include crowding out private sector investment, redistribution of wealth from future to current generations, and inflation.

Economic Growth and Fluctuations

The need to understand economic fluctuations is often the motivation for studying macroeconomics. People want to understand the reasons for a downturn and look for lessons that can be applied to future situations. This is true of the Great Recession. In the lead up to this downturn, some of the first signs of economic trouble emerged in the housing market. At the time, the housing market was riding high. Between 1990 and 2005, homeownership across America had increased steadily, reaching a high of over 69%. That number began to fall in 2006 and continued sliding for the next 10 years. With this decline, home values began to drop. Between 2007 and 2009, the median sales price for a home in the United States fell 19%. For homeowners, this contributed to a decrease in their overall wealth and caused them to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments. By 2008, the problem had spread throughout the financial markets. Lenders restricted credit, and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers. The culmination of these events was a 4.3 percent decline in real gross domestic product (GDP) and a peak unemployment rate of 10 percent.1 To analyze this series of events, economists use the aggregate demand-aggregate supply (AD-AS) model. This model depicts the interaction of all buyers and all sellers in all markets. This depiction allows for a closer look at the events affecting buying behavior, the events affecting selling behavior, and the interaction of different sides of the market as it moves toward a macroeconomic equilibrium. In particular, the model offers a means to examine the impact of different events or policies on three primary measures of macroeconomic performance—output, employment, and prices. In this module, you will be introduced to the model in three steps. First, the aggregate demand (AD) side of the market will be examined, followed by a look at aggregate supply (AS). Then, in the final lesson, the two sides will be brought together to see how the market moves toward equilibrium. As you will discover, the model provides a framework for thinking about many of the connections and trade-offs within the macroeconomy.

Quiz: Which description illustrates a business cycle that starts from a trough?

The output of the economy moves from a trough to an expansion, then to a peak followed by a recession until it returns to another trough. All phases of the business cycle are captured. It begins with its first low point (the first trough), moves to its next high point (the peak), then there is downward movement (the recession), and finally moves to its next low point (the second trough).

The Law of Diminishing Returns

The point where the level of profits or benefits gained is less than the amount of money or energy invested. This law asserts that as additional increments of resources are devoted to a certain purpose, the marginal benefit from those additional increments will decline. For example, after not spending much at all on crime reduction, when a government spends a specific amount more, the gains in crime reduction could be relatively significant. However, additional increases after that typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to zero would be tremendously expensive. The curve of the production possibilities frontier shows that as additional resources are added to butter production, moving from left to right along the horizontal axis, the initial gains are large, but those gains gradually diminish. Similarly, as additional resources are added to gun production, moving from bottom to top on the vertical axis, the initial gains are large but again gradually diminish. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier. Diminishing returns lead to increasing opportunity costs. The increasing opportunity costs are illustrated in the convexity of the PPF. Diminishing returns are not directly illustrated in the PPF graph, but as the cause of increasing opportunity costs, they are indirectly shown.

Negative Externalities and Pollution

The pollution associated with manufacturing is a good example of a negative externality. Consider a firm that makes refrigerators. The firm manufactures the profit-maximizing quantity of refrigerators, based on its private cost of production and the price in the market. In using metals, plastics, chemicals, and energy to manufacture refrigerators, some pollution is created. If there are no regulations on this pollution, the firm can emit pollution at no cost to itself. Unfortunately, this does not mean at no cost to anyone. When these pollutants are emitted into the air and water, they create costs of $100 per refrigerator. These costs include things like injuries to human health, pollution of drinking water, damage to property, loss of wildlife habitat, and reduction of recreation possibilities. Because these are external costs, the firm assesses the cost of making a refrigerator at $100 less than its true costs. As a result, more than the efficient quantity of refrigerators is made. Now imagine the firm must factor in the external cost of pollution—that is, it has to consider the social costs. If the firm is required to pay an additional $100 each time it produces a refrigerator, production becomes more costly. The firm will reduce its output, moving toward a more efficient outcome. When negative externalities are present, markets overproduce relative to the efficient quantity. In this way, externalities generate market failures. When there is market failure, the private market fails to achieve efficient output because firms do not account for all costs incurred in the production of output.4

Supply Curve

The positive relationship between price and the quantity supplied will generate a supply curve that is upward sloping. The supply curve is a graphical representation depicting the relationship between the price of a good or service and the quantities companies are willing to sell at those prices. The curve can be derived from a supply schedule, which is a table view of the price-quantity pairings that compose the supply curve. Suppliers will shift production for nonprice changes related to the determinants of supply and will move production levels along the supply curve for price-related changes.

Shifts in Short-Run Aggregate Supply Continued

The previous figure demonstrates that the rise in input prices causes the SRAS curve to shift to the left. The original equilibrium E0is at the intersection of AD, LRAS, and SRAS0. When SRAS shifts left, the new equilibrium E1 is at the intersection of AD and SRAS1. The increase in input prices also leads to an increase in the price level from PL0 to PL1 and a decrease in output from Y* to Y1. On the other hand, a decline in the price of a key input like oil will shift the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs. From 1985 to 1986, for example, the average price of crude oil fell by half, from $24 a barrel to $12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil dropped from $17 per barrel to $11 per barrel. In both cases, the plummeting oil price led to an increase in SRAS, shifting it to the right, which allowed the economy to expand and unemployment to fall. Along with energy prices, two other key inputs that may shift the SRAS curve are the cost of labor, or wages, and the cost of imported goods that are used as inputs for other products. As in previous cases, the lesson is that lower prices for inputs cause SRAS to shift to the right, whereas higher prices cause it to shift back to the left. Note that, unlike changes in productivity, changes in input prices do not generally cause LRAS to shift, only SRAS does.3

Lesson Summary

The production possibilities curve shows the combinations of goods and services, which utilize efficient production with the existing factors of production and state of technology. Points on the curve are efficient, points inside the curve are inefficient, and points outside the curve are unattainable without trade. With specialization and trade, the overall production levels of any pair of goods are higher than any single country can produce alone. Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer. Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency. A country that has an absolute advantage can produce a good more efficiently with fewer resources. Even when a country has an absolute advantage in the production of all goods, it will still benefit from trade. Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost. Whenever countries have different opportunity costs in production, they can benefit from specialization and trade. Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors. The disadvantages of specialization include threats to uncompetitive sectors, the risk of overspecialization, and strategic vulnerability.

The Elasticity of Demand Curve in a Perfectly Competitive Market

The second equation will result in the same amount of profit but is rearranged to see how price, quantity, and average cost influence profit. Since a perfectly competitive firm must accept the price for its output as determined by the product's market demand and supply, it cannot choose the price it charges. The perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price.. The reason why the demand is perfectly elastic is due to the substitutability of all products on the market for each other. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm's total revenue, total costs, and, ultimately, level of profits. A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. If the firm sells a higher quantity of output, then total revenue will increase. If the market price of the product increases, then total revenue also increases whatever the quantity of output sold.2 Essentially, a firm has only two choices in the short run: to produce or to shut down production

Quiz: A tire manufacturer is deciding the quantity of tires to produce over the next year. The firm is operating in a leased factory, has two years left on its lease, and has no other contractual obligations that would prevent it from altering its production technology. Which time frame should the tire manufacturer consider given this set of circumstances?

The short run since it has a fixed input in the period under consideration. The firm can alter all of its variable inputs, but it cannot adjust its factory size since it still has two years left on its lease and is planning production over the next year.

Monopolistic Competitive Market: Long Run

The suppliers in monopolistic competitive markets are price makers.6 If firms in a monopolistic competitive market are making a profit in the long run, then more firms will enter the market. The entry of new firms will increase the options from which consumers can choose, which reduces demand for the incumbents in the market and thus the price they can charge. The opposite is also true. If firms are not making a profit, they have an incentive to leave the market. Firms leaving the market will increase demand for firms that are staying in the market as customers of the closed firms have to find somewhere else to get the product. Firms that stay in the market will find that they can increase their prices when other firms leave. The process of entering and leaving the market continues until the firms in the market are making zero economic profit. At this point, there is no incentive for firms to enter or leave the market The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency: Goods are produced at the lowest possible average cost. However, in monopolistic competition, the result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the average cost curve. Thus, monopolistic competition will not be productively efficient.7

The Reality of Creating Money

The true rate of money growth is often lower than theoretically possible for several reasons. First, some banks may choose to hold excess reserves. In the decades before the financial crisis of 2007-2008, this was very rare. Banks held almost no excess reserves, lending out the maximum amount possible. During this time, the relationship between reserves, reserve requirements, and the money supply was relatively close to that predicted by economic theory. After the crisis, however, banks increased their excess reserves dramatically, climbing above $900 billion in January of 2009 and reaching $2.3 trillion in October of 2013. Second, customers may hold their savings in cash rather than in bank deposits. Recall that when cash is stored in a bank vault, it is included in the bank's supply of reserves. When it is withdrawn from the bank and held by consumers, however, it no longer serves as reserves and banks cannot use it to issue loans. When people hold more cash, the total supply of reserves available to banks goes down and the total money supply falls. Third, some loan proceeds may not be spent. Imagine that the reserve requirement ratio is 10%, and a customer deposits $1,000 into a bank. The bank then uses this deposit to make a $900 loan to another one of its customers. If the customer fails to spend this money, it will merely sit in the bank account. In this case, the $1,000 deposit allowed the bank to create $900 of new money, but it could have created even more if the customer spent the money, and it was deposited in another account where 90% of it could be loaned out again.

How U.S. Unemployment Data Is Collected

The unemployment rate announced by the U.S. Bureau of Labor Statistics (BLS) on the first Friday of each month for the previous month is based on the Current Population Survey (CPS), which the Bureau has carried out every month since 1940. The Bureau takes great care to make this survey representative of the country as a whole. The country is first divided into 3,137 areas. The U.S. Bureau of the Census then selects 729 of these areas to survey. It divides the 729 areas into districts of about 300 households each and divides each district into clusters of about four dwelling units. Every month, Census Bureau employees call about 15,000 of the four-household clusters, for a total of 60,000 households. Employees interview households for four consecutive months, then rotate them out of the survey for eight months, and then interview them again for the same four months the following year, before leaving the sample permanently.1 In addition to employment information, this survey collects data on the state, industry, urban and rural areas, gender, age, race or ethnicity, and education level of participants. A wide variety of other information is available, too. For example, how long have people been unemployed? Did they become unemployed because they quit, or were laid off, or their employer went out of business? Is the unemployed person the only wage earner in the family? The CPS is a treasure trove of information about employment and unemployment.1

Natural Rate of Unemployment

The unemployment rate that would exist in a growing and healthy economy from the combination of economic, social, and political factors that exist at a given time The natural rate of unemployment is not natural in the sense that water freezes at 32 degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not an unchanging law of nature. Instead, it is only the natural rate because it is the unemployment rate that would result from the combination of economic, social, and political factors that exist at a specific time—assuming the economy was neither booming nor in recession. In other words, the underlying economic, social, and political factors that determine the natural rate of unemployment can change over time, which means that the natural rate of unemployment can change over time, too. For example, estimates by economists of the natural rate of unemployment in the U.S. economy in the early 2000s run at about 4.5% to 5.5%. Two of the common reasons proposed by economists for this change are outlined below. 1. The internet has provided a remarkable new tool through which job seekers can find out about jobs at different companies and easily contact them. Also, social networking sites such as LinkedIn have changed how people find work. 2. The growth of the temporary worker industry has probably helped reduce the natural rate of unemployment. In the early 1980s, only about 0.5% of all workers held jobs through temp agencies; by the early 2000s, the figure had risen to above 2%. The combined result of these factors is that the natural rate of unemployment was, on average, lower in the 1990s and the early 2000s than in the 1980s.1

Real GDP

The value of all goods produced in a given year Real GDP is the total value of all the final goods and services that an economy produces during a given year, accounting for inflation. It is calculated using the prices from a selected base year. Using prices from a chosen year allows government statisticians to hold prices constant from year to year. This removes the influence of inflation. Any observed changes in real GDP can be attributed to changes in output. Converting to real GDP transforms the money value measure, nominal GDP, into an index for quantity of total output. In other words, real GDP is nominal GDP adjusted for inflation. If prices change from one period to the next but actual output does not, real GDP remains the same. Real GDP reflects changes in real production. If there is no inflation or deflation, nominal GDP will be the same as real GDP. As an example, the graph below shows U.S. nominal and real GDP since 1960. Because 2012 is the base year, the nominal and real values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the rise in real GDP (i.e., the nominal GDP line rises more steeply than the real GDP line) because the presence of inflation, especially in the 1970s, exaggerates the rise in nominal GDP. The graph shows that the U.S. economy has increased the real production of goods and services by nearly a factor of four since 1960.

Nominal GDP

The value of all goods taking price changes into account Nominal GDP is the value of all the final goods and services produced in a given year calculated using the prices from that same year. The nominal value of GDP identifies the actual number of dollars spent. If prices change from one period to the next, the nominal GDP changes even if output remains constant. Because changes in either output or price affect nominal GDP, it is difficult to glean information about economic growth by watching its movements.

Criticisms of Measuring Unemployment

There are always complications in measuring the number of unemployed. For example, what about people who do not have jobs and would be available to work but are discouraged by the lack of available jobs in their area and stopped looking? Such people, and their families, may be suffering the pains of unemployment. However, the survey counts them as out of the labor force because they are not actively looking for work. Other people may tell the Census Bureau that they are ready to work and looking for a job but, in truth, they are not that eager to work and are not looking very hard at all. They are counted as unemployed, although they might more accurately be classified as out of the labor force. Still other people may have a job, perhaps doing something like yard work, childcare, or cleaning houses, but are not reporting the income earned to the tax authorities. They may report being unemployed when they actually are working. Although the unemployment rate gets most of the public and media attention, economic researchers at the BLS publish a wide array of surveys and reports that try to measure these kinds of issues and develop a more nuanced and complete view of the labor market. It is true that economic statistics are imperfect. However, even imperfect measures, such as the unemployment rate, can be quite informative when interpreted knowledgeably.1

Types of Unemployment

There are many reasons why workers are unemployed, sometimes by choice. They may choose to move to a new city. They may quit their current jobs and look for a new one in the city where they have moved. New graduates take time to find that first job. It is also possible that a person could lose his or her job if the company they work for closes for some reason not related to a downturn in the economy, such as poor management. It takes time to find out about new jobs and to interview and figure out if the new job is a good match or perhaps to sell a house and buy another in proximity to a new job. Economists call the unemployment that occurs as workers move between jobs as frictional unemployment. Frictional unemployment is not inherently a bad thing. It takes time to match those looking for employment with the correct job openings. For individuals and companies to be successful and productive, you want people to find the job for which they are best suited, not just the first job offered. For example, In the mid-2000s, before the 2008-2009 recession, it was true that about 7% of U.S. workers saw their jobs disappear in any three-month period. However, in periods of economic growth, those lost jobs are counterbalanced for the economy as a whole by a larger number of jobs created. In 2005, for example, there were typically about 7.5 million unemployed people at any given time in the U.S. economy. Even though about two-thirds of those unemployed people found a job in 14 weeks or fewer, the unemployment rate did not change much during the year because those who found new jobs were largely offset by others who lost their jobs. The level of frictional unemployment depends on how easy it is for workers to learn about alternative jobs, which may reflect the ease of communications about job prospects in the economy. The extent of frictional unemployment also depends to some extent on how willing people are to move to new areas to find jobs—which in turn may depend on history and culture.1

Unemployment Continued:

There are painful adjustments, like watching your savings account dwindle, selling a car and buying a cheaper one, or moving to a less expensive place to live. Even when an unemployed person finds a new job, it may pay less than the previous one. For many people, their job is an important part of their self-worth. When unemployment separates people from the workforce, it can affect family relationships as well as mental and physical health. In addition to the human costs of unemployment, there are economic costs to the broader society. When millions of unemployed but willing workers cannot find jobs, economic resources are unused. An economy with high unemployment is like a company operating with a functional but unused factory. The opportunity cost of unemployment is the output that the unemployed workers could have produced. This lesson will discuss how economists define unemployment and compute the unemployment rate. It will also examine the patterns of unemployment over time.1

The Downward Slope of the AD Curve

There are three key reasons for the downward slope of the AD curve. These are the wealth effect, the interest rate effect, and the foreign price effect. The wealth effect holds that as the price level increases, the buying power of money is depleted to some extent by inflation. Consequently, people feel less wealthy and may decide to reduce their buying. When prices fall, the buying power of money increases, making people feel wealthier. In this case, they will be more likely to make purchases. The wealth effect contributes to the negative relationship between the price level and aggregate GDP demanded.1 The interest rate effect reflects the fact that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.1 The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.1

Lesson Summary

There are three tools governments use to restrict the flow of free trade: tariffs, import quotas, and nontariff barriers. These barriers are put in place to protect domestic producers from losing sales due to lower prices offered by foreign importers. The end result of protectionist behavior will be to raise the price of the protected good in the domestic market, which increases the price charged to domestic customers but allows domestic producers to earn more. Increases in global free trade shift jobs away from industries in which a country or producer does not have a comparative advantage to industries in which it does. This results in increased wages and job gains in some industries and losses in others. Tariffs can be classified based on how the duty amount is imposed. Specific tariffs levy a flat amount on each item that is imported. Ad valorem tariffs are based on a percentage of the value of each item. Compound tariffs are tariffs that are a combination of specific tariffs and ad valorem tariffs. There are two types of quotas: absolute and tariff-rate. Absolute quotas are quotas that limit the amount of a specific good that may enter a country. Tariff-rate quotas allow a quantity of a good to be imported under a lower duty rate. Any amount above this is subject to a higher duty. Quotas often hurt domestic consumers and benefit domestic producers. Quotas may also provide incentives for administrative corruption and smuggling. Comparative advantage is the driving force behind international trade. Differences in opportunity costs support trade and specialization and encourage each country to make the goods and perform the services for which it has a comparative advantage. The increase in trade since WWII is likely due to decreasing costs of transportation and changes in global trade policies. This has led to decreased tariffs primarily due to the work of the GATT and the WTO. The advantages of trade based on comparative advantage lead to lower production costs, higher levels of output, and, therefore, the opportunity for higher consumption levels. A production possibilities frontier can be used to illustrate the increased consumption and production that occurs when two nations produce goods or services for which they have a comparative advantage. Governments may choose to use tariffs and quotas or other nontariff barriers to control the flow of trade across their borders. These barriers restrict free trade, leading to an increased cost for consumers. Governments may benefit as they collect the tariffs or rental fees, and domestic producers may also benefit. Concerns about free trade affecting jobs and wages have been debated. Redistribution of jobs has been seen, which can negatively affect some industries while having a much higher benefit for others.

Principle 3: Rational people think at the margin

Think at the margin: Thinking about what the next step or an additional action means for a person. In most cases, people make better decisions when they consider if the additional benefit they gain from one more unit is greater than the additional cost of that extra unit of a good or service. Example: Suppose you have studied for one hour and are considering if you should study for another hour. In making that decision, you would consider the benefit you would get from studying for one more hour (a higher test grade) against the cost of studying that additional hour (an hour watching TV). The marginal benefit is the additional benefit you gain from consuming one more of something—the higher test grade you get from studying one more hour. The marginal cost is the additional cost you incur from consuming that additional unit—the hour of TV you are giving up. This marginal or incremental plan of action is thinking at the margin. Principles of Economics One to Four: How People Make Decisions

Government Participation

This category of trade barriers represents direct governmental involvement in international trade. Some examples include the following: Government procurement programs: Public authorities, such as government agencies, are much like private interests in that they must also buy goods and services. Unlike private interests, governments are more likely to buy domestically produced goods and services rather than the lowest cost commodities. Because government procurement often represents a significant portion of a country's GDP, foreign suppliers are at a disadvantage to domestic ones when it comes to these programs. Export subsidies: Export subsidies are production subsidies granted to exported products, usually by a government. With export subsidies, domestic producers can sell their commodities in foreign markets below cost, which makes the commodities more competitive. Countervailing duties: Countervailing duties, or antisubsidy duties, are extra duties levied on imports to neutralize an export subsidy. If a country discovers that a foreign country subsidizes its exports and domestic producers are injured as a result, a countervailing duty can be imposed to reduce the export subsidy advantage. In that respect, countervailing duties are similar to antidumping duties in that they both bring an imported product's value closer to the world price.3

Lesson Summary

This lesson discussed the expanded version of the circular flow model. Following are the key points to remember: The expanded circular flow diagram includes interactions between households, firms, governments, and the rest of the world, as well as the financial, factor, and goods and services markets. The firm's component includes elements associated with flows into and out of the business sector. The household component summarizes the behavior of private individuals in their roles as consumers, savers, and suppliers of the factors of production. The government sector summarizes the actions of all levels of government. The expanded circular flow also incorporates dealings with the rest of the world. These flows include exports, imports, and borrowing from other countries.

Lesson Summary

This lesson discussed the role of AS in a market economy. It looked at the AS curve and introduced the concepts of LRAS and SRAS. In addition, the following key facts were discussed: Aggregate supply (AS) refers to the total quantity of output (real GDP) firms will produce and sell at different price levels, which is illustrated with the aggregate supply curve.2 Higher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on AS.3 In the long run, the most important factor shifting the LRAS curve is productivity growth. Productivity is how much output can be produced with a given quantity of labor or capital and is measured by output per worker or GDP per capita.3 A higher level of productivity shifts the SRAS curve to the right because, with improved productivity, firms can produce a higher quantity of output at every price level. Every time there is a shift in the LRAS curve, the SRAS curve will also shift in the same direction because what affects LR production also affects SR production. The SRAS curve shifts with changes in the cost of inputs. When input costs rise, SRAS shifts to the left. When input costs fall, SRAS shifts to the right.3

Lesson Summary

This lesson explained that unemployment comes with human, social, and economic costs. It also discussed patterns of unemployment as well as how economists define and measure it. The following was explored in detail: The adult population can be divided into those in the labor force and those out of the labor force. Those in the labor force are then divided into employed and unemployed. A person without a job must be willing and able to work and actively looking for work to be counted as unemployed; otherwise, a person without a job is counted as out of the labor force. Economists define the unemployment rate as the number of unemployed persons divided by the number of persons in the labor force. Frictional unemployment occurs when people either choose to change jobs, such as when a person moves to a new city, or is a new college graduate. Structural unemployment happens when demand shifts permanently away from a certain type of job skill, such as when jobs are outsourced or replaced by technology. Cyclical unemployment occurs when there is a downturn in the economy, and it rises and falls with the business cycle. The U.S. unemployment rate rises during recession and depression and falls to around 4% to 6% when the economy is strong, but it never falls to zero.1

Lesson Summary

This lesson has focused on how economists measure inflation, the historical experience with inflation, how statisticians combine prices of individual goods and services to create a measure of overall inflation through price indexes, and how inflation affects the economy. The following was explored in detail: Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. The most commonly cited measure of inflation is the CPI, which is based on a basket of goods representing what the typical urban consumer buys. Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias and the quality and new goods bias. In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. Inflation is good for borrowers and bad for lenders because it reduces the value of the money paid back to the lenders. A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with COLAs and loan agreements like ARMs. Examples of indexing in the public sector include tax brackets and social security payments. GDP measures production in the economy, is used to measure economic growth, and is a measure of the prevailing standard of living in a country. Economists measure growth by the percentage change in real (inflation-adjusted) GDP. A growth rate of more than 3% is considered good. Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who do not have a job but are actively looking for one. When people lack jobs, the economy is wasting a precious resource—labor—and the result is lower goods and services produced. Unemployment, however, is more than a statistic. It represents people's livelihoods. Even though measured unemployment is unlikely to ever be zero, economists consider a measured unemployment rate of about 5% to be good. Inflation is a sustained increase in the overall level of prices and is measured by the consumer price index. If many people face a situation in which the prices that they pay for food, shelter, and healthcare are rising much faster than the wages they receive for their labor, there will be widespread unhappiness as their standard of living declines. For that reason, low inflation—an inflation rate of about 2%—is a major goal.1

Employed

Those who are currently working for pay.

Expanded Circular Flow Model

To depict the macroeconomy in more detail, the expanded circular flow diagram shown here follows the flow of money between households, firms, governments, and the rest of the world. The diagram illustrates the relationships between each of the economic actors and their roles in each of the markets. The inclusion of additional economic actors adds complexity to the decisions described by the circular flow model. Interactions between households, government, firms, and the rest of the world occur in three markets: 1. the goods and services market 2. the factors market 3. financial market In each of the markets, prices adjust to clear the market by balancing supply and demand. Examine the diagram as you read descriptions of each market. Firms supply the goods and services desired by these four buyers. Prices adjust with changes in the demand and supplies of these goods and services. The purchase of goods and services creates a flow of money to suppliers of the products. This flow of payments is shown in the diagram by the darker blue arrow going from the goods and services market to the firms. It is the sum of the expenditures listed above and is the total value of production in the economy. The total flow of money into the firm sector equals the gross domestic product (GDP). Factor markets—Productive inputs are traded in the factor markets. Households own the land, labor, capital, and entrepreneurship. They bring these resources to the factor markets where they are purchased by firms. Factor prices adjust with changes in the demand or supply of inputs. When firms buy inputs, payments to those inputs in the form of wages, profit, interest, and rent flow to the households. These payments compose household income. Financial market—The financial market facilitates the exchange of money between borrowers and lenders. Interest rates adjust to coordinate the demand and supply of funds. The circular flow diagram shows two flows into the financial sector: private savings and foreign lending. These compose the total funds available to borrowers. Flows out of the financial sector fund government borrowing, foreign borrowing, and borrowing by firms. When the government is running a deficit, some of the savings of households must be used to fund that deficit, so there is less left over to finance investment.2 In conclusion, the expanded circular flow model identifies the critical economic actors and displays their interactions in different markets. Understanding the behavior of these actors and the functioning of these markets is the focus of macroeconomics. The circular flow diagram provides the context for understanding the macroeconomic measurements discussed in the next lessons. GDP measures the value of the total product purchased in the goods and services market. The consumer price index measures the overall price level in that market. The unemployment rate is a measure of how well the factors market is performing.

The Forms of Money

To function as money, an item must be generally accepted as a means of payment for goods and services. General acceptance is essential as it eliminates the need for a double coincidence of wants during transactions. With money, the accountant no longer needs to find a shoe seller in need of accounting services to buy shoes. Instead, both the accountant and the shoe seller accept money for their goods and services. Money facilitates efficient transactions While general acceptability is the minimum requirement for money, there are several additional characteristics shared by successful currencies. To function well, money should be durable, divisible, portable, and resistant to counterfeiting. These characteristics ensure that the item chosen meets the use requirements of money. Money has taken a wide variety of forms in different cultures. Gold, silver, cigarettes, and even cocoa beans have been used as money. When used as money, these items are considered commodity money, meaning they also have a value from use as something other than money. Gold, for example, is a good conductor of electricity and is used in the electronics and aerospace industries. Gold is also valued for its beauty and malleability in the creation of jewelry. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or another commodity held at a bank. During much of its history, the money supply in the United States was backed by gold and silver. Interestingly, antique dollars dated as late as 1957, have "Silver Certificate" printed over the portrait of George Washington. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar's worth of silver. Using either commodity or commodity-backed money limits the ability of a nation to control its money supply. Under a gold-backed system, the money supply increases with the supply of gold and decreases when gold is lost. As changes in the supply of gold are unrelated to the monetary needs of the economy, reliance on a gold-backed currency introduces economic instability. Nations have experienced hyperinflation with the discovery of new gold sources. They have also experienced recessions when the supply of money has been insufficient. To gain more control over their money supply, countries have moved toward the use of fiat money. Fiat money has no intrinsic value but is declared by a government to be the legal tender of a country. The United States' paper money, for example, carries the statement: "This note is legal tender for all debts, public and private." In other words, by government decree, if you owe a debt, then legally you can pay that debt with the U.S. currency, even though a commodity does not back it. The only backing for the money is universal faith and trust that the currency has value and nothing more.

Lesson Summary

To measure the overall size of the economy, macroeconomists use gross domestic product, or GDP. This measure is the sum of the market value of all final goods produced in a country over a given year. These goods can include food, household items, manufactured goods, and education. This lesson examined the way GDP is calculated, the implications and limitations of the measurement, the specific selection of goods and services that are included in the GDP, and the uses of GDP. Key concepts to remember include the following: GDP is calculated by summing expenditures on consumption, investment, government spending, and net exports. To be included in GDP, a good or service must be a final good made within a particular year, traded in a legal market, and made within the geographic boundaries of the country. The nominal value of an economic statistic indicates the value in current dollars. The real value is the nominal value after adjusting for changes in inflation. The pattern of expansion and contraction of GDP is called the business cycle. When GDP declines significantly, a recession occurs. A longer, deeper recession is a depression. Countries with large populations often have large GDPs, but GDP alone can be a misleading indicator of a nation's wealth. A better measure is GDP per capita. GDP is an indicator of a society's standard of living, but it is only an approximate indicator.2

Relationship between SRAS and LRAS

To provide a complete picture of the relationship between real GDP supplied and the price level, economists typically draw both the AS curve and the LRAS or potential GDP line on the same graph. In the previous graph, these lines cross when the price level is 105, and the real GDP is $9,600 billion. As price deviates from 105, real GDP deviates from potential GDP. When the price level is above 105, real GDP exceeds potential GDP. This result may seem puzzling: How can an economy produce at an output level, which is higher than its potential or full employment GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: All workers would be on double overtime, and all machines would run 24 hours a day, seven days a week. Such hyperintense production would go beyond using potential labor and physical capital resources fully to using them in a way that is not sustainable in the long term. Thus, it is possible for production to sprint above potential GDP, but only in the short run. It is also possible for real GDP to fall below potential GDP. In the short run, if demand is too low, producers can lay off employees and shut down factories. Both output and employment are then lower than when the economy is at full employment.2

The Barter System

To understand the usefulness of money, consider for a minute what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient when trying to coordinate multiple trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be challenging to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods. Another problem with the barter system is that it does not allow people to easily enter into future contracts for the purchase of many goods and services. For example, if the goods are perishable, it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, although the barter system might work adequately in small economies, it will keep those economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time is spent bartering. Despite the long list of limitations, the barter system continues to be used in certain situations. Barter is used in times of monetary crisis when the currency is either unstable or simply unavailable for conducting commerce. It can also be useful when there is little information about the creditworthiness of trade partners or when there is a lack of trust.

Total Cost

Total Cost = Total Variable Cost + Total Fixed Cost TC = TVC + TFC The fixed costs are always shown as the vertical intercept of the total cost curve. The relationship between the quantity of output produced and the total cost is shown in the following graph. The fixed costs are always shown as the vertical intercept of the total cost curve. That is, they are the costs incurred when the output is zero, so there are no variable costs. Total costs show the effect of diminishing marginal returns with a steeper increase in total cost with additional workers.3 Notice that the total cost curve very much resembles the shape of the variable cost curve. This is because the changes in total cost, as the output increases, are driven by changes in variable cost. Fixed costs appear as a horizontal line on the graph. The line shows that fixed costs do not change with the level of output.

Net Exports

Two factors can significantly impact net exports—foreign income and exchange rates. Higher foreign incomes will increase demand for exports, shifting AD to the right (AD0 to AD1); lower foreign income will reduce demand for exports, shifting it to the left (AD0 - AD1). Net exports are also influenced by the exchange rate or the price of the country's currency in terms of other currencies. When the exchange rate increases, the price of a dollar is higher, making foreign goods cheaper and U.S. goods more expensive. This increase in the exchange rate reduces U.S. exports and increases U.S. imports, shifting AD to the left. Depreciation of the dollar lowers the exchange rate and leads to an increase in net exports. A lower exchange rate would shift AD to the right.2

Discuss aggregate supply and factors that shift the curve.

Two periods are evaluated when studying aggregate supply (AS)—the short run and the long run. The short run refers to the time frame in which input prices are fixed, and there can be disequilibrium in the factors markets. In the long run, price adjustment is complete and all factor markets have cleared. In these different time frames, the relationship between the quantity of real GDP supplied and the price level is different. In the short run, there is a positive relationship between the quantities of goods and services businesses are willing to produce and the price level in an economy. Higher outputs of final goods and services and higher prices go together. In the long run, the quantity of real GDP supplied is independent of the price level.1 Focusing on AS, this lesson explores the reasons behind the differences between the short run and the long run. It also explains how these are displayed graphically, comparing the slope of the short-run AS curve to the slope of the long-run AS curve. Just as firms react differently to price changes in the short run and the long run, they also react differently to changes in nonprice factors. The lesson identifies these factors and explains how AS reacts to changes in these factors. Finally, the lesson explains the distinction between real GDP and potential GDP and demonstrates how to use these values to evaluate fluctuations in economic performance.

Explain inflation and unemployment using the Phillips curve.

Unemployment and inflation cause macroeconomic instability and are targets for both monetary and fiscal policies. These policies both work by changing aggregate demand. An increase in aggregate demand is expected to increase prices, output, and employment, whereas a decrease in aggregate demand moves all variables in the opposite direction. In these predicted outcomes, there is an inverse relationship between price levels and employment. Although the aggregate demand-aggregate supply (AD-AS) model can depict the theoretical relationship between inflation and unemployment, this lesson looks at conclusions drawn from data on these variables. This lesson introduces the Phillips curve and describes its history. You will then look at the performance of the Phillips curve over time. This reveals how the understanding of the inflation-unemployment relationship has become more nuanced. Finally, the lessons of the Phillips curve are applied to fiscal policy to assess its strengths and weaknesses.

Unemployment Rates by Group

Unemployment is not distributed evenly across the U.S. population. The following graphs show unemployment rates broken down by gender, age, and race and ethnicity. Notice the following while examining the graphs: 1. The unemployment rate for women had historically tended to be higher than the unemployment rate for men, perhaps reflecting the historical pattern that women were seen as secondary earners. By about 1980, however, the unemployment rate for women was essentially the same as that for men. During the 2008-2009 recession and in the immediate aftermath, the unemployment rate for men exceeded the unemployment rate for women. Subsequently, however, the gap has narrowed. 2. Younger workers tend to have higher unemployment, whereas middle-aged workers tend to have lower unemployment, possibly because the middle-aged workers feel the responsibility of needing to have a job more heavily. Younger workers move in and out of jobs more than middle-aged workers as part of the process of matching of workers and jobs, and this contributes to their higher unemployment rates. Elderly workers have extremely low rates of unemployment because those who do not have jobs often exit the labor force by retiring and thus are not counted in the unemployment statistics. 3. The unemployment rate for people who are black is substantially higher than the rate for other racial or ethnic groups, a fact that surely reflects, to some extent, a pattern of discrimination that has constrained the labor market opportunities for people who are black. However, the gaps between unemployment rates for people who are whites, for those who are black, and those who are Hispanic diminished in the 1990s. In fact, unemployment rates for black Americans and Hispanic Americans were at the lowest levels for several decades in the mid-2000s before rising during the recent Great Recession. 4. Finally, those with less education typically suffer higher unemployment. In January 2017, for example, the unemployment rate for those with a college degree was 2.5%. For those with some college but not a four-year degree, the unemployment rate was 3.8%. For high school graduates with no additional degree, the unemployment rate was 5.3%, and for those without a high school diploma, the unemployment rate was 7.7%. This pattern arises because additional education typically offers better connections to the labor market and higher demand. With less attractive labor market opportunities for low-skilled workers compared to the opportunities for the more highly skilled, including lower pay, low-skilled workers may be less motivated to find jobs.

Cyclical Unemployment

Unemployment that results when the overall demand for goods and services in an economy cannot support full employment. It occurs during periods of slow economic growth or during periods of economic contraction Economists call the variation in unemployment that happens when people lose their job or are laid off because of a downturn in the economy as cyclical unemployment. Much of the unemployment from the 2008 recession was due to cyclical unemployment. Millions of people were laid off because of the downturn in the economy as businesses closed or cut back on production. Cyclical unemployment captures the rise in unemployment during a recession and the fall during an economic expansion. Why is the unemployment rate never zero? Because there will always be structural and frictional unemployment. Even when the U.S. economy is growing strongly, the unemployment rate only rarely dips as low as 4%. Economists have a term to describe the remaining level of unemployment that occurs even when the economy is healthy: They call it the natural rate of unemployment, which will be discussed next.1

Variable Costs Continued

Variable costs are incurred in the act of producing—the more you produce, the higher the variable cost. Labor is treated as a variable cost since producing a higher quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials and expenses for operating machinery.3 While variable costs may initially increase at a decreasing rate, at some point, they begin increasing at an increasing rate. As the number of workers increases from zero to one in the table, the output increases from 0 to 16 for a marginal gain of 16. As the number rises from one to two workers, the output increases from 16 to 40, with a marginal gain of 24. From that point on, though, the marginal gain in output diminishes as each additional worker is added.2 This pattern demonstrates the law of diminishing marginal returns due to the effects of specialization and congestion. Initially, as you add more workers, each worker can specialize in separate tasks, and productivity increases. Eventually, there will be too many workers, and productivity will decrease as the number of employees goes beyond the optimal combination of capital and labor (Beveridge, 2013). As a result, the total costs of production will begin to rise more rapidly as the output increases. Notice that no assumption about the individual productivity of the workers was made. It is not that worker two is more productive than worker three. It is that the second worker, irrespective of who it is, is more productive than the third worker. If you were to switch worker two with worker three, the outcome would be the same. This pattern of diminishing marginal returns is typical in production.

Protectionism Continued

When a government legislates policies to reduce or block international trade, it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three primary forms: tariffs, import quotas, and nontariff barriers. To the noneconomist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers) who are also affected by the trade barriers. An analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses, but a policy that imposes substantial domestic costs as well.2 As you saw in the last lesson, trade allows both countries to move outside of their production possibilities curve and gain from trade when each country is producing the product for which they have a comparative advantage. Restricting imports is clearly positive for protected domestic producers. These producers can sell more at a higher price because the trade restrictions lead to increased prices and leave consumers with fewer alternatives. Those consumers who decide to pay the higher price don't have the extra money. Others may decide the good is not worth the higher price and forgo purchasing it altogether. Both are examples of the domestic cost of protectionism. Consumers are made worse off. That is not the end of the story, though. Resources which were being put to more efficient uses must be diverted to increase the domestic production of this good that could be purchased cheaper from other countries. Protectionism helps producers without a comparative advantage but harms those who have a comparative advantage relative to their foreign competitors. The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers. The subsidy is indirect because it is paid by consumers through higher prices rather than being a direct subsidy paid by the government with money collected from taxpayers; but protectionism works like a subsidy, nonetheless.

Is the Federal Deficit a Significant Problem?

When he recommended an interventionist fiscal policy role for the federal government, Keynes was not encouraging persistent deficit spending. However, it is politically challenging to cut back spending or increase taxes during the expansionary phase of the business cycle. This is apparent in the strong bias toward deficit spending in the United States over the last 40 years. In response to this, there have been calls for legislation requiring Congress to have a balanced budget. To assess the value of this idea, consider first the benefits of being able to borrow and the costs of running deficits. There are several benefits to giving Congress the ability to run deficits. First, with full power over budget decisions, policymakers can react to economic conditions. They can implement appropriate tax and spending measures to stabilize the economy, preventing it from sinking into a severe downward spiral. Next, deficits enable governments to make large-scale infrastructure investments. Government purchase of infrastructure that supports the transportation of goods and services can have positive consequences for long-run economic growth. Deficits allow the enormous cost of these investments to be spread out over time. Finally, deficit spending provides funding for wars. Although this power can be abused to engage in wars that some consider unjust, nations generally want the ability to respond to national security threats. Although these benefits are significant, there are also a number of concerns related to deficit spending. First, there is concern over crowding out or the potential to decrease loan availability for private-sector businesses. If the government borrows funds during a period of recession when investments are low, these funds are being effectively used. If the government borrows during a period of strong economic growth, it increases competition for limited funds and drives up interest rates. This limits private sector investment and borrowing. Next, the accumulation of deficits creates a debt burden that redistributes wealth from the future to the current generation. Those in the present are enjoying the benefits of income that someone else will have to earn in the future. Taxes will have to be increased at some point to pay for current deficits. Finally, deficits create the potential for inflation. To finance a deficit, the Treasury department sells government securities. Treasury debt is not considered part of the money supply. However, if these securities are purchased by the Fed, the debt is monetized. Excessive monetization could lead to inflation.

Quiz: What causes a change in a market's equilibrium?

When market events shift either the supply or demand curves, the market equilibrium will shift. One of the determinants of supply or demand must occur in the market, such as a change in the number of business suppliers or customers and buyers, for the equilibrium to shift.

Arguments for and against Government Price Controls

When prices are especially high or when there is a shortage of goods, it can be difficult for people to get what they need at an affordable price. In these circumstances, governments face pressure to provide solutions. Government-imposed price controls can seem like an effective way to ensure that producers stay in business or that citizens can purchase what they need in times of national economic hardship. This is not generally true. When there is an underlying market problem that either inflates or suppresses prices, price controls may improve outcomes. For example, if a pharmaceutical firm is exploiting its market power to charge an extremely high price for its drug, a well-designed price ceiling can limit the firm's power and ensure that the product remains affordable to most of a country's citizens. When a firm uses its market power to suppress workers' wages, a minimum wage can reduce income inequality. In each of these cases, a problem exists in the market and price control is imposed to address the problem. However, observing that prices are either above or below the desired level does not mean that the market is not well functioning. Even in a perfect market, prevailing supply and demand conditions can produce undesirable prices. Using price controls in well-functioning markets is inefficient. They redistribute benefits and create either shortages or surpluses. As Nobel Prize winner Milton Friedman said, "We economists do not know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers cannot sell tomatoes for more than two cents per pound. Instantly you'll have a tomato shortage."3

Expansionary Gap and the AD-AS Model

When the equilibrium level of real GDP is above potential GDP, there is an inflationary or expansionary gap. Though the quantity of GDP demanded is equal to the quantity of GDP supplied, the economy produces more than the full-employment level of output. An inflationary or expansionary gap is illustrated in the following graph. The short-run equilibrium E1, where AD and SRAS cross, is to the right of the LRAS or potential GDP. This means the economy is producing at Y0, which is above potential GDP. The difference between Y0 and Y* is known as the inflationary or expansionary gap. When this is the case, the push to keep output high is likely to lead to inflation. This equilibrium is a short-run equilibrium, but not a long-run equilibrium. As with a recessionary gap, given enough time, the economy will adjust and move toward long-run equilibrium. At the current equilibrium, the economy lacks sufficient resources to sustain this high level of output. Businesses are competing for workers. This competition for workers drives wages up. Higher wages add to production costs, and AS will decrease. The AS curve will shift to the left. Eventually, the increase in wages will bring the economy back to a long-run or full-employment equilibrium. This movement is depicted in the following graph. The economy begins at E0. With many employers looking to hire, wages increase thus shifting AS from SRAS0 to SRAS1. A full-employment equilibrium is reached at E1. This equilibrium occurs at a higher price level and a lower output level than the original equilibrium. The inflationary gap is closed.

Contractionary Gap and the AD-AS Model Continued

When the equilibrium real GDP is less than potential GDP, there is a recessionary or contractionary gap. Though the quantity of GDP demanded is equal to the quantity of GDP supplied, the economy produces less than the full-employment level of output. A recessionary or contractionary gap is illustrated in the following graph. The short-run equilibrium E0, where AD and SRAS cross, is to the left of the LRAS or potential GDP meaning the economy is producing at Y0, which is below potential GDP. The difference between Y0 and Y* is known as the recessionary or contractionary gap. When this is the case, the economy is experiencing a recession. This equilibrium is a short-run equilibrium, but not a long run equilibrium. Given sufficient time, the economy will adjust and move toward long-run equilibrium. Adjustment takes place in the input markets, specifically in the labor market. At the current equilibrium, the economy is in a recession and many people are unemployed. As those individuals enter the labor market looking for work, they drive wages down. The decrease in wages lowers the cost of production, increasing AS. The AS curve will shift to the right. Eventually, the decrease in wages will bring the economy back to a long-run or full-employment equilibrium. This movement is depicted in the following graph. The economy begins at E0. With many people out of work, wages fall shifting AS from SRAS0 to SRAS1. A full-employment equilibrium is reached at E1. This equilibrium occurs at a lower price level and a higher output level than the original equilibrium. The recessionary gap is closed.

Labor Standards and Working Conditions

Workers in countries like China, Thailand, Brazil, South Africa, and Poland are often paid less than the United States minimum wage. For example, in the United States, the federal minimum wage is $7.25 per hour; a typical wage in many low-income countries might be more like $7.25 per day, often much less. Moreover, working conditions in low-income countries may be extremely unpleasant or even unsafe. In the worst cases, production may involve the labor of children or even workers who are treated nearly like slaves. These concerns over standards of foreign labor do not affect most of U.S. trade, which is intraindustry trade and used with other high-income countries that have labor standards similar to the United States; but it is, nonetheless, morally and economically significant.

Shifts in Short-Run Aggregate Supply

When there is a change in a nonprice factor affecting AS, the curve will shift. A change that causes an increase in AS will shift the curve outward and to the right. AS increases when there is a change that makes it easier or cheaper to bring products to the market. These changes include an improvement in technology, a reduction in wages, an improvement in labor productivity, or a reduction in fuel prices. A change that decreases AS will shift the curve inward and to the left. Changes that make production more expensive or more difficult decrease AS. These changes include an increase in wages, a loss of productivity, or an increase in fuel prices. Higher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on aggregate supply. Examples of such widely used inputs include labor and energy products such as oil. Increases in the price of such inputs will cause the SRAS curve to shift to the left, which means that at each given price level, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits, causing the SRAS curve to shift to the left. The following figure shows the AS curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1. The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a less than favorable set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and a higher price level. For example, the U.S. economy experienced recessions in 1974-1975, 1980-1982, 1990-1991, 2001, and 2007-2009. Each was preceded or accompanied by a rise in oil prices, a key input in production. In the 1970s, this pattern of a decrease in SRAS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation.

Credit

Where does "plastic money" like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the user's bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in the definition of money used here, it is checkable deposits that are money, not the paper check or the debit card. Although you can purchase with a credit card, it is not considered money but rather a short-term loan from the credit card company to you. When you purchase with a credit card, the credit card company immediately transfers money from its checking account to the seller, and, at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a specific value of money on the card and then use the card to make purchases. In short, credit cards, debit cards, and smart cards are different ways to move money when a purchase is made. However, having more credit cards or debit cards does not change the quantity of money in the economy any more than having more checks printed increases the amount of money in your checking account.4

Distribution Effects of Inflation

Whether inflation is seen as good or bad depends on one's economic situation. Assuming that loans must be paid back according to a fixed nominal amount, inflation is good for borrowers and bad for lenders. When there is inflation, the value of the money borrowers pay back is less. When inflation is expected, it has few distribution effects between borrowers and lenders. This is because the inflation rate is built into the nominal interest rate, which is the sum of the real interest rate and expected inflation. For example, if the real cost of borrowing money is 3% and inflation is expected to be 4%, the nominal interest rate on a loan would be 7%. If the inflation rate unexpectedly jumps to 8% after the loan is made, however, then the creditor is essentially transferring purchasing power to the borrower. In general, this means that those with savings in the form of currency or bonds lose money from inflation. The lower purchasing power of money erodes the value of currency, and inflation reduces the real interest rate earned on bonds. Those with debt or savings in the form of stocks, however, are better off with higher inflation as stocks tend to rise in value to reflect the inflation rate. In demographic terms, this often manifests as a transfer from older individuals, who are wealthier and who tend to hold their savings in more conservative assets such as cash and bonds, to younger individuals, who have more debt and tend to hold their savings in more aggressive assets such as stocks. Retirees who receive private company pensions sometimes get a large share of their income in a form that does not increase over time. Some pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two. The unintended redistributions of buying power that inflation causes may have a broader effect on society. America's widespread acceptance of market forces rests on a perception that people's actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer as opposed to someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises and renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that the general public dislikes inflation is a sense that it makes economic rewards and penalties more arbitrary—and therefore likely to be perceived as unfair.1

Explain the role, creation, and regulation of money in the economy.

Which item was used for money over the broadest geographic area and for the longest period? The answer is not gold, silver, or any precious metal. It is the cowrie, a mollusk shell found mainly off the Maldives Islands in the Indian Ocean. Cowries served as money as early as 700 B.C. in China. By the 1500s, they were in widespread use across India and Africa. For several centuries after that, cowries were used in markets in places including southern Europe, western Africa, India, and China for a wide range of purchases: everything from buying lunch or a ferry ride to paying for a shipload of silk or rice. Cowries were still acceptable as a way of paying taxes in certain African nations in the early twentieth century. What made cowries work so well as money? First, they are incredibly durable, lasting a century or more. Second, parties could use cowries either by counting shells of a specific size, or—for large purchases—measuring the weight or volume of the total shells to be exchanged. Third, it was impossible to counterfeit a cowrie shell, but gold or silver coins could be counterfeited by making copies with cheaper metals. Finally, in the heyday of cowrie money, from the 1500s into the 1800s, the collection of cowries was tightly controlled, first by the Portuguese and later by the Dutch and the English. As a result, the supply of cowries was allowed to grow quickly enough to serve the needs of commerce, but not so quickly that they were no longer scarce. Though cowries are no longer used as money, many of the lessons of their success can be applied to modern currency. Throughout the ages, money has taken many different forms. Regardless of form, the uses of money and its role in facilitating transactions have remained consistent. In this lesson, you will learn about the characteristics of money, the uses of money, and the measurement of the money supply. You will also learn about the structure of the banking system and the role of the Federal Reserve in monitoring and adjusting the money supply.

Calculating Opportunity Costs

You can see that Golden can produce 12,000 guns if it produces only guns or 6,000 pounds of butter if it produces only butter. Maple, on the other hand, can produce 4,000 guns if it produces only guns or 5,000 pounds of butter if it only produces butter. It is important to remember that the PPF is the production possibilities frontier and represents what is physically possible for a nation to produce, given its resources and level of technology. A glance at the graphs demonstrates that Golden has an absolute advantage in both goods because it can produce more of both goods than Maple in the same amount of time. However, Golden does not have a comparative advantage in both goods, which will be discussed next. The nation with a comparative advantage in the production of a good is the nation that has the lowest opportunity cost in the production of that good. To find out which nation has a comparative advantage in each good, calculate the opportunity cost of each good for each nation. Here are the steps for calculating opportunity cost: 1. Pick a nation and a good. 2. Calculate what the nation gives up divided by what they get. For this example, first, calculate Golden's opportunity cost of producing butter. Because the PPF is a straight line, the opportunity cost will be constant at all points along the curve. Imagine Golden is at Point A in the graph above. What would be the opportunity cost of moving to Point B, which is producing fewer guns and more butter? When Golden moves from Point A to Point B, it gains 2,000 extra pounds of butter but gives up 4,000 guns. Golden's opportunity cost of butter is as follows: Golden's opportunity cost of butter = 4,000 guns / 2,000 lb butter = 2 guns / 1 lb butter This says that Golden must give up one-half or 0.5 pounds of butter for each gun it produces. Calculating Opportunity Costs for Maple Next, perform the same procedure for Maple, except this time, find the opportunity cost of producing more butter by moving from D to E on Maple's PPF. Maple's opportunity cost of butter=1,200 guns1,500 lb butter=45 guns1 lb butter You can interpret this as Maple needing to give up four-fifths or 0.8 of a gun for every pound of butter it produces. From here, you know Maple's opportunity cost of a gun because it is the reciprocal of the opportunity cost of butter. Maple's opportunity cost of gun=1,500 lb butter1,200 guns=54 lb butter1 gun or 1.25 pounds of butter for every gun it produces. Now you have all the information necessary to calculate comparative advantage. Use the information above to fill in the following table.

Minimum Wage

a minimum price that an employer can pay a worker for an hour of labor Perhaps the best known example of a price floor is the minimum wage. The federal minimum wage in 2019 was $7.25 per hour, although some states and localities have a higher minimum wage. The federal minimum wage yields an annual income for a single person of $15,080, which is slightly higher than the federal poverty line of $11,880. Congress last increased the minimum wage in 2009. About 1% of American workers are actually paid the minimum wage. This means wages for the vast majority of the U.S. labor force are not affected by the price control. In many cities, employers offer more than the minimum wage to checkout clerks and other low-skilled workers without any government prodding. This information suggests that federal minimum wage lies slightly below the equilibrium wage level. In this situation, the price floor minimum wage is said to be nonbinding—that is, the price floor is not determining the market outcome. Wages can fluctuate according to market forces above the price floor but are not allowed to move beneath the floor. Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skilled labor. A typical result of such studies is that a 10% increase in the minimum wage decreases the hiring of unskilled workers by 1% to 2%, which seems a relatively small reduction. In fact, some studies have even found no effect of a higher minimum wage on employment at certain times and places—although these studies are controversial. However, if the minimum wage were increased dramatically—say, if it were doubled to match the living wages that some U.S. cities have considered—its impact on reducing the quantity demanded of employment would be far greater.4

Price elasticity is divided into three broad categories:

elastic, inelastic, and unit elastic. Elasticity can be described as elastic (quantity is very responsive), unit elastic (equal change in quantity), or inelastic (quantity is not very responsive). An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a relatively high responsiveness of the quantity demanded or supplied to changes in price. Elasticities that are less than one indicate relatively low responsiveness of the quantity demanded or supplied to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of the quantity demanded or supply to a change in price. Inelastic goods are often described as necessities. A change in price does not drastically impact consumer purchasing or the overall supply of the good because it is not something people are able or willing to go without or is something of which companies cannot quickly change their production. Examples of inelastic consumer goods would be gasoline and food. Examples of inelastic producer goods would be movie tickets or housing. Elastic goods are usually viewed as nonessential and can also be luxury items. An increase in price for an elastic good has a noticeable impact on consumption or production. The good is viewed as something that individuals are willing to sacrifice to save money or companies can quickly change their production of. An example of an elastic consumer good is movie tickets, which are viewed as entertainment and not a necessity.2 An example of an elastic producer goods would be pizza or books. The law of demand states that a fall in the price of a good or service raises the quantity demanded and a rise in the price of a good or service lowers the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price in percentage terms. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in price. Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in the quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in the quantity demanded or supplied. If demand is inelastic, then an increase in price causes an increase in total revenue. You obtain the opposite result if demand is elastic: An increase in price causes a decrease in total revenue.