1 THE ECONOMIC APPROACH - Find the cheapest test …testbankeasy.eu/sample/Solution Manual for Economics... · Web viewPart 2 Text Overview This section, which is organized by chapter,

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Part 2

Text Overview

This section, which is organized by chapter, has several features. First, an outline of the text is provided. Second, a brief summary of the important points of each chapter and tips on how best to use the text and supplementary materials is included. Third, possible answers (or approaches) to many of the Critical Analysis questions that are not answered in Appendix B of the text are included. Lastly, fun illustrations and games that have been successfully used to communicate economic concepts to students are provided.


Chapter 1/The Economic Approach 19

Chapter 1The Economic Approach

OUTLINE

I. What Is Economics About?A. Scarcity Means Having to Make Choices

1. Scarcity and choice are the two essential ingredients of an economic topic.2. Goods are scarce because desire for them far outstrips their availability in nature.

a. Scarce goods are called economic goods.3. Scarcity forces us to choose among available alternatives.

B. Scarcity and Poverty Are Not the Same1. Scarcity and poverty are not the same thing.

a. Absence of poverty implies some basic level of need has been met.b. An absence of scarcity would imply that all of our desires for goods

are fully satisfied.2. We may someday eliminate poverty, but scarcity will always be with us.

C. Scarcity Necessitates Rationing1. Every society must have a method to ration the scarce resources among competing uses.

a. Various factors can be used to ration (first-come, first-served).b. In a market setting, price is used to ration goods and resources.c. When price is used, the good or resource is allocated to those

willing to give up “other things” in order to obtain ownership rights.D. Scarcity Leads to Competitive Behavior

1. Competition is a natural outgrowth of the need to ration scarce goods.2. Changing the rationing method used will change the form of competition, but it will not eliminate competitive tactics.

II. The Economic Way of ThinkingA. Guideposts to Economic Thinking

1. The use of scarce resources is costly, so tradeoffs must be made.a. Someone must give up something if we are to have more scarce

goods.(1) The highest-valued alternative that must be sacrificed is the opportunity

cost of the choice.2. Individuals choose purposefully; therefore they will economize.

a. Economizing: gaining a specific benefit at the least-possible cost.3. Incentives Matter


a. As personal benefits (costs) from choosing an option increase, other things constant, a person will be more (less) likely to choose that option.4. Economic reasoning focuses on the impact of marginal changes.

a. Decisions will be based on marginal costs and marginal benefits (utility).



5. Since information is scarce, uncertainty is a fact or life.6. In addition to their initial impact, economic events often generate secondary events that may be felt only with the passage of time.7. The value of a good is subjective and varies with individual preferences.8. The test of an economic theory is its ability to predict and explain events in the real world.

III. Positive and Normative EconomicsA. Positive Economics

1. Positive Economics: The scientific study of “what is” among economic relationships.

a. Positive economic statements can be proved either true or false.(1) Ex: The inflation rate rises when the money supply is

increasedB. Normative Economics

1. Normative Economics: Judgments about “what ought to be” in economic matters.

a. Normative statements cannot be proved true or false.(1) Ex: The inflation rate should be lower.

IV. Pitfalls to Avoid in Economic ThinkingA. Pitfalls

1. Violation of the ceteris paribus condition.a. Ceteris paribus is a Latin term meaning “other things constant.”b. Used when the effect of one change is being described, recognizing

that if other things changed, they also could affect the result.2. Good Intentions Do Not Guarantee Desirable Outcomes

a. Policies formed with good intentions may have unintended adverse secondary effects.3. Association is not causation.

a. Statistical association alone cannot establish causation.4. Fallacy of composition

a. The fallacy of composition is the erroneous view that what is true for the individual (or the part) will also be true for the group (or the whole).

b. Microeconomics focuses on narrowly defined units, while macroeconomics focuses on highly aggregated units.(1) One must beware of the fallacy of composition when shifting from micro to

macro units.

22 Chapter 1/The Economic Approach

OBJECTIVES

The purpose of this chapter is to introduce the student to the economic way of thinking. Unless students understand the concept of scarcity, the importance of personal incentives, and subject their thinking to the scientific method, they will do poorly in economics.

Generally, teachers overestimate their students. While many of your students will easily grasp the basics of the economic way of thinking, others will need additional examples and illustrations before they understand the essentials. The concepts of scarcity, economizing behavior, and incentives are so important, they are worth an entire lecture. Use several illustrations to highlight the impact on human behavior of changes in personal benefits or costs.

Introductory students tend to associate economics with business decision making. We must illustrate to them that the basic principles of economics and personal incentives influence all of human decision making, including choices in the political and social spheres. You may also want to contrast the methodology of economics with that of other social sciences and the physical sciences. Discuss both the similarities and differences.

IMPORTANT POINTS AND TEACHING SUGGESTIONS

1. Be sure to distinguish clearly between scarcity and poverty (and shortages, once supply and demand have been covered). Anything that we would like to have more of at no cost is scarce. Thus, almost everything from clean air to leisure time to the ingenuity necessary to make other resources useful is scarce. Poverty is defined as failure to attain some minimum level of income. Poverty can conceivably be eliminated, whereas scarcity persists since goods are scarce for both the rich and the poor. A shortage is present when purchasers would like to buy more than is available at the current price.

2. Introducing the subject of incentives, one can readily emphasize the importance and generality of this basic principle of economics. When an activity is made more costly, people will be less likely to choose it. Similarly, when the benefits derived from an event increase, people will be more likely to undertake it. Numerous examples can illustrate this concept. How does hot weather influence one’s decision to do without air-conditioning (or a swimming pool)? How does rewarding class attendance with higher grades influence one’s decision to go to class? How does the grading policy of the instructor influence a student’s incentive to study?

3. Discuss the meaning of “the margin” with students. Use non-economic examples to help clarify the idea. For example, ask students how an additional outstanding running back will influence the quality of a football team. (This is a marginal change.) If the running back position was previously a team weakness, the new player may make a substantial difference. On the other hand, if the team was already strong at this position, the new player may exert little influence on the overall performance of the team. Indicate clearly the difference between (a) the overall performance of the team (a total concept) and (b) the change that results from the addition of the new player (a marginal concept).


4. A good way of illustrating the search for information is to ask students how long they would search for a $50 bill. If your time had an opportunity cost of $10, you would look as long as you thought the probability of finding the bill in the next hour was at least 1/5. (The answer is not five hours in this case, because time already spent searching is then a sunk cost. A person could look well more or less than five hours.)

5. Give examples of actions that have secondary effects. What are the secondary effects of overeating? Lack of adequate sleep? Restricting trade with Japan? Fixing the price of wheat at $6 per bushel?

6. Emphasize both the theory and empirical parts of economics. Many professional economists are engaged in the continual testing of various aspects of economic theory. Discuss how economic theory is tested. Indicate real-world events that have convinced economists to modify their theories. Two examples of the latter are:

a. the impact of the Great Depression on the theory that wage and price flexibility quickly restores full employment.

b. the economic events of the 1970s on the theory that moderate inflation enables us to permanently attain low levels of unemployment.

7. Discuss the distinctions between positive and normative economics. Point out that positive economic statements are testable, whereas normative statements are not. Give several illustrations of both positive and normative economic statements. The following are examples of positive economic statements:

a. “If the price of wheat rose, buyers would purchase less of it.”

b. “Nations that import substantial amounts of crude oil will experience inflation when crude oil prices rise.” (Although this may or may not be true, it is nonetheless a positive statement.)

c. “An increase in government borrowing will cause interest rates to rise.”

The following are examples of normative statements:

a. “The price of wheat is too high.”

b. “The United States should impose price controls on domestic oil producers if the price of foreign oil rises.”

c. “It is wrong for lenders to charge higher interest rates to poor people than they charge the low-credit-risk customers.”

24 Chapter 1/The Economic Approach

8. It is important to emphasize that association is not the same thing as causation. Discuss the following points with regard to this point.

a. Skirt lengths tend to rise during prosperous times (1920s and 1960s, for example) and fall during bad times (1930s). Therefore, prosperity is caused by short skirts, whereas hard times result from low hemlines.

b. High crude oil prices caused the inflation experienced by the United States during the 1970s.

c. The post-World War II baby boom caused the prosperity of the period from 1946 to 1965.

d. War causes inflation.

9. Provide examples that illustrate the fallacy of composition, such as the following statements:a. “Total output remains virtually unchanged whether I work or not; thus output is largely

unaffected by whether or not people work.”

b. “I am no more likely to have an accident by driving ten miles over the speed limit than by obeying the limit. Thus, even if everyone drove 10 miles over the speed limit, the number of automobile accidents would not change.”

c. “Jones, a Kansas wheat farmer, doubled her income this year when she doubled her production of wheat. If all wheat farmers doubled their production of wheat, they could double their annual income.”

10. The addendum is remedial material and should be assigned, along with Chapter 1, to students who have difficulty perceiving graphical relationships.

11. The Critical Analysis questions at the end of each chapter are very useful in getting students to think more clearly about issues and events in the real world. Frequently, they can be used to also stimulate classroom discussion. Our experience suggests that only by using the economic way of thinking can most students really learn it.

12. A bird-watching analogy can help students see the usefulness of the economic way of thinking. Just as training and experience direct birdwatchers “where to look” to spot various birds, the economic way of thinking directs students to look at decision makers’ incentives to “see” the predictable consequences of actions and policies. This is why those trained in economics can often find predictable policy consequences that others are unable to grasp very easily

13. Another analogy that can help students see the power of the economic way of thinking is the framing of a building. Just as buildings will not be structurally sound if the framing is not done correctly, economic analyses will be faulty unless it is built on the framework of the set of incentives faced by the relevant decision makers. This is why economists spend so much effort trying to properly specify the incentives facing the actors involved, because predictions that are inconsistent with actors’ incentives are likely to be incorrect.


14. In talking about choices and costs, one helpful illustration is to show that sometimes it is cheaper to make some mistakes than to be right all of the time. This is true whenever the costs associated with being wrong a certain fraction of the time are expected to be low compared to the costs of avoiding such mistakes (although these expectations themselves may prove incorrect). Examples run the gamut from dating (“you’ve got to kiss a lot of frogs before you find your prince”), to exams (you don’t generally want to incur the costs to get every problem on an exam correct because you can miss some and still get an A), to buying “off brands” when shopping (where you trade off lower prices for greater risks of unsatisfactory product performance).

HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS

2. Production of scarce goods always involves a cost; there are no free lunches. When the government provides goods without charge to consumers, other citizens (taxpayers) will bear the cost of their provision. Thus, provision by the government affects how the costs will be covered, not whether they are incurred.

6. Self-interest implies neither selfishness nor greed. Neither does it imply that people are only interested in their own welfare. Self-interest and selfishness do not have the same meaning. Webster defines self-interest as “concern for one’s own well-being.” There is no implication that a self-interested person is either desirous of the possessions of others or seeking to gain at the expense of others. In contrast, Webster defines selfishness and greed as “pursuit of one’s own welfare without regard for the welfare of others.” A selfish person willingly pursues gain at the expense of others.

11. Statements (a) and (c) are normative and statements (b) and (d) are positive.


Chapter 2Some Tools of the Economist

OUTLINE

I. What Shall We Give Up?A. Opportunity Cost

1. Opportunity costa. The highest-valued activity sacrificed in making a choice.

b. Opportunity costs are subjective and vary across individuals.2. The opportunity cost of college.

a. Monetary cost: tuition, books.b. Non-monetary cost: forgone earnings.

1. If the opportunity cost of college rises (e.g. tuition rises), then one will be less likely to attend college.

II. Trade Creates ValueA. Voluntary Exchange1. When individuals engage in voluntary exchange, both parties are made better off.

2. By channeling goods and resources to those who value them most, trade creates value and increases the wealth created by society’s resources.

B. Transactions Costs1. Transactions costs: the time, effort, and other resources needed to search out, negotiate, and consummate an exchange.

a. Transactions costs reduce our ability to produce gains from potential trades.

C. Middleman1. Middleman: a person who buys and sells, or who arranges trades.A middleman reduces transactions costs.The Internet lowered transactions costs.

III. The Importance of Property RightsA. Private Property Rights

1. Property rights: the right to use, control, and obtain benefits from a good or service.

2. Several features of private property rights. a. They provide the right to exclusive use.b. They provide legal protection against invaders.c. They provide the right to transfer to another.

B. Private Property Rights Incentives1. Private owners can gain by employing their resources in ways that are beneficial to others and they bear the opportunity cost of ignoring the wishes of others



2. Private owners have a strong incentive to care for and properly manage what they own.


Chapter 2/Some Tools of the Economist 29

3. Private owners have an incentive to conserve for the future—particularly if the property is expected to increase in value.4. Private owners have an incentive to lower the chance that their property will cause damage to the property of others.

a. Private ownership links responsibility with the right of control.C. Private Property and Markets

1. When private property rights are protected and enforced, permission of the owner is required for use of a resource.

a. If you want to use a good or resource, you must either buy or lease it from the owner.

b. Individuals and firms are faced with the cost of using scarce resources.

2. Market prices provide a strong incentive for private owners to consider the desires of others and to use and develop resources that are highly valued by others.

IV. Production Possibilities CurveA. Shifting the Production Possibilities Curve Outward

1. An increase in the economy’s resource base would expand our ability to produce goods and services.2. Advancements in technology can expand the economy’s production possibilities.3. An improvement in the rules under which the economy functions can increase output.4. By working harder and giving up current leisure, we could increase our production of goods and services.

V. Trade, Output, and Living StandardsA. Division of Labor

1. Division of labor: breaks down the production of a commodity into a series of specific tasks, each performed by a different worker.2. Division of labor increases output for three reasons:

a. Specialization permits individuals to take advantage of their existing skills.

b. Specialized workers become more skilled with time.c. Permits adoption of mass-production technology.

B. Law of Comparative Advantage1. Law of comparative advantage: total output is greatest when individuals specialize in the production of goods that they produce at a low opportunity cost, and trade those goods for goods that they are a high-opportunity-cost producer.

a. The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

VI. Human Ingenuity and the Creation of Wealth A. Economic Pie

1. Economic goods are the result of human ingenuity and action; thus the size of the economic pie is variable.

30 Chapter 2/Some Tools of the Economist

a. At any point in time, our ability to produce goods and services is constrained by the availability of resources, technology, institutions and human effort.

b. With the passage of time, however, output can be expanded through investment and the discovery of better ways of doing things.

VII. Economic OrganizationA. Methods of Economic Organization

1. Market organization: A method or organization that allows unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems.

a. Sometimes market organization is called capitalism.2. Collective decision making is the method of organization that relies on public-sector decision making to resolve basic issues.a An economic system in which the government owns the income-producing

assets and directly determines what goods they produce is called socialism.b In a democratic process, decision-makers have to consider how their actions

will influence their election prospects. Otherwise, their tenure will be short.

OBJECTIVES

In this chapter, we introduce the student to some basic economic tools—opportunity cost, the production possibilities curve, the law of comparative advantage, property rights, and the theory of exchange. The basic description of these concepts, without applications, are often boring to the student. Accordingly, it is vitally important that, as instructors, we present interesting and creative examples to help the student to visualize and retain these concepts. Two alternative institutional arrangements—market and government planning—are available to deal with economic issues. In this chapter, basic tools are introduced and the stage is set for the following three chapters.


1. Clearly, opportunity cost is the most vital and widely applicable concept in economics. From the beginning, students should be taught to think of “costs” as “the highest-valued alternative given up when a choice is made.” Use of examples with which students can readily identify will help to reinforce the concept. What does the student give up when he studies economics for an hour? When she works ten hours per week? When he owns a car and drives 50 miles a week? In each case the answer is the highest-valued alternative that could have been chosen (consumed) had the choice not been made. Assignment of Critical Analysis question three will help the student understand this important concept.

2. The fact that trade creates value, the role of transactions costs, and the middleman’s reduction of transactions costs are introduced. Later in the chapter, the myth that trade is a zero sum game is dispelled. Students might gain from a discussion of why it might be considered “socially irresponsible” to sell a used car too cheaply, rather than waiting until a buyer comes along who puts a higher value on the car, and is willing to pay more. Of course, the resale market is a potential antidote to the problem.


3. The section on property rights is important. Students need to understand how privately held rights hold owners accountable, in an opportunity cost sense, for opportunities missed, and for potential options turned down. Additional examples of how local businesses or landowners might lose by overlooking new ways to meet consumer desires will help drive this point home. Discussion of Critical Analysis questions eight and nine will help students better understand the economic function of private property.

4. The concept of production possibilities provides the foundation for the constraints on aggregate supply that will be discussed later. Resources can be used to produce alternative commodities. However, when resources are being utilized efficiently, production of more of one good will necessitate less of something else being produced. There are no free lunches when resources are utilized efficiently. Be careful not to give students the impression that an economy confronts either an automatic or an immovable production possibilities curve. Institutional arrangements, work effort, the past investment rate, and economic efficiency are important determinants of an economy’s production possibilities.

5. The law of comparative advantage is introduced here since it ties in nicely with both opportunity cost and attainment of maximum output from one’s resource base. The concept is general and applies to specialization and trade between individuals, regions, and nations. It explains why specialization and trade can (and do) increase wealth. In our judgment, it is a mistake to relegate it to a chapter on international trade.

6. The myth dispelled in this chapter is the dangerous and increasingly popular misconception that when one person gains from a transaction another must lose. The myth can be used as a focus for a lively class discussion on exchange and economic nonsense.

7. It is difficult to overemphasize the importance of incentives and the broadness of this basic principle of economics. Critical Analysis question 14 should be an interesting starting point for a classroom discussion on this topic.

8. The conclusion of Chapter two would be an excellent time to give a short quiz. Ample questions, designed to test both understanding and application of the basic tools presented in these introductory chapters, can be found in the Microeconomic and Macroeconomic Test Banks.

9. Teachers are always looking for new examples illustrating the gains from specialization and trade. I have used one involving a “mythical” couple named Nancy and Ronnie to supplement the text presentation. Each must chop one cord of wood and decorate one room each day. Nancy can do either in one hour; Ronnie can chop a cord of wood in two hours and decorate a room in 1-1/2 hours. Starting from this basic data, the normal conclusions can be drawn about absolute advantage and comparative advantage, how comparative advantage is just another term for lower opportunity costs, gains from trade, and the limitations imposed by transactions costs (how long they haggle about the terms of trade must be weighed against the time savings from specialization).

10. Since this chapter is the main one dealing with the concept of opportunity cost, it needs to be emphasized that costs are attached to choices, not goods. One effective way to do this in class is to ask “What’s the cost of a car?” and then lead the students to see that their answers do not make sense without a verb describing what action involving a car is being contemplated. One


can speak of the cost of verbing a car (buying, owning, driving, insuring, borrowing, selling, etc.), but not sensibly of the cost of a car.

11. A way to integrate student understanding of how value is created and the crucial role of entrepreneurship in the process is to show students that all forms of creating value involve one or more of the following: resources are being moved from less- to more-valuable forms (what we typically think of as production does not create atoms; it simply rearranges them), from less- to more-valuable locations (the value created by transportation), from less- to more-valuable time periods (the value created through speculation), or from lower valuing to higher valuing uses and/or users (the value created through exchange). In each case, there is large dose of entrepreneurship in trying to discover higher-valued forms, locations, times, and higher-valuing users than others have discovered.

12. There are many illustrations that can be used to supplement the text’s discussion on the importance of property rights under differing incentive structures that are faced by different parties. Examples include why your athletic team’s coach wants you in better shape than you do, why your mother wants you to get better grades than you do, why draftees and jurors tend to be used inefficiently, and why damage deposits arise as a way to make renters act more like they were owners.

13. Games one to five described in the next section will help reinforce the material in chapter

two.

14. The “Applications in Economics” feature on endangered species is the first of several in the book, designed to show that economics can be fruitfully applied to contemporary problems in the real world—in this case, how private property rights can help solve problem of protecting endangered species.

15. This chapter includes three “Keys to Economic Prosperity” which highlights the main sources of economic prosperity. In all, 12 of the most important factors that underlie modern economic prosperity are included at appropriate places throughout the text. These “keys to prosperity” are also listed in the front cover end papers.

16. The addendum to the chapter gives a detailed numerical example of comparative advantage and the gains from trade. Going over a similar example in class helps reinforce the concepts of comparative advantage and gains from trade with students.

GAMES

1. Getting Dressed in the Global Economy

Type: In-Class AssignmentTopics: Specialization, interdependence, self-interest, consumer choice,

international linkagesTextbook: Chapter 1 The Economic Approach

Chapter 2 Some Tools of the EconomistMaterials Needed: noneTime: 20 minutes


Class limitations: works in any size class

Purpose

The advantages of specialization and division of labor are very clear in this example. The worldwide links of the modern economy are also illustrated. We depend on thousands of people we don’t know, won’t see, and don’t think of, in order to get dressed in the morning. Self-interest follows naturally from interdependence. Wages, profits, and rents give people the incentive to perform these varied tasks. We depend on them to clothe us, and they depend on our purchases for their income.


Instructions

Ask the class to answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question. The first question can be answered with a brief phrase. The second question is the core of the assignment and takes several minutes. Ask them to list as many categories of workers as possible. (Offering a dollar to the first student to list 20 categories adds a competitive element.) Question three introduces demand concepts; most of the determinants of demand can be introduced during its discussion. For the fourth question, ask the class to look at the country-of-origin tags sewn in their garments.

1. Where did your clothes come from?

2. Who worked to produce your clothes?

3. What things do you consider when buying a garment?

4. Where were your clothes produced (what countries)?

Common answers and points for discussion

1. Where did your clothes come from?

There are many possible ways to answer, but a majority of students say “the mall”, “K-Mart”, or another retail outlet. Some say “a factory”, “a sweatshop”, or “a foreign country.”

Mention the importance of markets here; (this can be emphasized by asking “Is anyone wearing something made by a friend or relative?) discuss distribution versus production.

2. Who worked to produce your clothes?

There is no end to the possible answers; garment and textile workers are obvious but most students will also list raw materials, transportation, management, design, or machinery. Some think more broadly to inventors, road crews, bankers, oil refiners, engineers, and accountants.

Three important points are specialization, interdependence, and self-interest.

3. What things do you consider when buying a garment?

Most answers focus on preferences (fit, style, quality, color). Price is cited less frequently. Ask about the importance of price until someone volunteers that income is important and the prices of substitute goods are important. Expectations of price change (e.g. “clearance sales”) can also be discussed. Few students mention complementary goods and most reject the idea of choosing a sweater to match a particular outfit. More convincing sets of complements involve activities and garments: skiing and insulated overalls; surfing and wetsuits; aerobics and spandex.

4. Where were your clothes produced (what countries)?

A large number of countries will be represented, even in small classes. Students are usually surprised to find how many garments are domestically produced. Asia is always well represented.


Latin American and European goods appear in smaller numbers. African products are conspicuously absent.

This pattern shows the limits of simple explanations such as “cheap labor”. Briefly discuss the importance of comparative advantage, specialization, exchange rates, tariffs and quotas.

2. Screwdrivers and Bloody Marys

Type: In-Class demonstrationTopics: graphing, opportunity cost, choiceTextbook: Chapter 2 Some Tools of the EconomistMaterials Needed: noneTime: 10 minutesClass limitations: works in any size class

Purpose

This activity leads students from a simple graphing exercise to the concepts of scarcity, opportunity cost and choice.

Instructions

Draw a graph with Bloody Marys on the horizontal axis and Screwdrivers on the vertical axis.

A Bloody Mary contains tomato juice and one shot of vodka. A Screwdriver contains orange juice and one shot of vodka. Assume we have plenty of orange juice and tomato juice, but only one small bottle of vodka, containing six shots.

How many Bloody Marys could we make, if we only made Bloody Marys?

How many Screwdrivers could we make if we only made Screwdrivers?

Could we make six of both drinks? Why not?

On your graph, show all the possible combinations of Bloody Marys and Screwdrivers that could be made, given a small bottle of vodka.

Points for discussion

The combinations will make a continuous line, since we could pour half drinks, or quarter drinks, or any fraction of either drink.

Several basic graphing techniques can be demonstrated: inverse relation, negative slope, linear relation, etc.

The economic points are more interesting. We can produce any combination, on or inside the line. If we produce inside the line, say two screwdrivers and two Bloody Marys, we are not fully using our resources. This is inefficient.


If we do use all of our scarce resources, increasing production of one drink requires sacrificing production of the other. This lost production is opportunity cost.

Scarcity, or limited resources, requires choice. Producing a Bloody Mary means we can not use those resources to produce a screwdriver. Opportunity costs exist whenever we make choices.

3. Realism and Models: An Analogy

Type: In-Class demonstrationTopics: modelsTextbook: Chapter two Some Tools of the EconomistMaterials Needed: airplane kit, sheet of paper, whirl-a-gig wing toy (Note: the whirl-a-gig

wing toy is a helicopter wing on a stick; it is often sold in museum gift shops, as well as toy stores.)

Time: 5 minutesClass limitations: works in any size class

Purpose

Students frequently complain about the lack of realism in economic models. This demonstration uses airplane toys to illustrate that simplicity can be an asset in modeling.

Instructions and points for discussion

Ask the class if a realistic model is better than an unrealistic model. Realism, of course, will be favored.

Show them the airplane model kit. Describe some of the details included in the model (rivets, canopy, struts, etc). Shake the box to rattle the large number of parts. This a fairly realistic model, although obviously not a real airplane. Its complexity adds realism, but at a cost; assembling the model is very time consuming. Drop the box on the floor. Tell the class, “this model (even when completed) can’t fly.”

Take the sheet of paper and fold it into a paper airplane. Show the class this new model. Its virtues include simplicity and ease of assembly, but it is less realistic than the hobby shop airplane: no rivets, no seats, no windows. Then throw the paper airplane and explain, “while less-detailed, this model can glide through the air.”

Show them the whirl-a-gig wing toy. This model looks nothing like an airplane—no body, no tail just a T-shaped piece of wood. Yet this model does something, the other two models can’t do: it actually generates lift. This toy displays the same aerodynamic principles as a real airplane wing; it truly flies. Twirl the stick between your palms and the whirl-a-gig toy will fly over your head.

Economic models are like the whirl-a-gig model. They are much less complex than the real world, but they can show how markets actually work.


4. A Short Trip with Many Contributors

Type: In-Class AssignmentTopics: Specialization, interdependence, self-interest, international

linkages, role of governmentTextbook: Chapter 2 Some Tools of the EconomistMaterials Needed: noneTime: 20 minutesClass limitations: works in any size class

Purpose

This assignment shows the advantages of specialization and division of labor, and global links. It also introduces concepts of public and private financing.

Instructions

Ask the class to answer the following questions. Give them time to write an answer to a question, then discuss their answers before moving to the next question.

1. Think of a recent trip you have taken. The distance traveled is unimportant, just choose a specific trip. Where did this trip start and finish?

2. Who produced the goods and services that made your trip possible? (List as many types of workers as possible.)

3. How were the different elements of your trip financed? (e.g. the vehicle, the road network, or the airport).


Who produced the goods and services that made your trip possible?

The specific answers will vary depending on the mode of travel. The discussion below focuses on automobiles but the ideas easily extend to airplanes, busses, trains, or boats.

Most students will include autoworkers, gas station attendants and, if they traveled through snow, road maintenance crews. These answers touch on three important elements—the vehicle, the fuel, and the transportation network—but the details are much more complex. Any single element represents the work of a vast interlinking network of firms and individuals.

Look, for example, at a car produced in Michigan. This car is made up of thousands of components, including tires produced in Ohio. These tires are made of many materials including rubber, produced from petroleum. The petroleum, perhaps, was refined in New Jersey from oil pumped from the North Sea. Extracting this oil required a multitude of resources including warm clothing for the drill workers. One essential garment could be a warm parka filled with goose down. The down comes from geese raised in southern China.


This can be repeated in a million directions for any individual component—miners to extract ores, cooks to feed the miners, farmers to supply the cooks. Of course a crowd of others are needed: accountants, designers, managers, inventors, engineers, janitors, secretaries, computer operators, communications technicians, chemists, and so on.

And this is only for the automobile itself. The roads have been constructed through a similar web of work, from the cement mixers to workers who produce the tiny glass beads that make highway paint reflect light. Similarly the fuel has passed through a chain of retailers, jobbers, refiners, shippers, and oil field workers.

One important point is the complexity and connectedness of the modern economy. Change in one part of the world can affect many other countries. A second point is people work to earn money. The Chinese goose farmer isn’t motivated by concern for an automobile produced 7000 miles away, or even for the individuals wearing the goose down parka. He works to better his own economic well-being. Wages, profits, and rents coordinate this complex network.

How were the different elements of your trip financed?

Public and private financing are both involved in transportation. The students (or their parents) typically pay for gasoline, automobiles, airfare, or bus tickets, often using some form of credit. Highways, roads, and airports are usually publicly financed through bonds and taxes.

This can be a good place to introduce credit markets, their regulation, and the role of government.

5. Lawless Transactions

Type: In-Class DemonstrationTopics: the legal system and property rightsTextbook: Chapter 2: Some Tools of the EconomistMaterials Needed: a volunteer, a paper sackTime: 15 minutesClass limitations: works in any size class

Purpose

This example shows the importance of the legal system as part of the institutional framework of a market system. It illustrates that even simple market transactions rely on an established body of law. Four required elements for a legal system can be demonstrated. A legal system needs to: 1) enforce contracts 2) define and protect property 3) prevent fraud 4) define and enforce liability.

Instructions

Explain that the transactions in this example are only hypothetical; no money or goods will actually be exchanged.

Ask the volunteer how much he or she would be willing to pay for a backpack.

Agree to the offered price. This represents a typical market transaction, a good in exchange for a payment. While this transaction seems very straightforward it won’t work without a legal system.


Ask the volunteer, “What if you paid me, but I didn’t give you anything in exchange? Would you be happy?”

Markets won’t work if agreements are not honored. A legal system can eliminate this problem by enforcing contracts.

Now take a backpack from another student. Give it to the volunteer. In this case, both the buyer and seller are satisfied. The volunteer gets a backpack, the professor gets paid. Ask the class if anyone is unhappy?

The problem here is one of property rights. The professor has appropriated another student’s backpack. This causes several problems for market transactions. If property is not protected, the volunteer has little incentive to buy the backpack since he or she could steal it and pay nothing. Further, the volunteer has little incentive to pay for something that could immediately be stolen by someone else. The legal system needs to define and protect property rights to allow market transactions to work.

Return the backpack to its owner.

Now give the volunteer a paper sack. Tell the volunteer you have a legally binding contract and you expect full payment. The problem here is misrepresentation. Legal systems can prevent this problem by stopping fraudulent contracts.

Finally tell the volunteer that you have a new backpack made of a high-tech material developed in the Chemistry department. It’s very strong, very light and very fashionable. You make the transaction and everyone is happy. A couple of weeks pass, and the volunteer is studying in the library when the backpack bursts into flames and explodes. The new backpack material was internally unstable. The entire library burns down. Who should pay?

Is the student responsible for the damages? Should the professor pay? Or should the Chemistry department be responsible? Determining liability is another important role for the legal system.


The transitional economies of Eastern Europe provide daily examples of the problems of markets without established legal systems. Markets can be a very effective tool for allocation and distribution, but they only work within a social framework.

Definition of property rights may be trivial for personal property like a backpack, but more generally it’s very important. Changes in property rules can cause big gains and losses. Environmental regulations (particularly those regarding wetlands or endangered species) and intellectual property rights have been recent controversies over property definition.

Defining liability continues to be an important public issue.



1. False. Jones must value the car more than $5,000 and Smith less than $5,000 or otherwise the exchange would not take place.

3. The rational decision-maker would choose the bus if the opportunity cost of his/her time was $6 per hour, be indifferent between traveling by bus or flying if the opportunity cost of his/her time was $10 per hour, and would choose flying over traveling by bus if the opportunity cost was greater than $10 per hour (as in the case of $14).

4. The statement reflects the view that “exchange is a zero sum game.” This view is false. No private business can force customers to buy. Consumers purchase various goods and services from businesses because they gain by doing so. If they did not gain, they would not continue to purchase items from a business. Similarly, the business firms also gain from their production and sale activities. Mutual gain provides the foundation for voluntary exchange, including that between business firms and their customers.

5. The major function of the middleman is to increase the value of resources by reducing transaction costs and thereby facilitating the movement of goods and services into higher-valued uses. The people would be worse off without middlemen since transaction costs would be higher and less trade would occur.

11. If consumer demand for beef fell, the profitability of cattle herding would fall as well. Many cattle farmers would let their cattle herds dwindle and quit keeping cattle altogether. The result would be a smaller population of cattle, not a larger one. Because cattle are privately owned, an increase in their value in human consumption results in more cattle being kept, whereas a decrease would result in fewer cattle. To “save the cows,” you should eat more beef!

Chapter 3Supply, Demand, and the Market Process

OUTLINE

I. Consumer Choice and Law of DemandA. Law of Demand

1. Law of Demand: There is an inverse relationship between the price of a good and the quantity consumers are willing to purchase.

a. As price of a good rises, consumers buy less.b. The availability of substitutes—goods that do similar functions

—explains this negative relationship.B. Market Demand Schedule

1. The height of the demand curve at any quantity shows the maximum price that consumers are willing to pay for that additional unit.

C. Consumer Surplus1. Consumer Surplus: the area below the demand curve but above the actual price paid.

a. Consumer surplus is the difference between the amount consumers are willing to pay and the amount that they have to pay for a good.2. Lower market prices will increase consumer surplus.

D. Elastic and Inelastic Demand Curves1. Elastic demand: quantity demanded is sensitive to small price changes.

a. Easy to substitute away from good.2. Inelastic demand: quantity demanded is not sensitive to price changes.

b. Difficult to substitute away from good.II. Changes in Demand Versus Changes in Quantity Demanded

A. Changes in Demand and Quantity Demanded1. Change in Demand: shift in entire demand curve.

2. Change in Quantity Demanded: movement along the same demand curve in response to a price change.

B. Demand Curve Shifters1. Changes in Consumer Income2. Change in the Number of Consumers3. Change in Price of Related Good4. Changes in Expectations5. Demographic Changes6. Changes in Consumer Tastes and Preferences

III. Producer Choice and Law of SupplyA. Producers


1. Opportunity Cost of Production: the sum of the producer’s cost of employing each resource required to produce the good.


Chapter 3/Supply, Demand, and the Market Process 43

2. Firms will not stay in business for long unless they are able to cover the cost of all resources employed, including the opportunity cost of those owned by the firm.

B. Role of Profits and Losses1. Profit occurs when revenues are greater than cost.

2. Firms supplying goods for which consumers are willing to pay more than the opportunity cost of resources used will make a profit.3. Firms making a profit will expand and those with a loss will contract.

C. Law of Supply1. Law of Supply: there is a positive relationship between the price of a product and the amount of it that will be supplied.

a. As the price of a product rises, producers will be willing to supply more.

D. Market Supply Schedule1. The height of the supply curve shows two points about the cost of production.a. The minimum price necessary to induce producers to supply that additional

unit.b. The opportunity cost of producing the additional unit of the

good.E. Producer Surplus

1. Producer Surplus : The area above the supply curve but below the actual sales price.

a. Producer surplus is the difference between the minimum amount required to induce producers to produce a good and the amount they actually receive.

F. Elastic and Inelastic Supply Curves1. Elastic supply: quantity supplied is sensitive to small price changes.2. Inelastic supply: quantity supplied is not sensitive to price changes.

IV. Changes in Supply Versus Changes in Quantity SuppliedA. Changes in Supply and Quantity Supplied

1. Change in Supply: shift in entire supply curve.2. Change in Quantity Supplied: movement along the same supply curve in response to a price change.

B. Supply Curve Shifters1. Changes in Resource Prices2. Change in Technology3. Elements of Nature and Political Disruptions4. Changes in Taxes

V. How Market Prices are Determined: Supply and Demand InteractA. Prices bring the conflicting forces of supply and demand into balance.

1. There is an automatic tendency for market prices to move toward the equilibrium price, at which the quantity demanded equals the quantity supplied.

44 Chapter 3/Supply, Demand, and the Market Process

VI. How Markets Respond to Changes in Demand and SupplyA. Effects of a Change in Demand

1. If Demand decreases, the equilibrium price and quantity will fall.2. If Demand increases, the equilibrium price and quantity will rise.


B. Effects of a Change in Supply1. If Supply decreases, the equilibrium price will rise and the equilibrium quantity will fall.2. If Supply increases, the equilibrium price will fall and the equilibrium quantity will rise.

VII. Invisible Hand PrincipleA. Invisible Hand

1. Invisible Hand: the tendency of market prices to direct individuals pursuing their own interest into productive activities that also promote the economic well-being of society.

B. Communicating Information1. Product prices communicate up-to-date information about consumers’ valuation of additional units of each commodity.2. Without the information provided by market price it would be impossible for decision-makers to determine how intensely a good was desired relative to its opportunity cost.

C. Coordinating Actions of Market Participants1. Price changes bring the decisions of buyers and sellers into harmony.2. Price changes create profits and losses which change production levels.

D. Prices and Market Order1. Market order is the result of market prices, not central planning.

E. Qualifications1. The efficiency of market organization is dependent upon:

a. The presence of competitive markets.b. Well-defined and enforced private property rights.

OBJECTIVES

In this chapter, we illustrate how markets work and why pricing signals are so important. Basic supply and demand analysis is developed. However, the text places greater emphasis than most textbooks on (a) the market as a process and (b) the period of time needed for purchasers and suppliers to respond fully to changes in market prices. In our judgment, this adds realism to the material and helps to convince the student that market prices really do matter. It also lays the groundwork for future discussions on (a) the search theory of unemployment, (b) uncertainty as to whether an increase in demand is temporary or permanent, and (c) adjustment of secondary markets to economic changes. One cannot fully understand today’s macroeconomic problems without understanding these microeconomic concepts.

This chapter also discusses the role played by market prices as they communicate information, coordinate the actions of economic decision makers, and motivate participants to undertake economic activity. This discussion supplements the analysis of how market prices answer the three basic economic questions. Unless students understand (a) what market prices are doing and (b) why prices influence the actions of individuals, they will never be able to grasp the concept of the “invisible hand.”



1. Our experience suggests that failure to distinguish between changes in demand and changes in quantity demanded is among the most common mistakes in economics. Use Exhibit four to clarify this distinction. List the major factors (changes in income, prices of related goods, consumer preferences, number of buyers, and expected future prices) that cause demand to change (the curve to shift). Point out that a change in the price of a product causes a change in quantity demanded, but not a change in demand. Critical Analysis questions one and two should help students to see the distinction more clearly.

2. Consumer choices underlie the demand curve. Changes in factors (other than product price) that influence consumer decisions will cause a change in demand. The choices of producers underlie the supply curve. Therefore, changes in such things as input prices, production technology, and taxes will cause the supply curve to shift since these factors influence the producer’s costs.

3. Changes in one market often have feedback effects that alter the market conditions for productive resources and related products. Students should begin to see how markets are interrelated.

4. Exhibit 10 summarizes the concepts of supply, demand, and market equilibrium. Most instructors will want to go over this exhibit (or one similar to it) in class.

5. The impact of Alfred Marshall on modern economics has been enormous. The outstanding economist feature profiles his contribution to the development of economics.

6. Economists often neglect one of the most important functions of market prices—the ability to summarize and communicate information. The section in Chapter three on the invisible hand principle adds perspective to the mechanical material on supply and demand. Market prices inform decision makers, motivate individuals to action, and coordinate the behavior of economic participants who neither see nor are fully aware of each other. Economists from Adam Smith to Nobel laureate Friedrich van Hayek have emphasized the importance of these functions. When instructors gloss over these points, they fail to fulfill their responsibilities to students.

7. The Critical Analysis questions provide material that will both stimulate classroom discussion and help students better understand the primary topics covered in this chapter.

8. A marble in a perfectly rounded bowl provides an analogy that may help students understand the process of adjustment toward equilibrium and the role of comparative static equilibria. A marble placed at the exact bottom of the bowl with no momentum will tend to stay there because there is no force pulling it away; placed anywhere else, there will be a force pulling it back toward the bottom. In market systems, the force that replaces gravity is the frustration of transactors unable to trade at current prices. Frustrated buyers at below equilibrium prices have incentives to offer sellers a better deal as a way to be able to trade, and similarly for sellers at above equilibrium prices. Just as with the marble in the bowl, however, adjustment is not instantaneous. There may be some overshooting, and predicting the actual dynamic movements over time is far more difficult than comparisons of static equilibria.


9. A useful extension of the supermarket lines example for spontaneous coordination would be to see what would happen to traffic if the rules of the road were unpredictable (e.g., what if the “real” speed limit is unknown, if laws changed between cities, etc.).

10. A good illustration of markets in action is the response of Canadians to tax differences on cigarettes in the United States and Canada. As a result of taxes, Canadian-blend cigarettes are often substantially cheaper in the United States than in Canada. Despite additional transportation and transaction costs, Canadians often purchase the cigarettes in the United States and smuggle them into Canada. Several colorful attempts have been documented, including smuggling by kayakers, cigarettes stuffed inside car doors, and even into turkeys.

11. The games one to five in the next section provide suggestions about how to help your students gain a greater appreciation for the tools of supply and demand.

12. Remember that changes in the opportunity costs of owned resources (e.g., a farmer’s own land) have the same analysis as change in the explicit costs of resources hired in markets.

13. In applying supply and demand analysis, students can be shown that if either curve shifts, it will result in either a shortage or surplus at the current price, which is what sets the market adjustment process in motion.

GAMES

1. A Market Example

Type: In-Class DemonstrationTopics: Individual demand, market demand, equilibrium price, allocationTextbook: Chapter 3: Supply, Demand, and the Market ProcessMaterials Needed: a bag of Pepperidge Farm cookies (15 cookies),

5 volunteersTime: 35 minutesClass limitations: works in large lectures or small classes with over 15 students.

Purpose

This is an example of a real-world market, where real goods are exchanged for real money. It is a free market, so there will be no coercion, but participants should think carefully about their answers since actual trades will take place.

Instructions

Ask for five volunteers to participate in a market, a market for Pepperidge Farm Milano cookies. Read some of the package copy describing these “distinctively delicious” cookies. Write each volunteer’s name on the board.

Ask the volunteers how many cookies they would be willing to buy at various prices. Record these prices and quantities.


Give the volunteers the opportunity to revise their numbers, if the figures don’t accurately reflect their willingness to pay. Remind them this isn’t a hypothetical exercise and they will have to pay real money.

At this point there will be five individual demand curves, which can be graphed if desired.

Add the individual quantities at each price to find the market demand at that price. This overall demand is used to find the market equilibrium. Sketch a graph of the market demand.

Supply, in this case, is fixed at the number of cookies in the bag. There are fifteen cookies. No more can be produced, and any leftovers will spoil. This gives a vertical supply curve in the very short run at Q = 15. Sketch the supply curve.

Try various prices until the individual quantities sum to 15. This will give the equilibrium price and quantity.

Distribute the cookies and collect money from each participant.

An example:How many of these cookies, if any, would you be willing to buy at a price of $10 per cookie?

How many cookies would you be willing to buy at a price of $0.01 per cookie?

How many cookies, if any, would you be willing to buy at a price of $0.50 per cookie?

How many cookies, if any, would you be willing to buy at a price of $0.25 per cookie?

Our volunteers give the responses below. The market quantity is the sum of the individual quantities at each price.

Maria Ricardo Amy Jay MarketPrice Quantity$10 0 0 0 0 0

0.50 0 2 1 3 6

0.25 1 4 2 4 11

0.01 6 100 50 25 181

We look at the intersection of this supply curve with the market demand curve to find our equilibrium point. In this example, our equilibrium will occur at some price below 25¢ and above 1¢.

For Example:Maria Ricardo Amy Jay Market

Price Quantity$0.20 2 5 3 5 15


This is the equilibrium price. At this price the market clears. Once the price is established, we allocate the goods based on individual demand, so Maria buys two cookies at 20¢ each, Ricardo buys five cookies, Amy, three and Jay, five.


The demand curves display the typical inverse relation between price and quantity. Remark on any unusual patterns. These tell us about each individual’s willingness to pay and reveal information about the marginal benefits of additional cookies to each consumer.

Market demand is aggregated from individual demand curves.Notice the consumers do not get an equal number of cookies. This is typical of markets, since tastes and incomes vary across individuals.

Also notice that the total cost to the consumers is equal to the total revenue to the firm, Price Quantity.

2. Supply and Demand Article

Type: Take-home assignmentTopics: shifts in supply or demand, changing equilibriumTextbook: Chapter 3: Supply, Demand, and the Market ProcessClass limitations: works in any class

Purpose

This assignment is an excellent discriminator. Students who have difficulty with it often need remedial help. Allowing students to correct errors and then resubmit the assignment can be worthwhile since it is fundamental to their understanding of how markets work.

Instructions

Warn students to avoid advertisements since they contain little information. They should be wary of commodity and financial markets unless they have a good understanding of the particular market. Markets for ordinary goods and services are most easily analyzed.


Most changes will only shift one curve, either supply or demand, not both. Remind students that price changes will not cause either curve to shift. (But shifting either curve will change price.)

Equilibrium points are not fixed. They change when supply or demand changes. Prices will not necessarily return to their previous levels nor will quantities.

Remind the class of the fundamental relations:1. Increases in demand cause price and quantity to increase.2. Increases in supply cause price to decrease and quantity to increase.3. Decreases in demand cause decreases in price and quantity.4. Decreases in supply cause price increases and quantity decreases.


Name _________________________ Course _______________________

Supply & Demand

Find an article in a recent newspaper or magazine illustrating a change in price or quantity in some market.

Analyze the situation using economic reasoning.

Has there been an increase or decrease in demand? Factors that could shift the demand curve include changes in preferences, changes in income, changes in the price of substitutes or complements, and changes in the number of consumers in the market.

Has there been an increase or decrease in supply? Factors that could shift the supply curve include changes in costs of materials, wages, or other inputs, changes in technology, and changes in the number of firms in the market.

Draw a supply and demand graph to explain this change. Be sure to label your graph and clearly indicate which curve shifts.

Turn in a copy of the article along with your explanation.

Date of Article ___________ Source __________________________________


3. Campus Parking

Type: In-Class AssignmentTopics: demand, supply, disequilibrium, shortage, rationingTextbook: Chapter 3: Supply, Demand, and the Market ProcessMaterials Needed: a shortage of student parking on campusTime: 35 minutesClass limitations: works in large lectures or small classes, if there is a campus parking

problem.

Purpose

Nothing seems to generate more heated discussion than campus parking. If your school has a parking shortage this assignment brings the ideas of price rationing and resource allocation to an issue close to the students’ hearts.

A. K. Sen’s parable of the bamboo flute is a good introduction to this assignment: An artist makes a beautiful instrument that becomes famous throughout the country. A number of claimants arise, each of whom argues that they deserve the flute: the artist who created it, the most-talented musician, the poorest, most-needy citizen, and the hardest-working musician, etc. Who deserves the flute? Students will have different opinions on who is most deserving but many will accept a market solution—the person who is willing to pay the most (who has the highest marginal benefit, given the existing distribution of wealth and income). The allocation of campus parking spots makes a nice parallel.

Instruction



1 and 2. Write down three things that are true about the parking situation on campus. What two problems do you think are most important?The parking problem has two components in the eyes of most students. Parking permits are too expensive and there are too few spaces.

3. What policies could the administration take to resolve these problems?Students have many policies to alleviate the situation. The most common suggestion is to ban parking for freshmen. Freshmen respond with lists of other groups who should be banned. Another popular policy would be to open faculty lots to student parking. Parking fees should be lowered or better yet eliminated. Parking violations should have lower fines. More lots should be built. Shuttles, moving sidewalks, and monorails should be installed.

Students never suggest raising prices to reach a market solution.

4 and 5. Who needs parking the most? Who would pay the most for parking?Asking about need and willingness to pay moves the discussion away from group prohibitions; freshmen may be just as needy and equally able to pay.


6. Use a supply and demand graph to analyze this problem.Many students initially have difficulty graphing this problem. They want to illustrate that permit prices are too high, but then their graph won’t show the shortage. Eventually they can be convinced that parking, while expensive, is actually priced too low.

7. How would your policy proposals affect the market for parking?Analysis of the various proposals in a supply and demand framework shows some popular policies, like free permits, would aggravate the parking shortage. Policies to restrict demand can reduce the shortage, although there will be inefficiencies in the resulting allocation. Building more parking lots isn’t a shift in the supply curve. New construction is an increase in quantity along the existing supply curve. The additional costs need to be covered by some means: higher parking fees, tuition increases, or taxpayer subsidies.


Name _________________________ Course _________________

Campus Parking

1. Write down three things that are true about the parking situation on campus.

2. What two problems do you think are most important?

3. What policies could the administration take to resolve these problems?

4. Who needs parking the most?

5. Who would pay the most for parking?

6. Use a supply and demand graph to analyze this problem.

7. How would your policy proposals effect the market for parking?


4. Cold Soda

Type: In-Class demonstrationTopics: Demand, substitutes and changing demandTextbook: Chapter 3: Supply, Demand, and the Market ProcessMaterials Needed: a teaching assistant to tally quantitiesTime: 15 minutesClass limitations: works in large classes

Purpose

This activity demonstrates the demand curve’s inverse relation between price and quantity. Students answer a series of questions about their willingness to pay. A teaching assistant collects their answers and then sums their responses, while the instructor lectures on other material. Two demand curves are found from the class responses, one with, and one without a substitute good. These are shared with the class.

Instructions

Ask the students to answer the following questions. These are hypothetical questions; no exchange will actually take place.

1. “Assume I have a cooler of ice-cold Pepsi-Cola. If I offered to sell you a Pepsi for $1.50 would you be willing to buy one? (Yes or no?)”

2. “If I offered to sell you a Pepsi for $1.00 would you be willing to buy one? (Yes or no?)”




6. “Now assume I have two coolers, one full of ice-cold Pepsi-Cola and one full of ice-cold Coca-Cola. I am going to repeat my offers to sell Pepsi, but now consider the availability of Coke. Assume Coke is available as an alternative, and the price of Coke is always $0.75. You can buy either Pepsi, or Coke, or nothing.”

7. “If I offered to sell you a Pepsi for $1.50 would you be willing to buy one? (Answer ‘Yes’: if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you would buy nothing.)”






Collect the student’s responses and have your assistant add the number of “yes” votes for each question.


Use the first five questions to draw a demand curve for Pepsi. More students will be willing to buy Pepsi as its price decreases.

Use questions 6-10 to draw a second demand curve for Pepsi. This demand curve shows the impact of lowering the price of a substitute good. (The price of Coke was essentially infinite for the first questions, and it has dropped to $0.75 for the second set of questions.) The demand for Pepsi will still be downward sloping, but fewer students will choose Pepsi at any given price. This illustrates the decrease in demand when a substitute’s price decreases.


5. Value of a Time Machine

Type: In-Class DemonstrationTopics: Consumer surplusTextbook: Chapter 3: Supply, Demand, and the Market ProcessMaterials Needed: noneTime: 10 minutesClass limitations: works in any size class

Purpose

Consumer surplus can be a hard concept for students because it’s based on avoided expense rather than on money that is actually exchanged. This example puts a specific dollar value on consumer surplus.

Instructions

Tell the class, “a new technology has been developed that allows individuals to travel backward or forward in time. We want to identify the value this time machine provides to consumers. Let’s assume the four consumers who most desire this product are in this class.”

Choose four student names and use them in the following example.

“Scott is the consumer who most values this product. He wants to go back to the time of the dinosaurs. He is willing to pay $3000.”

“Carol is the consumer with the next highest willingness-to-pay. She would like to see 200 years in the future. She’d pay $2500. “

“Steve is the next highest bidder. He’d like to relive this entire semester. He’ll pay up to $800.”

“Jeanne is our fourth consumer. She’d pay $200 to move the clock forward to the end of this class period.”

On the board write:Scott $3000Carol $2500Steve $800Jeanne $200

“This represents the demand curve for the time machine. Consumer surplus is the difference between what consumers are willing to pay and the amount they actually have to pay. The market price will determine who uses the time machine and how much surplus they keep.”

“If the price of a time machine ride was $500, 3 rides would be sold—one to Scott, one to Carol, and one to Steve. Jeanne is not willing to pay $500, so she wouldn’t time travel.”


“We can calculate the consumer surplus of three time trips. Scott would pay $3000 but only pays $500 leaving $2500 of net benefits.” (Put these numbers on the board.) “Carol has net benefits of $2000. Steve has $300 in net benefits. Adding up these net savings gives $4800 in Consumer Surplus.”


The consumer surplus depends on a good’s selling price and the number of consumers who are willing to purchase the good at that price. The lower the price the greater the consumer surplus.


14. Questions for thought: What happened to the cost of producing calculators during the period? How would this affect the supply curve and price of the calculators?

15. Substitutes are good that perform similar functions (pencils and pens). Complements are goods that are consumed jointly (butter and bread)

16. Business firms do have a strong incentive to serve the interest of consumers, but this is not what motivates them. Instead, they are motivated by self-interest and the pursuit of income, but they must provide consumers with a quality product if they are going to be successful. Good intentions are not required for people to engage in actions that are helpful to others.

Chapter 4Supply and Demand: Applications and Extensions

OUTLINE

I. The Link Between Resource and Product MarketsA. The markets for resources and products are closely linked.

1. Changes in one will affect the other.a. An increase (decrease) in resource prices will reduce (increase)

supply in the product market.b. An increase in product demand will increase the demand for

resources used in production of the good.II. Economics of Price Controls

A. Price Ceilings1. A price ceiling is a legally established maximum price that sellers may charge.

a. Example: rent control2. The direct effect of a price ceiling below the equilibrium price is a shortage: quantity demanded exceeds quantity supplied.

B. Secondary Effects of Price Ceilings1. Reduction in the quality of the good.2. Inefficient use.3. Lower future supply.4. Non-price rationing will be of more importance.

C. Effects of Rent Control1. Shortages and black markets will develop.2. The future supply of housing will decline.3. The quality of housing will deteriorate.4. Non-price methods of rationing will increase in importance.5. Inefficient use of housing will result.6. Long-term renters will benefit at the expense of newcomers.

D. Price Floor1. Price floor is a legally established minimum price that buyers must pay.

a. Example: minimum wage2. The direct effect of a price ceiling below the equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

E. Minimum Wage Effects1. Direct effect.

a. Reduces employment of low-skilled labor.2. Indirect effects.

a. Reduction in non-wage component of compensation.


b. Less on-the-job training.3. A higher minimum wage does little to help the poor.

III. Black Markets and the Importance of the Legal StructureA. Black Markets

1. Black market: markets that operate outside the legal system.a. Either sell illegal items or items at illegal prices or terms.

2. Black markets have a higher incidence of defective products, higher profit rates, and greater violence.

B. Legal System1. A legal system that provides secure property rights and unbiased enforcement of contracts enhances the operation of markets.

IV. The Impact of a TaxA. Tax incidence

1. The legal assignment of who pays a tax is called the statutory incidence.a. The actual burden of a tax (actual incidence) may differ

substantially.V. Tax Rates, Tax Revenues, and the Laffer Curve

A. Average Tax Rate1. Average tax rate equals tax liability divided by taxable income.

a. Progressive tax is one in which the average tax rate rises with income.

b. Proportional tax is one in which the average tax rate stays the same across income levels.

c. Regressive tax is one in which the average tax rate falls with income.

B. Marginal Tax Rate1. Marginal tax rate equals change in tax liability divided by change in taxable income.

C. Tax Rate and Tax Base1. Tax rate is the percentage rate at which an economic activity is taxed.

2. Tax base the level of the activity that is taxed.a. The tax base is inversely related to the rate at which the activity

is taxed.D. Laffer Curve

1. Laffer curve illustrates the relationship between tax rates and tax revenues.a. Laffer curve shows that tax revenues are low for both low- and

high-tax rates.b. The point of maximum tax revenue is not optimal because of

high excess burden.E. Laffer Curve and Tax Changes in the 1980s

1. During the 1980s, the top marginal income tax rate fell from 70% to 33%.2, Need to distinguish between changes in tax rates and changes in tax revenues.


Chapter 4/Supply and Demand: Applications and Extensions 61

a. Between 1980 and 1990 real income tax revenue collected from the top one percent of earners rose a whopping 51.4 percent.

62 Chapter 4/Supply and Demand: Applications and Extensions

VI. The Impact of a SubsidyA. Benefit of a Subsidy

1. The division of a benefit from a subsidy us determined by the relative elasticities of demand and supply rather than to whom the subsidy is actually paid.

OBJECTIVES

In this chapter, we provide applications of supply and demand analysis in a variety of contexts. The applications emphasize that trading can take place in many different forms. For example, a market can be legal or illegal, formal or informal. The first part of the chapter analyzes wage rates within a supply-and-demand framework. The chapter then discusses the impact of government intervention in several types of markets. First, this chapter investigates the effect of price ceilings such as rent control as well as price floors such as minimum wages. Second, the text explores black markets. Third, the chapter discusses the impact of a tax on a market. In particular, the distribution of the tax burden between buyers and sellers. Fourth, the chapter considers the impact of taxes on the incentive to earn, as well as report, taxable income. Tax avoidance is introduced as a natural offspring of the relative price changes induced by taxation. Fifth, the chapter examines the impact of a subsidy on a market. It emphasizes that the distribution of the benefits from the subsidy is determined by the relative elasticities of supply and demand.


1. An important point in the first application is the connection between markets. That is, changes in one market will lead to changes in other markets and alter the relative prices of many goods. It is worthwhile to emphasize this point.

2. The rent control discussion of quality changes and the price of a product highlights the multidimensional nature of economic terms of trade. When monetary prices play a lesser role in exchange, non-price factors, such as quality adjustments, congestion, and discrimination, will play a larger role. Be sure to indicate that quality deterioration (holding money price constant) is an alternative means by which producers can increase the real price to the consumer.

3. Attempts to repeal the laws of supply and demand are continually being made by legislative bodies. Current examples familiar to students will reinforce the analysis of the text. In each case, discussion of the shortage or surplus and quality adjustments that result from attempts to control prices will help students understand the secondary effects of price controls.

4. Exhibit four illustrates that minimum wage legislation reduces the quantity of employment available to low-skill workers. As in the case of other price floors, the minimum wage elevates the importance of non-price methods of rationing. When legislation keeps wages of low-skill workers above the market equilibrium, low-skill workers will confront more unemployment (waiting in line for the minimum-wage jobs), more employment discrimination, and less opportunity for job training. Point out that these are simply examples of non-price factors that increase in importance when wages of low-skill workers are pushed above market equilibrium.

5. Critical Analysis question eight provides material that will stimulate classroom discussion of black markets.


6. The concept of deadweight loss is both important and elusive. Be sure to emphasize that it reflects the loss of the gains from mutually beneficial economic activity that does not take place because taxation increases the personal cost of the activity.

7. The analysis of the burden of a tax under differing price elasticities of demand and supply serves to illustrate the usefulness of the elasticity concept as well as to explain some of the key problems in tax policy.

8. A good analogy to the tax incidence discussion in the text is the game of dodge ball. The government throws the balls (taxes) because they want to hit the players (raise revenue, which can only come from someone in society), and they want to throw balls where they will successfully hit people, that is, where the people cannot dodge very well (inelastic suppliers or demanders)—if people could dodge perfectly, there would be no point in throwing the balls. The fraction of the burden (incidence) borne by each of the two groups, suppliers and demanders, is determined by those who can most easily alter their behavior (the group with the more elastic behavioral response will be better able to dodge the tax, dumping a larger share of the burden on others).

9. Since the Laffer curve is merely a reflection of the relative price effects of taxation, we introduce it in this chapter. Be sure to emphasize that relative price effects reduced the size of the tax base on both the upward-sloping and the backward-bending portion of the Laffer curve. The difference is that the impact of the higher tax rate on output dominates the revenue effect on the backward-bending portion. Unless you note otherwise, many students will believe that the point of maximum revenue on the Laffer curve (Exhibit 11, point B) is optimal. Actually this point implies that tax revenue is infinitely inelastic with respect to an increase in tax rates. Be sure to point out that the excess burden of taxation is exceedingly large as this point is approached.

10. In the discussion of the Laffer curve be sure to distinguish between an individual’s average tax rate and his or her marginal tax rate. Of course, the marginal tax rate is more relevant to the decision making of taxpayers. One side effect of a high marginal tax rate is that tax-deductible purchases become cheap. Ask students whether they think that high-income persons should face high marginal tax rates. Then ask them if they think that tax-deductible goods (business-related vacations, luxury hotels, and expensive business lunches, for example) should be cheap for high-income persons. Point out that the former emanates from the latter.

11. A good application of marginal tax rate analysis is to discuss the idea of the importance of the cumulative marginal tax rates across all tax and subsidy programs. In particular, the cumulative marginal tax rate for those in multiple means-tested “welfare” programs, for senior citizens subject to the social security earnings tax, and on income from capital (including property taxes, state and federal corporation taxes, capital gains taxes on (unindexed) increases in asset values, and taxes on dividends), can be shown to be far higher than commonly thought.

12. The Laffer curve discussion of marginal tax rates and incentives should be clearly related to the data on how the tax cuts of the 1980s affected the distribution of the tax burden among income groupings.


13. To show students the importance of correctly understanding incidence analysis, it is often worth discussing why there are so many hidden taxes designed to burden people without them being very aware of government as the source of that burden (the squawk minimization principle). Examples include the employer half of social security taxes, corporate income taxes, and mandated benefits for employees.

14. Games one to two will help reinforce the material in chapter 4.

GAMES

1. Ducks in a Row

Type: In-Class demonstrationTopics: price ceilings, subsidies, and unintended consequencesTextbook: Chapter 4: Supply and Demand: Applications and Extensions Materials Needed: 2 toy ducks, some play money, 3 volunteersTime: 10 minutesClass limitations: works in any size class

Purpose

This demonstration illustrates some common problems of government intervention in markets.

Instructions

One volunteer plays the role of the government in a poor country. Give the play money to the “government”, except for $1. The government uses this money to buy ducks from the farmer and provides the ducks to the shopkeeper. The second volunteer is an urban shopkeeper. The shopkeeper asks the government for more ducks whenever it is sold out. Give the shopkeeper one duck. The third volunteer is a consumer. The consumer buys ducks. Give the consumer $1 in play money. The instructor is a duck farmer. The farmer keeps the second duck.

Explain this background, “Ducks are a staple food in this country but they are expensive at $3 each. The government wants to make food cheap for the urban poor to alleviate hunger. They calculate people could afford ducks if they were priced at $1. The government decides to impose a price ceiling of $1; $1 is now the maximum retail price for ducks.”

Start the game. The consumer buys one duck from the shopkeeper. The shopkeeper requests more ducks from the government. The government comes to the farmer.


The instructor, as the duck farmer, controls the game. There are three points to make in this demonstration.

1. Shortage. The farmer refuses to sell ducks at $1 each. The shopkeeper has no ducks.

2. Subsidy. The farmer offers to sell the ducks for $3. The ducks can then be sold in the marketplace for $1. The government pays a $2 subsidy to keep food prices low.


3. Black markets. After the farmer sells the duck to government for $3, the duck goes to the shopkeeper for $1. The farmer buys back the original duck for $1 and resells it to the government for $3. This can continue until the government runs out of money.

Government intervention in markets can have unintended consequences. The price ceiling initially decreased the amount of food available in the cities. Subsidies to producers can increase production, but subsidies create new incentives.

This example is based on subsidies and price ceilings used in southern China. The farmers did buy & resell poultry to the government.

4.2 A Flat Tax?

Type: In-Class activityTopics: progressive, regressive, proportional taxesTextbook: Chapter 4 Supply and Demand: Applications and ExtensionsMaterials Needed: noneTime: 3 minutesClass limitations: works in any size class

Purpose

This activity emphasizes the importance of looking at percentages when classifying a tax as progressive, regressive, or proportional.

Instructions

Tell the class Congress has approved a new tax to fund scientific research on clones. Everyone will pay $1000.

Ask them is classify this tax as progressive, regressive, or proportional.


Many students erroneously see this head tax as proportional. A simple example can show its regressive nature.

Compare a low income student who earns only $1000 washing dishes at a summer job. to a high income university president who earns $100,000 for running the school. Each are required to pay $1000 for this tax. For the student, the effective tax rate would be 100%. For the president, the effective tax rate would be 1%.

A head tax taxes low-income individuals at a higher percentage of their incomes and taxes high-income individuals at a lower percentage. This is a regressive tax.It may help to point out that low-income earners pay a lower dollar amount when taxes are proportional. Using the same example, if the student paid $10 and the university president paid $1000 then the tax would be proportional.

This example can be used to introduce other types of taxes with regressive impacts, such as sales taxes on food or cigarettes.



1. An increase in the demand for housing will raise the demand for carpenters, plumbers, and electricians. The rise in demand for construction workers will raise their wages and employment.

2. The imposition of rent control will hurt college students for several reasons. The quality of rental housing will tend to fall as will the amount of rental housing available. The price ceiling will decrease the incentive of landlords to maintain their property. In addition, the amount of racial, gender, and other types of discrimination in the local rental housing market will rise. Students will be less able to find housing. Lastly, a “black market” for housing would develop.

6. a. Decreases; b. Increases; c. Decreases; d. Increases

11. The deadweight loss is the loss of the potential gains of buyers and sellers emanating from trades that are squeezed out by the tax. It is an excess burden because even though the exchanges that are squeezed out by the tax impose a cost on buyers and sellers, they do not generate tax revenue (because the trades do not take place).

13. A tax on luxury automobiles is not a good idea if the goal is to raise revenue from the rich. The demand for luxury automobiles is likely fairly elastic. As a result, sellers (and the workers in the luxury automobile industry) will tend to bear a larger share of the burden of the tax.

Chapter 5The Economic Role of Government

OUTLINE

I. A Closer Look at Economic EfficiencyA. Economists often use the concept of efficiency to judge actions because the efficient use of resources implies the maximum value of output from the resource base.B. Two conditions are necessary for ideal economic efficiency:

1. All activities that provide individuals with more benefits than costs must be undertaken.2. No activities that provide benefits less than costs should be undertaken.

II. If It’s Worth Doing, It’s Worth Doing ImperfectlyA. Although perfection is a noble goal, it is rarely worth achieving because additional

time and resources devoted to an activity generally yield smaller and smaller benefits and cost more and more. B. Inefficiency can result when either too little or too much effort is put into an activity.

III. Thinking About the Economic Role of Government A. Protective Function of Government: The most fundamental function of government is the protection of individuals and their property against acts of aggression.

1. Involves the maintenance of a legal structure (rules) within which people interact peacefully and have a process for the settlement of disputes.

B. Productive function of Government1. Involves the provision of a limited set of goods that are difficult to supply through the market.

IV. Potential Shortcomings of The MarketA. There are four major reasons why the invisible hand may fail to allocate resources efficiently: (1) Lack of competition, (2) Externalities, (3) Public goods, and (4) Poor information.

1. Lack of Competition: Sellers may gain by restricting output and raising price. Too few units will be produced.

2. Externalities—the failure to fully register costs and benefits.a. External cost: Present when the actions of an individual or group

harm the property of others without their consent. Note: problem arises because property rights are imperfectly defined and/or enforced.

(1) Because costs are not fully registered, the supply curve understates the true cost of production.

(2) Units may be produced that are valued less than their cost.(3) From the viewpoint of efficiency, too many units are produced.


(4) Pollution problems are often a side effect.


Chapter 5/The Economic Role of Government 69

b. External benefits: Present when the actions of an individual or group generate benefits for nonparticipating parties.

(1) Demand curve understates total value of output.(2) Units that are more highly valued than costs may not be produced.

(3) From the viewpoint of efficiency, too few units may be produced.

3. Public Goodsa. Goods that are (a) jointly consumed by individuals who simultaneously enjoy consumption of the same product or service and (b) non-excludable consumption of the good cannot be restricted to the customers who pay for it.

(1) If a public good is made available to one person, it is simultaneously made available to others.

b. Because those who do not pay cannot be excluded, no one has much incentive to help pay for such goods. Each has an incentive to become a free rider, a person who receives the benefits of the good without helping to pay for its cost.

c. When a lot of people become free riders, too little is produced.d. Note: It is the characteristics of the good, not the sector in which

it is produced, that distinguishes a public good.e. Examples of public goods: national defense, radio and television

broadcast signals, and clear air.f. Markets often develop ways of providing public goods (e.g. use

of advertising to support provision of radio and television.) Nonetheless, public goods often cause a breakdown in the harmony between self-interest and the public interest.4. Problems Arising From Poor Information

a. The consumer’s information problem is minimal if the item is purchased regularly.

b. Major problems of conflicting interests and unhappy customers can arise when goods are either (a) difficult to evaluate on inspection and seldom repeatedly purchased from the same producer or (b) potentially capable of serious and lasting harmful side effects that cannot be predicted by a lay person.

c. Information as a profit opportunity: Entrepreneurial publishers and other providers of information help consumers find what they seek by providing expert evaluations of the special characteristics built into complex products.

V. Market Failure and Government FailureA. Market Failure

1. Market failure is the term used to describe the failure of markets to achieve the ideal conditions of economic efficiency.2. When markets allocate goods inefficiently, the problem can generally be traced back to the absence of competition, externalities, public goods, or poor information

B. Government Failure

70 Chapter 5/The Economic Role of Government

1. Government failure is the term used to describe the situation when there is reason to anticipate that political decision-making will fail to achieve the ideal conditions of economic efficiency.

2. Government action directed by political decision-making is merely an alternative form of economic organization. It is not a corrective device that can be counted on to provide a remedy for the shortcomings of markets.

3. Merely because market failure is present, it does not follow that political action will necessarily lead to a more efficient allocation of resources.

OBJECTIVESThis chapter explains why public sector actions might improve efficiency when certain conditions are present. Monopoly power, externalities, public goods, and economic instability are economic forces that are likely to result in market inefficiency. When the market fails to meet our conditions of ideal efficiency, public-sector action can potentially generate net economic gain for a community (or an economy). Public-sector action need not be merely a zero-sum game in which the gain of one group is precisely offset by another’s loss.

However—and this point is also important—collective action is merely another method of organizing economic activity. It also suffers from deficiencies (e.g., rational ignorance on the part of voters, the special interest effect, and the attractiveness of shortsighted action). Through economics we can better understand both the strengths and weaknesses of public sector and market economic organization and use this knowledge to help us think more clearly about political economy institutions.



1. The concept of economic efficiency must be explained carefully. First, explain that efficiency simply means getting the most out of the available resources. When applied to the entire economy, this criterion requires that:a. all activities with greater social benefits than social costs be undertaken, andb. when social costs exceed the social benefits, an activity should not be undertaken.

2. After pointing out that competitive markets are consistent with efficiency, indicate that lack of competition (monopoly, collusion, etc.), spillover effects, and public goods create circumstances for which the invisible hand will fail to meet the criteria of ideal efficiency. These three deficiencies, plus complications that arise because of macro instability, are the core of the case for government intervention.

3. When explaining what economic theory says about public sector economic organization, point out that this is a new and exciting area of thinking. Public choice theory is not as well developed (and tested) as is the theory of market behavior. Our teaching experience has shown that many students often become extremely interested in this material.

4. Exerting an influence on government is costly. Yet moving a government toward more efficient policies, and rooting out fraud or dishonesty will benefit the citizenry as a whole. However, this benefit usually cannot be captured by the group producing it. An interesting discussion topic here, especially for advanced students, would be: “Is good government a public good, and thus likely to be underproduced?”

5. Our teaching experience indicates that Critical Analysis questions 2, 6,7, 8, and 11 are good “discussion starters.”

6. Since this chapter emphasizes the discussion of efficiency, it is helpful to show students that the (first part of the) right answer to any efficiency question is “it depends,” but that the crucial analytical questions pertain to what it depends on and how importantly it depends on each of the determinants. For example, you can show students that the most efficient car for a given decision maker (and it is important to emphasize that the answer varies with the decision maker and the situation faced) depends on a huge number of variables, including age, height, driving record, distance traveled to work, insurance costs, whether one is married, whether one has children, attitudes toward risk, etc. Similarly, the most efficient grade to get in a course depends on major, difficulty of grading, difficulty of the material, whether you will see the same instructor again, whether you are on academic probation, whether you are an intercollegiate athlete in season, etc. There are many ways in which this message can be communicated to students, but showing them a real world discussion of what the efficient choice depends on is crucial to understanding this point.

7. Roommate problems provide a rich source of analogies that illustrate the analysis of public goods and externalities, particularly the free-rider problem. Whether one considers the generally poor conditions of common areas, problems of noise or taste pollution, the transactions costs incurred in trying to internalize externalities, or the importance of the number of parties involved, roommate illustrations can make the analytical points about market failures clearer.

8. Games one to five will help reinforce the material in chapter 5.


GAMES

1. Externalities on a River

Type: In-Class DemonstrationTopics: negative externalitiesTextbook: Chapter 5: The Economic Role of GovernmentMaterials Needed: noneTime: 10 minutesClass limitations: works in any size class

Purpose

This helps students understand who bears external costs and why externalities are a type of market failure.

Instructions

Draw a simple picture of a river. (Two curving lines are sufficient.) Add a rectangle labeled “FACTORY” at on end of the river. Draw a stick figure farther down the river. Add a rectangle labeled “BREWERY” at the other end of the river.

Replace the names in the example below with names of students.

“This drawing represents three users of a natural resource. Tiffany owns a sweater factory on the river. Dan enjoys going to a beach on the river. Pat owns a brewery that uses water from the river.”

Draw a line into the Brewery from the river. Add a beach umbrella for Dan. Draw a discharge pipe from the Factory to the river.

“Let’s look at the market for Tiffany’s Sweaters. The demand for these sweaters will be based on consumers’ tastes, incomes, the prices of substitutes and complements, and the number of consumers in the market.”

Graph a normal downward-sloping demand curve.

“The supply curve for Tiffany’s Sweaters is based on the costs of producing sweaters.”

Add an upward-sloping supply curve to the graph. Label this “Supply with All Costs.”

Ask the class how the supply curve would shift if Tiffany got her materials for free. Then ask them how the curve would shift if she didn’t have to pay her workers. The supply curve would shift to the right, in either case.

“Of course these labor and material costs are hard to avoid, but there are costs of production that firms can avoid paying.”


Explain that a by-product of sweater production is toxic sludge. Draw thick lines representing this sludge from the factory’s discharge pipe. This sludge is dumped in the river. Draw more thick lines of sludge over the stick figure and into the brewery.

“Dan’s day at the beach is ruined. He’s covered with goop. Pat’s beer is ruined. The entire production run has been contaminated. These are real costs associated with Tiffany’s sweater production, but Dan and Pat pay these costs. Tiffany does not consider these external costs when making supply decisions.”

Return to the supply and demand graph. Draw a new supply curve to the right of the original curve. Label the new curve “Supply with Private Costs.”


Avoiding external costs, such as the pollution damages, increases the supply curve just like avoiding any other cost of production. In this case the costs are not truly avoided, but imposed on third parties. This causes a divergence between the socially optimal outcome and the firm’s decision based on its private costs.

Comparing the two intersections on the graph shows: consumers pay too low a price for sweaters and too large a quantity is produced. If the external costs were considered, prices would be higher and quantity lower.

There are several possible ways to improve the outcome. All involve making decision makers consider the external costs. This example can be used to introduce the concepts of discharge fees, regulation, liability rules.An interesting extension is to explore how changes in ownership might affect the outcome. If the sweater factory, the beach, and the brewery were all owned by one individual then the external costs would be considered.

2. Everyone “enjoys” a good cigar

Type: In-Class demonstrationTopics: negative externalitiesTextbook: Chapter 5: The Economic Role of GovernmentMaterials Needed: a cigar (and lighter)Time: 3 minutesClass limitations: works best in classes with 50 or fewer students

Purpose

This helps students understand external costs and why externalities cause non-optimal outcomes. It also illustrates externalities in consumption.

Instructions

Light the cigar and smoke it. Blow as much smoke as possible at the students. Tell the class how enjoyable the cigar is.


As the room fills with smoke, explain that you intend to bring a cigar to class everyday, since it gives so much pleasure. Ask if anyone has objections.


Most of the class will object to daily exposure to cigar smoke. Second-hand smoke is a negative externality, imposing costs on the class. The smoker’s decision, based on his or her own pleasure, ignores these external costs. The private decision will not be optimal.

This demonstration could be done using other irritants besides cigar smoke. A loud radio could be played during the lecture. Garlic bread or crackers could be offered to half the students. Again the private decisions will not lead to a socially optimal outcome.

If the class is large enough, there will frequently be a small group of students who chat during lecture. They can be used as an example of negative externalities. Their decision to talk is based on their own private enjoyment, disregarding the external cost they impose on their classmates. Once again, private decisions lead to an inefficient outcome.

3. Private Goods/ Public Goods: A Demonstration

Type: In-Class DemonstrationTopics: public and private goodsTextbook: Chapter 5: The Economic Role of GovernmentMaterials Needed: a candy barTime: 10 minutesClass limitations: works in any size class

Purpose

This example vividly illustrates the difference between public and private goods.

Instructions

Ask for a volunteer. Give the volunteer a candy bar and ask him or her to eat it.

While the student eats the candy, explain that you don’t want the student’s enjoyment of the candy to be marred by taking notes. Offer to draw some beautiful artwork on the board to increase the volunteer’s enjoyment.

Draw a picture on the board. It need not be complex and probably won’t be beautiful. A canoe with a couple of stick figures, on a river works well, particularly if the canoe is headed for a waterfall. A large poster, or a slide, of real artwork could be substituted.

Ask the volunteer if he, or she, is enjoying the candy and the art.Ask the rest of the class if they get any enjoyment from the candy.

Ask the rest of the class if they get any enjoyment from the art.



The candy is a private good. It is depletable and excludable. Only the volunteer got to enjoy the candy. The candy could easily be rationed by price.

The “artwork” is neither depletable nor excludable. The volunteer’s enjoyment did not diminish the enjoyment of the rest of the class. Price rationing would not be effective for the “artwork” since all students in the classroom could see the art, even if they didn’t pay. The “artwork” is a public good.

This makes a good introduction to many public goods issues.

4. Alphabet Soup: The Role of Government

Type: In-Class assignmentTopics: The role of governmentTextbook: Chapter 5: The Economic Role of GovernmentMaterials Needed: noneTime: 15 minutesClass limitations: works in any size class

Purpose

This assignment shows many government activities exist in a market economy.

Instructions

Ask the students to list as many government-provided goods and services as possible. They should include activities at the Federal, State and Local levels.

Then ask them to list all the “alphabet” agencies (FBI, CIA, USDA, etc.)

The most important question to ask is “WHY?” Why, in a predominantly market economy, does the government play so many roles?


Students will be able to list dozens of government activities and nearly as many agencies.

The rationale for government action can include:Creating an institutional framework for markets (laws, courts, money, SEC)Addressing market failure (national defense, education, highways, EPA)Addressing monopoly (antitrust, public utilities, FTC)Addressing equity and income distribution (Social Security, food stamps)Macroeconomic Stability (fiscal policy, monetary policy)Financing the above activities (taxes, bonds, IRS)


5. Article on the Role of Government

Type: Take-home assignmentTopics: the role of government, market failureTextbook: Chapter 5: The Role of GovernmentMaterials Needed: noneClass limitations: works in any size class

Purpose

This assignment gives students an opportunity to identify real-world market failures and how government can address these issues. Categorizing a real problem helps students clearly distinguish the various types of market failure.

Instructions

This assignment is difficult for many students, particularly if they are unclear on the concept of market failure. Not every example of government action will be appropriate for this assignment. Students may find it easier to make a list of possible areas of market failures before looking for an article.


A market system depends on accurate price signals to allocate goods and services. Market failure distorts the price system, leading to the inefficient use of resources. Government intervention in cases of market failure can improve economic efficiency.

Some students may choose inappropriate examples for this assignment. Emphasize the fact that business failure is not the same as market failure. An effective market will drive inefficient firms out of business; this is a market success. Similarly, entry or the introduction of new technology may hurt the profits of incumbent firms, but these are not examples of market failure.


Name____________________ Course ______________________

Role of Government

Find an article in a recent newspaper or magazine that shows the government addressing market failure.

Identify the type of market failure. Is it a problem of negative externalities, positive externalities, public good, or open access?

Explain how government action can improve economic efficiency.

Graph the market failure and explain the problem. The show how the government action will change the situation.

Turn in a copy of your article with your explanation.

Write the date and source on the article.



4. The antimissile system is a public good for the residents of Washington, D.C. Strictly speaking, none of the other items is a public good because each could be provided to some consumers (paying customers, for example) without being provided to others.

6. Without protection of person and property, there is no assurance that one can benefit from either (1) current productive effort or (2) saving (and investing) for the future. Under such circumstances, the incentive of individuals to produce and plan for the future is greatly diminished. In contrast, protection of person and property provides individuals with assurance that they will be permitted to “reap what they sow.” Under these circumstances, individuals sow far more abundantly.

11. Whether a good is currently provided by government or not decides whether the good is a public good. This has nothing to do with whether a good is a public good in economics.

14. A government intervention would be efficient if the benefits from the intervention exceeded the cost of the intervention. All opportunity costs (such as tax money required, resources utilized, and deadweight losses) would need to be considered in the comparison. A government intervention would be considered inefficient if the costs exceeded the benefits.

Chapter 6The Economics of Collective Decision Making

OUTLINE

I. The Size and Growth of the U.S. GovernmentA. Total government spending accounted for only 9.4% of GDP in 1930, and only one

third of this spending was at the federal levelB. Government spending, particularly at the federal level, soared from

1930 to 1980. Total government spending rose from 9.4% of GDP in 1930 to 32.8% in 1980 (more than 3 times its 1930 level).

C. After remaining fairly constant between 1980 and 2000, the size of the US government has increased dramatically since (increasing to almost 40% of the U.S. economy in 2010).

D. Personal income and payroll taxes provide about one-half of government revenue.E. The largest categories of government spending are education, health care, Social Security and other transfer payments.

II. The Differences and Similarities Between Governments and MarketsA. Competitive behavior is present in both the market and public sectors.B. Public-sector organization can break the individual consumption-payment link.C. Scarcity imposes the aggregate consumption-payment link in both sectors.D. Private-sector action is based on voluntary choice; public sector (when democratic) is based on majority rule.E. When collective decisions are made legislatively, voters must choose among candidates who represent a bundle of positions on issues.F. Income and power are distributed differently in the two sectors.

III. Political Decision-Making: An OverviewA. Public choice analysis applies the tools of economics to the political process. The goal is to provide insight concerning how the process works.

1. Self-interested behavior is present in both market and political sectors.2. Political process can be viewed as a complex exchange process involving (1) voter-taxpayers, (2) politicians, and (3) bureaucrats.

3. Incentives Confronted by the Votera. Voters will tend to support those candidates whom they believe

will provide them the most government services and transfer benefits, net of personal costs.

b. Rational Ignorance Effect: Recognizing their vote is unlikely to be decisive, most voters have little incentive to obtain information on issues and alternative candidates.

c. Because of the rational ignorance effect, voters will be uninformed on many issues; such issues will not enter into their decision making process.


4. Incentives Confronted by the Politiciana. Political officials: interested in winning elections. Just as profits

are the lifeblood of the market entrepreneur, votes are the lifeblood of the politician.

b. Rationally uninformed voters often must be convinced to “want” a candidate.

c. Legislative bodies are something like a Board of Directors.5. Incentives Confronted by the Government Bureaucrat

a. Bureaucrats (persons that handle day-to-day operations of government) seek promotions, job security, power, etc.

b. The interests of bureaucrats are often complementary with those of the interest groups they serve.

c. Bureaucrats can usually expand their own interests, as well as that of their constituents, by working for larger budgets and program expansion.

IV. When the Political Process Works WellA. Other things constant, legislators will have a strong incentive to support the political actions that provide voters with large total benefits relative to costs.B. If a government project is really productive, it will always be possible to allocate the project’s cost so that all voters will gain.C. When voters pay in proportion to benefits received, all voters will gain if the government action is productive (and all will lose if it is unproductive.) Under these circumstances, there is a harmony between good politics and economic efficiency.

V. When the Political Process Works PoorlyA. Special Interest Effect

1. Special Interest Issue: One that generates substantial personal benefits for a small number of constituents while imposing a small individual cost on a large number of other voters.2. Members of an interest group will feel strongly about an issue that provides them with substantial personal benefits. Such issues will dominate their political choices.3. In contrast, the voters bearing the cost of special-interest legislation will often be uninformed on such an issue because it exerts only a small impact on their personal welfare and because they are unable to avoid the cost by becoming better informed.4. Politicians have a strong incentive to favor special interests even if action is inefficient.5. Logrolling and pork-barrel legislation strengthen the special interest effect.

B. Shortsightedness Effect1. Issues that yield clearly defined current benefits at the expense of future costs that are difficult-to-identify.2. The political process is biased toward the adoption of such proposals even when they are efficient.

C. Rent Seeking


Chapter 6/The Economics of Collective Decision Making 81

1. Actions by individuals and interest groups designed to restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves.2. Widespread use of the taxing, spending, and regulating powers of government that favors some at the expense of others will encourage rent seeking.3. Rent seeking moves resources away from productive activities. The output of economies with substantial amounts of rent seeking will fall below their potential.

D. Inefficiency of Government Operations1. In the public sector, the absence of the profit motive reduces the incentive of producers to keep costs low.2. Neither is there a bankruptcy process capable of weeding out inefficient producers.3. Public-sector managers are seldom in a position to gain personally from measures that reduce costs.4. Because public officials and bureau managers spend other people’s money, they are likely to be less conscious of cost than they would be with their own resources.

VI. Political Favoritism, Crony Capitalism, and Government FailureA. Crony capitalism is the situation where ….

1. political decision-makers direct subsidies, grants, tax breaks, and regulatory favors toward businesses willing to provide them with campaign funds and other forms of political support.2. It is a natural outgrowth of increases in government spending, constant changes in taxes, and expansion in regulation.

B. Crony Capitalism is often driven by the bootlegger–Baptist strategy: greedy action packaged as moral behavior

1. Opportunistic rent-seekers often frame their programs in a manner designed to attract support from naïve idealists.2. They argue their programs will enhance child safety, promote energy independence, save family farms, or some other widely supported goal. 3. But when one looks below the surface, one discovers that these programs are about government favoritism providing handsome profits to the well-organized special interest groups.

C. Bootlegger—Baptist examples include: 1. Mattel incorporating costly testing procedures into the Consumer Product Safety Improvement Act of 2008. a. The action increased the costs of rivals and drove used toy sellers like Goodwill out of the market.2. General Electric partners with environmentalists to advocate subsidies and tax breaks for alternative energy sources. a. This government favoritism increased demand for GE turbine engines, solar panels, and wind farms. b. Result: GE earned $15 billion in 2010 and paid zero corporate income taxes.

D. Market Entrepreneurs versus Crony Capitalists

82 Chapter 6/The Economics of Collective Decision Making

1. Market entrepreneurs get ahead by providing consumers with products that are more highly valued than the resources required for their production.2. Crony capitalists get ahead by providing political players with campaign contributions and other political resources in exchange for government contracts, subsidies, tax benefits, and other forms of political favoritisma. Projects of crony capitalists will often be counterproductive.

3. Crony capitalism reflects government failure and undermines the legitimacy of the democratic political process

VII. The Economic Way of Thinking About GovernmentA. Both bad news and good news flow from public-choice analysis.1. The bad news: For certain classes of economic activity, unconstrained democratic

government will predictably be a source of economic waste and inefficiency.2. The good news: Properly structured constitutional rules can improve the expected result from government.

ADDENDUM:VIII. Economic Organization: Who Produces, Who Pays, and Why It Matters

A. The incentive to economize is influenced by who produces a good and who pays for it.B. Economizing behavior will be strongest when consumers purchase goods produced by private firms.1. Examples: apples, oranges, television sets.

C. The incentive to economize is reduced when payment is made by a third party (health care) and when production is handled by the government (national defense, post office)


OBJECTIVES

In this chapter, the basic tools of economics are utilized to analyze the collective decision-making process. Using the individual as the unit of analysis, we develop theories of political behavior. This chapter outlines both how we would expect the collective-choice process to work and why it will sometimes fail to allocate resources efficiently.

When the market fails to allocate resources efficiently, the public sector can potentially act to improve the welfare of all citizens—government action need not be a zero-sum game. As we discuss in the text, government action in such areas as crime prevention, national defense, provision of a stable monetary environment, and regulation of monopoly power is rooted to the potential gains from action to correct market failure.

However, there is good reason to expect that collective action will promote economic inefficiency when certain conditions are present. Special interests exert disproportionate power when decisions are made collectively. The political process is biased toward short-term solutions even if these actions cause substantial problems later. Bureaucratic decision making and the incentive structure confronted by public sector managers provide little incentive for entrepreneurial efficiency. There is often a conflict between good economics and a winning electoral strategy. Thus, it should not surprise us to find that public policy is sometimes a source of rent seeking and economic inefficiency.

This chapter provides a vivid illustration of the power and breadth of economic analysis.


1. At the outset, explain to students that the purpose of political economic theory is to expand our understanding of real-world events. Economists typically ask, “What should the government do?” The theory outlined in Chapter six asks, “What can the government be expected to do?”

2. Carefully outline how the individual welfare of both voters and political entrepreneurs is influenced by a candidate’s position on issues. Be sure to highlight the importance of voter ignorance and the information provided by candidates to voters.

3. When externalities are present, political action has the potential to improve social (total) welfare. A diagram such as Exhibit 3 in the previous chapter could help to illustrate this point.

4. The most compelling reason for public sector action is that market failure results in inefficiency relative to the hypothetical ideal. Therefore, corrective action could generate greater social benefits than costs.

5. In addition to public sector action to improve allocative efficiency, the political process may be utilized to redistribute income. Public choice analysis indicates that self-interest redistribution of income from the rich to the poor will not be particularly attractive to political entrepreneurs. Such redistribution generates unstable majorities. However, if potential income recipients were well-organized and easily identified, redistribution would become more attractive to political entrepreneurs. There is little reason to expect that redistribution of this sort (to well-organized groups) will necessarily promote greater equality.


6. The section on the “Special-Interest Effect” explains the economic logic behind these political facts of life. A classroom discussion of this topic should be of interest to students.

7. The special-interest effect is one of the major sources of government failure. Be sure to explain that the rational ignorance effect reinforces the special-interest effect since many non-special-interest voters remain uninformed on issues that are of little consequence to their personal well-being.

8. The shortsightedness effect stems from the inability of political entrepreneurs to gain from maximizing long-range future political benefits. Since future benefits (and costs) tend to be elusive and difficult to identify, in a sense the shortsightedness effect is merely a special case of the elusive nature of the benefits (or costs). The political process is biased against programs yielding elusive benefits at the expense of easily identified costs. In contrast, the process is biased in favor of programs that yield readily identified benefits at the expense of elusive costs kept hidden from the voter. As explained in the text, these factors can cause allocative inefficiency by the government.

9. The text presents the argument that public sector firms (agencies, departments, etc.) are likely to be operated less efficiently than their private sector counterparts, particularly competitive firms. However, it is important to note that this conclusion does not presume that public sector employees are lazy, incapable, and work less intensively. Rather, emphasis is placed on the incentive structure faced by public-sector managers and employees; also stressed is the corresponding lack of incentive for individuals (or small groups of individuals) to promote public-sector efficiency. The taxpayer is in an extremely weak position to identify and eliminate operational inefficiency resulting from actions designed to further the personal and political aims of the public sector administrators. There is no public sector counterpart to bankruptcy that would automatically eliminate extreme cases of operational inefficiency. In addition, collective decision making theory suggests that the widely dispersed interests of taxpayers can be expected to lose out when they conflict with the highly concentrated interests of public-sector managers, employee groups, and favored consumers, even though economic inefficiency may result. The incentives are simply perverse. Therefore, it is difficult to believe that this incentive structure does not adversely affect the operational inefficiency of the public sector.

10. The Thumbnail Sketch summarizes the major weaknesses of both the market and public sectors.

11. Discuss the incentive structure that generates the rational ignorance effect. Ask students whether they know the positions of their congressional representatives on such issues as: (a) a reduction in national defense spending; (b) an increase in the minimum wage; (c) price controls on energy products; and (d) an expansion in the funding for higher education.

12. A good analogy to rational voter ignorance is rational student ignorance. Just as the incentives facing voters lead them to be less informed about political decisions than private ones, the incentives facing students lead them to be rationally far less informed about material that is less likely to appear on an exam.


13. A good extension of rational voter ignorance is why it leads to rational representative ignorance when it comes to bureaucratic oversight and the likelihood of bureaucratic scandals (but once public attention is focused on the subject, much political effort will be spent to show voters “tough” oversight; and to blame someone else). This incentive structure tends to result in cosmetic “reforms” that make little actual difference.

14. As a way of integrating the material in this chapter with what has gone before, it is helpful to explain that this is just another application of looking at incentive structures, with particular emphasis on the differences between the incentives facing consumers and those facing voters, between those facing sellers and those facing politicians, and between private- and public-sector bureaucrats.

15. The following analogies will help bring the concepts of “rational voter ignorance” and “rent seeking” more alive to students:a. rational student ignorance (students recognize that it is rational to be relatively more

ignorant of things thought less likely to be on the test, since the incentive to know them is less) as an analogy to rational voter ignorance, and

b. the rent seeking that goes on in class after test results have been announced (those who did poorly start lobbying for a reduction in the importance of the exam, while those who did better lobby against such “constitutional” changes in grading policy).

16. Discuss the differences and similarities between market and public-sector economic organization. Point out that most economies rely on some combination of these two general forms of economic organization.

17. Critical Analysis Questions 2, 6, 8, and 11 should provide discussion starters related to the major issues of this chapter.


5. Rent seeking is actions by individuals and interest groups designed to restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves. The incentive to engage in rent seeking is directly proportional to the ease with which the political process can be used for personal (or interest group) gain at the expense of others. When a government attempts to favor some at the expense of others, counterproductive activities will expand while positive-sum productive activities will shrink. People will spend more time organizing and lobbying politicians and less time producing goods and services. Since fewer resources will be utilized to create wealth (and more utilized in rent-seeking activities), economic progress will be retarded.

6. True. Because each individual computer customer both decides the issue (what computer, if any, will be purchased) and bears the consequences of a mistaken choice, each has a strong incentive to acquire information needed to make a wise choice. In contrast, each voter recognizes that one vote, even if mistaken, will not decide the congressional election. Thus, a voter has little incentive to search for information to make a better-informed choice.


11. The shortsightedness effect results from voters and politicians tending to support projects that promise substantial current benefits at the expense of difficult-to-identify future costs. In addition, the political process is biased against proposals with clearly identifiable current costs but yielding less concrete and less obvious future benefits. As a result, public-sector action tends to be less efficient.

15. The presence of the sugar price supports and highly restrictive import quotas reflect the special-interest nature of the issue. Even though there are far more sugar consumers than growers, politicians apparently gain more by supporting the sugar growers and soliciting their political contributions than by representing the interests of consumers. Government action in this area has almost certainly reduced the income levels and living standards of Americans.

Chapter 7Taking the Nation’s Economic Pulse

OUTLINE

I. GDP—A Measure of OutputA. Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a specific time period, usually a year.B. What Counts toward GDP?1. Only final goods and services count.

a. Sales at intermediate stages of production are not counted because their value is embodied within the final-user good. Their inclusion would result in double counting.

2. Financial transactions and income transfers are excluded because they do not involve production.3. Only production within the geographic borders of the country is counted.

4. Only goods produced during the current period are counted.C. Dollars—The Common Denominator for GDP

1. Each good produced increases output by the amount the purchaser pays for the good.2. GDP is equal to the sum of the total spending on all goods and services produced during the year.

II. GDP as A Measure of Both Output and IncomeA. Dollar flow of Dollar flow of

expenditures = GDP = income (and indirect cost)on final goods of final goods

B. Deriving GDP by the Expenditure Approach1. Sum of the expenditures on final-user goods and services purchased by households, investors, governments, and foreigners.2. When derived by the expenditure approach, there are four components of GDP.

a. Personal consumption purchasesb. Gross private investment (including inventories)

c. Government purchases (both consumption and investment)d. Net exports (exports – imports)

C. Deriving GDP by the Resource Cost-income Approach1. Sum of the costs incurred and income (including profits) generated producing goods and services during the period.2. When derived by the resource cost/income approach, the direct-cost income components of GDP are:

a. Employee Compensationb. Self-employment income


c. Rentsd. Intereste. Corporate profitf. Sum of a through e equals national income

3. Not all cost components of GDP result in an income payment to a resource supplier. In order to get to GDP, we need to account also for three other factors:

a. Indirect business taxes: Taxes that increase the business firm’s costs of production and therefore the prices charged to consumers.

b. Depreciation: The cost of the wear and tear on the machines and other capital assets used to produce goods and services during the period.

c. Net Income of Foreigners: The income that foreigners earn producing goods within the borders of a country minus the income Americans earn abroad.

4. When derived by resource cost/income approach, GDP is equal national income (employee compensation, self-employment income, rents, interest, corporate profit) plus indirect business taxes, depreciation, and the net income of foreigners.

D. Relative Size of GDP ComponentsIII. Adjusting for Price Changes and Deriving Real GDP

A. The term “real” means adjusted for inflationB. Price indexes are use to adjust income and output data for the effects of inflation.C. A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.D. Two Key Price Indexes: Consumer Price Index and GDP Deflator

1. The consumer price index (CPI) measures the impact of price changes on the cost of the typical bundle of goods and services purchased by households.2. The GDP deflator is a broader price index than the CPI. It is designed to measure the change in the average price of the market basket of goods included in GDP.

E. The rate of inflation is equal to:This year’s Price Index – Last year’s Price Index 100

Last year’s Price IndexF. Using the GDP Deflator to Derive Real GDP

1. Real GDP2 = Nominal GDP2 (GDP deflator1/GDP deflator2).2. Data on both money GDP and price changes are essential for meaningful output comparisons between two time periods.

IV. Problems with GDP as a Measuring RodA. It does not count non-market production.B. It does not count the underground economy.C. It makes no adjustment for leisure


Chapter 7/Taking the Nation’s Economic Pulse 89

D. It probably understates output increases because of the problem of estimating improvements in the quality of products.E. It does not adjust for harmful side effects.

90 Chapter 7/Taking the Nation’s Economic Pulse

V. Differences in GDP Over Time A. Per capita real GDP has risen substantially over the past several decades in the U.S.1. Per capita real GDP nearly tripled between 1960 and 2008.2. As real GDP per capita has risen, the quality of most goods has risen and the

amount of work time to purchase goods has fallen.VI. The Great Contribution of GDP

A. In spite of its shortcomings, real GDP is a reasonably accurate measure of short-term fluctuations in output.

OBJECTIVES

In this chapter the student is introduced to: (a) the technicalities of how we measure the flow of output; (b) the distinction between nominal and real income; (c) the mechanics of how price indexes are constructed; (d) the limitations of GDP as a measuring rod of economic activity; and (e) the importance of real GDP as an indicator of the short-term level of total output. This chapter lays the foundation for later macro material on cyclical economic conditions and the determinants of national income.


1. Be sure to emphasize that GDP is a flow concept designed to measure the amount of production generated during a period and not the total wealth of an economy.

2. Even though this point is highlighted in the text, instructors will find it useful to work an example similar to Exhibit 7-1, emphasizing that GDP counts only final products. Point out that if this were not the case, double-counting would result.

3. Use the two alternative methods of measuring GDP to show that there are both positive and negative aspects to economic activity. The expenditure approach focuses on the positive attributes of GDP—the fact that purchasers value the items produced enough to pay for them. However, the resource cost–income approach focuses on the cost involved in the production of goods. Resource owners were paid in order to induce them to undertake the production of the items during the period. This approach emphasizes to the student that GDP is not an index of economic welfare.

4. Calculating real GDP in terms of current dollars will help students to get a better grasp on this concept. Up-to-date information for both the GDP deflator and nominal GDP are available in the Federal Reserve Bulletin and Survey of Current Business (monthly publications) as well as at the web site www.bea.gov. As a classroom exercise, use the data on nominal GDP and the GDP deflator to calculate real GDP during the most recent year. Compare the real GDP data for 2005 and 2012 presented in Exhibit 6.

5. It is important to emphasize what is excluded from GDP. Otherwise, students may be led to believe that it is an indicator of something that it was not intended to measure. Point out that GDP excludes leisure but includes expenditures that minimize the effects of “bads” (e.g., pollution, crime, and war).



6. The boxed feature explains how the time cost of many goods has changed over time. The box helps illustrate the point that as real incomes rise the time cost required to purchase goods falls.

7. Given the shortcomings of GDP as a measuring rod, many instructors will want to ask their students why economists (and the news media) place so much emphasis on GDP. Answer—despite its shortcomings, GDP is still a reliable indicator of short-term ups and downs in the rate of production; it reveals accelerations or decelerations in output.

8. Discussion of the Critical Analysis questions will enhance student understanding of the major concepts of this chapter.

9. One good way to motivate students to learn the measurement issues in both Chapters 7 and 8 is to admit that while they are not exactly inherently interesting, they do help one understand common misuses of economic data. Knowledge of the measurement issues involved in economic data provides a self-defense against misleading analyses (e.g., the use of unemployment data instead of employment data as an indicator of output or taking advantage of biases in price index measures as a way to inflate or deflate the values attached to some “real” variable).

10. A good quick classroom way to introduce the question of how well GDP and other macroeconomic measurements capture what we want to know is by analogy to the question of how well tests measure what students really know and why teachers use them (sometimes appropriately and sometimes not) despite their known imperfections.

11. Game one in the next section helps students understand how price indexes are formed, while Game two familiarizes students with a variety of sources of economic data.

GAMES

1. Create a Student Price Index

Type: Take-home AssignmentTopics: Consumer choiceTextbook: Chapter 7 Taking the Nation’s Economic PulseClass limitations: works in any size class

Purpose

This assignment gives students a practical look at how price indices are measured. It also establishes base prices for calculating inflation rates later in the term. (See 8.2, Changes in the Student Price Index)

Instructions

The students should pick real transactions prices for goods they actually purchase. If the indices will be used to calculate the inflation rate, they should save a copy of this assignment in a safe place. They should not use prices from catalogs since they won’t be subject to change over the semester.



This assignment makes a good introduction to a discussion of market basket selection for price indices. The goods that students usually pick for their market basket account for a relatively small portion of consumer spending, compared to housing, medical care, transportation, etc. Ask the students which goods are likely to change price frequently.

This can be used to introduce problems with the measurement of the Consumer Price Index.


Name____________________ Course __________________

Price Index Assignment

The Consumer Price Index includes the prices of hundreds of goods purchased by consumers. It is possible to construct many other price indexes.

Your mission: make up a personalized student price index.

1. Choose 5 (or more) different products—be specific e.g.: unleaded gasoline, Budweiser beer.

2. Pick a quantity for each product—e.g.: 15 gallons gasoline, 12-pack Bud

3. Find the actual price for each product

4. Calculate the total cost of buying these products


2. Data Hunt

Type: In-class or Take-home AssignmentTopics: macroeconomic dataTextbook: Chapter 7: Taking the Nation’s Economic Pulse; Chapter 8: Economic

Fluctuations, Unemployment, and Inflation Materials Needed: noneTime: 50 minutes, or longerClass limitations: works in any size class

Purpose

This assignment has the student collect a wide variety of economic data. The numbers provide for many interesting comparisons. It also familiarizes students with a variety of sources of economic data.

Instructions

This is a scavenger hunt for economic data. It can be used as a class activity or as a take-home assignment. Structuring it as a race between teams of students adds a competitive element. Much of the data is available online from various sources on the World Wide Web. Unless students are already familiar with the Web sources, the library will be a faster resource.

Give each team of students a copy of the following list and a deadline. Ask them to get current statistics for each measure. The team with the most answers wins.


Ask students which data sources were the most informative. This activity can be used to introduce sources of economic data, both on-line and printed.

A variety of interesting observations can be made, depending on the specific figures that students find. International differences in income, unemployment, and inflation can be striking. The wide range of interest rates can be interesting. The components of National Income can be discussed.

Students will find numbers for some items that are several years old. This can make a huge difference for some variables, but other variables will be almost unchanged. This can be used to introduce a discussion of the relative volatility of different macroeconomic variables.


Name____________________ Course ________________

Data Hunt

Find current figures for the following items.1. U.S. unemployment rate2. the Consumer Price Index3. U.S. inflation rate4. U.S. Gross Domestic Product5. U.S. per capita GDP6. Net Domestic Product (U.S.)7. Disposable Income (U.S.)8. Consumption Spending (U.S.)9. Government Spending (U.S.)10. M111. M212. the National Debt13. the government budget deficit14. Imports15. Exports16. the trade deficit17. the discount rate18. the yield on government bonds19. an interest rate on home mortgages20. an interest rate on a savings account21. the prime rate22. the Dow Jones Industrial Average23. General Motors stock price24. Microsoft’s stock price25. Netscape’s stock price26. the value of the US dollar in yen (Japan)27. the value of the US dollar in pounds (Great Britain)28. the value of the US dollar in marks (Germany)29. the inflation rate in any European country30. the unemployment rate in any European country31. the Gross Domestic Product of any European country32. the per capita GDP of any European country33. the inflation rate in any African country34. the unemployment rate in any African country35. the Gross Domestic Product of any African country36. the per capita GDP of any African country37. the inflation rate in any Asian country38. the unemployment rate in any Asian country39. the Gross Domestic Product of any Asian country40. the per capita GDP of any Asian country41. the inflation rate in any Central or South American country42. the unemployment rate in any Central or South American country43. the Gross Domestic Product of any Central or South American country44. the per capita GDP of any Central or South American country



2. 2 percent.

4. Both the construction expenditures and the corporate profits of the plant will increase GDP because both take place in the United States. Since the construction involves U.S. workers, it also adds to GNP, but the profits, since they belong to foreigners, will not add to GNP.

8. The table bellows shows the box office receipts in $2012:

Movie

Box Office Receipts (Millions)

Year Releas

ed

CPI in Year

Released

Box Office

Receipts in

$2012Avatar $760.5 2009 214.5 $814.04 Titanc $600.8 1997 160.5 $859.46

Star Wars $461.0 1977 60.6$1,746.63

Shrek 2 $437.2 2004 188.9 $531.40 E.T: The Extra-Terrestrial $399.9 1982 96.5 $951.47

The movie with the highest box office receipts in 2012 dollars was Star Wars.

13. These items are omitted because it is difficult to assign them as a value since they do not involve a market transaction. The GDP is not intended to be sexist. However, it clearly does omit a number of productive functions that are often performed by women. Other measures of income that focus on markets usually omit these same productive activities. Of course, productive activities performed by men are also omitted when they do not involve a market exchange.

15. a. personal consumption expenditure; gross private domestic investment; government consumption and gross investment; exports – imports. $15,684.8 billion.

b. employee compensation; self-employment income; rents; corporate profits; interest income; indirect business taxes; depreciation; net income of Americans abroad. $15,684.8 billion.

Chapter 8Economic Fluctuations, Unemployment, and Inflation

OUTLINE

I. Swings in the Economic PendulumA. A Hypothetical Business Cycle

1. The phases of the business cycle are: expansion, peak (or boom), contraction, and recessionary trough.2. The duration of business cycles is irregular and the magnitude of the swings in economic activity varies.

II. Economic Fluctuations and the Labor MarketA. The non-institutional, civilian, adult, population is grouped into two broad categories: (1) persons not in the labor force and (2) persons in the labor force.B. Labor market participation rate = number in labor force (employed + unemployed) / population (age 16 and over).C. In order to be classified as unemployed, one must either be on layoff or actively seeking work.

D. Rate of unemployment = number unemployed/number in labor force (employed + unemployed)

E. Some economists argue that the employment/population ratio—the number employed divided by population 16 and over)—is a better indicator of job availability than the unemployment rate.

III. Three Types of UnemploymentA. Frictional Unemployment

1. Caused by imperfect information in a world of dynamic change.2. Occurs because (1) employers are not fully aware of all available workers and their job qualifications and (2) available workers are not fully aware of the jobs being offered by employers.

B. Structural Unemployment1. Imperfect matchup of employee skills and the skill demands of

available jobs.2. Reflects structural and demographic characteristics of labor market.

C. Cyclical Unemployment1. Reflects business cycle conditions

2. When there is a general downturn in business activity, cyclical unemployment increases.

IV. Employment Fluctuations—The Historical RecordA. The Concept of Full Employment

1. Level of employment that results when the rate of unemployment is normal, considering both frictional and structural factors.


2. Closely related to the concept of the natural rate of unemployment.3. The natural rate of unemployment is the amount of unemployment that reflects this job shopping in a world of imperfect information and dynamic change.4. The natural rate of unemployment is neither a temporary high nor a temporary low; it is a rate that is both achievable and sustainable into the future. It is the rate of unemployment accompanying the economy s “maximum sustainable rate of output.”5. Natural rate of unemployment is influenced by both demographic factors (e. g., youthful workers as a share of the labor force) and public policy (e. g., generous unemployment benefits)6. The actual rate rises above the natural rate during a recession and falls below the natural rate during an economic boom.7. The unemployment rates of major European countries were substantially higher in the last decade than the comparable figures for the United States and Japan.

V. Actual and Potential GDPA. Potential output: maximum sustainable output level consistent with the economy’s resource base, given its institutional arrangements.B. Actual and potential output will be equal when economy is at full employment.

VI. Effects of InflationA. Inflation is a sustained general rise in the level of prices. High rates of inflation are almost always associated with substantial year-to-year swings in the inflation rate.B. Anticipated and Unanticipated Inflation1. Unanticipated inflation: an increase in the price level that comes as a surprise, at

least to most individuals.2. Anticipated inflation: a change in the price level that is widely expected.C. Harmful Effects of High and Variable Rates of Inflation

1. Because unanticipated inflation alters the outcomes of long-term projects like the purchase of a machine or operation of a business, it will increase the risks and retard the level of such productive activities.

2. Inflation distorts the information delivered by prices.3. People will respond to high and variable rates of inflation by spending less time

producing and more time trying to protect their wealth and income from the uncertainties created by the inflation.

D. What Causes Inflation?1. Nearly all economists believe that rapid expansion in the supply of money is the

cause of inflation.

OBJECTIVES

This chapter is designed as an overview of the material that will be discussed in the subsequent chapters and introduces the student to several important economic issues. The business cycle is defined and related to real-world economic indicators. The cost of obtaining information, economic uncertainty, and inadequate aggregate demand are presented as factors contributing to real-world unemployment. The concepts of “full employment” and, its flip side, the “natural rate of unemployment,” highlight the macroeconomic supply factors that constrain our ability to


Chapter 8/Economic Fluctuations, Unemployment, and Inflation 101

produce goods and services. Inflation is also defined and its effects are analyzed from an economic viewpoint. The chapter should whet the reader’s appetite for the body of the macro material, which focuses on the general issues of unemployment, economic instability, and inflation.


1. Carefully define the four phases of the business cycle. This is a good place to provide an historical overview of economic instability, including the Great Depression of the 1930s, and the sluggish economic climate of the last decade.

2. Discuss the data of Exhibit 3. This table will help students understand the various categories of employment and unemployment. The Monthly Labor Review provides the data to update Exhibit three if you choose.

3. Many students have the idea that all unemployment is indicative of economic inefficiency. The myth on this topic would be an excellent focus for a class discussion that would clarify student thinking in this area.

4. The term full employment is troublesome to both laypersons and professionals. Students sometimes think it cannot be attained unless everyone is working. Point out that economists use the term when referring to the level of employment associated with normal operation of dynamic labor markets.

5. Of course, full employment incorporates the idea that at a given time there is a natural rate of unemployment consistent with dynamic change, institutions, and the characteristics of the labor force. It is important to note that the natural rate of unemployment is influenced by public policy. If public policy reduces the cost of remaining unemployed, more people will choose to continue searching for a better job. Thus, the natural unemployment rate is not a fixed rate determined immutably by nature.

6. Students are interested in how the unemployment rate is derived—how many households are sampled; what determines whether a person is classified as employed or unemployed; and oddities that result from the classification procedures. The boxed feature on the measurement of unemployment deals with these issues. Critical Analysis question three will also enhance student understanding of this issue. This is an important issue in that even a change in the wording of the question “keeping house or something else” (sometimes asked of women) to “working or something else” can appreciably change the measured unemployment rate.

7. As the result of the ambiguities associated with the rate of unemployment, economists increasingly have felt the need to supplement unemployment data with data on the rate of employment. The rate of employment (the percentage of the total non-institutional population, age 16 and over, that is employed) is measured more readily and involves fewer subjective judgments about a person’s employment status. Today’s student should be introduced to both the rate of unemployment and the rate of employment. This is especially so since employment and unemployment rates can move the same direction, as in the 1980s.

8. Students (among others) often forget that inflation influences money earnings as well as prices. If the rate of inflation in 1980 had been two percent (rather than approximately 12

102 Chapter 8/Economic Fluctuations, Unemployment, and Inflation

percent), the real income of individuals would not have increased by 10 percent. Inflation pushes up money earnings, but not necessarily real earnings. Question 13 provides a focal point for discussion of the issue.

9. The social costs of inflation stem largely from the uncertainty that it generates. Be sure to bring out how uncertainty about future rates of inflation makes long-term contractual agreement riskier.

10. Be careful not to argue that inflation necessarily benefits debtors at the expense of creditors. This would be true only if the inflation were not fully anticipated.

11. It is useful to stress that the natural rate of unemployment or “full employment” is a benchmark representing the maximum sustainable level of real output. In turn, the output associated with the natural rate of unemployment represents the long-run aggregate supply benchmark. While the full employment rate of output can be temporarily exceeded, the higher level of output cannot be sustained. A good analogy of output that is temporarily greater than the rate that is sustainable with which students can readily identify is finals week. During finals week, students temporarily study far harder than they are willing to do on a sustainable basis throughout the term.

12. A humorous way to introduce discussion of issues such as discouraged workers and how the typically reported unemployment data masks some very important information is to propose the following “solution” to high unemployment in class: hire people like Danny DeVito and Don Rickles to go berate those in the unemployment compensation lines about how they are losers, and that they’ll never find a job. To the extent that they succeed in discouraging workers into stopping their search for work, the unemployment rate will decline. Then pose the following questions: Does the lower unemployment rate indicate that society is better off? Will output increase? Is the unemployment rate a good indicator of labor market conditions? Why or why not?

13. It is worth emphasizing here that macroeconomic issues are not about statistical data but are all social coordination issues, where coordination failures lead to adverse consequences for real people (e.g., correlations between unemployment and domestic violence, suicides, alcoholism, etc.). We are not concerned with statistical data per se, but with the costs to people that those data represent. Just because the analysis relies on statistics does not mean it is solely about statistics.

14. Games 1 to 4 in the next section will help reinforce the material in chapter 8.

GAMES

8.1 Who’s Unemployed?

Type: In-Class AssignmentTopics: unemployment categoriesTextbook: Chapter 8: Economic Fluctuations, Unemployment, and InflationMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class


Purpose

This assignment helps familiarize students with labor force statistics.

Instructions

Ask the students to classify each of the following individuals in one of the following categories: employed, unemployed, not in the labor force.

Steve worked forty hours last week in a Music Supply store.

Last week, Elizabeth worked 10 hours as a computer programmer for the National Video Company and attended night classes at the local college. She would prefer a full-time job.

Roger lost his job at the R-gone Manufacturing Company. Since then he has been trying to find a job at other local factories.

Linda is a homemaker. Last week she was occupied with her normal household chores. She neither held a job nor looked for a job.

Linda’s father is unable to work.

Scott has a Ph.D. He worked full-time but doesn’t like his job as a dishwasher. He has applied for jobs with three companies and five universities. As soon as he gets an offer he’ll quit his current job.

Mary-Helen has been out of work for a full year. She would take a job if it was offered, but no local companies are hiring. She is not actively searching for work.


Steve, Elizabeth, and Scott are employed.

Roger is unemployed.

Linda, Linda’s father, and Mary-Helen are not in the labor force.

This assignment can also be used to discuss measurement problems such as underemployment (Linda & Scott are examples) and discouraged workers (Mary-Helen provides an example).

8.2 The Inflation Fairy

Type: In-Class demonstrationTopics: inflationTextbook: Chapter 8: Economic Fluctuations, Unemployment, and InflationMaterials Needed: noneTime: 10 minutesClass limitations: works in any size class


Purpose

This activity demonstrates the effects of inflation.

Instructions

Ask the class to consider the effect of an overnight doubling of prices.

Tell them everything doubled in price while they slept. A soft drink that sold for a dollar, now sells for two dollars; a car that sold for $20,000 now sells for $40,000.

The price of labor doubled as well, so a job paying $6 an hour, now pays $12; a $30,000 annual salary becomes a $60,000 annual salary.

The value of all assets doubled as well. Stock prices are twice what they were at yesterday’s closing. A thousand-dollar bond becomes a two thousand dollar bond. A $35 balance in a checking account become $70, and so on.

Debts have also doubled. The $5 borrowed from a roommate becomes $10. The $3000 in student loans becomes $6000. A $75,000 home mortgage becomes a $150,000 mortgage.

And even cash balances double. The inflation fairy sneaks in at night and replaces the $10 bill in their wallet with a new $20 bill. The inflation fairy even doubles the coins in their penny jars.

If the prices of everything doubled overnight, what would happen?


If the prices of everything doubled overnight, what would happen: NOTHING!

If all prices adjusted perfectly there would be no real effect. Everyone would have exactly the same purchasing power. They have twice as much money but everything costs twice as much. There have been no relative changes in price.

This is a fantastic rate of inflation: 100% daily. Prices would increase over a billion-fold in a month at this rate of price change. Yet, if everything adjusts perfectly there will be no real effect on the economy.

The problem, of course, is there is no inflation fairy insuring that everything adjusts smoothly. Some prices adjust quickly and others don’t.

Cash balances wouldn’t double without the inflation fairy, so people wouldn’t be willing to hold cash or accept cash in payment. This would increase transaction costs considerably.

If prices don’t change at the same rate there will be winners and losers from inflation. For example, if everything doubled in price overnight except debt then borrowers would see the real value of their loan payments halved. Borrowers would win and lenders would lose. If the overnight inflation is an ongoing process, everyone would try to borrow, but no one would be willing to lend. Credit markets would collapse.


More generally, anyone who’s income doesn’t keep up with inflation will lose. Anyone who’s costs rise less than inflation will come out ahead.

Other problems can be introduced here: bracket creep, increased uncertainty, weakening of price signals, shoe leather costs, menu costs, etc.

Much of the problem with inflation is distributional, but there are real consequences as well. Time spent worrying about inflation, or profiting from inflation, is a diversion of resources away from productive activity.

8.3 Changes in a Student Price Index

Type: Take-home assignmentTopics: inflationTextbook: Chapter 8: Economic Fluctuations, Unemployment, and InflationMaterials needed: Initial prices for a market basket (see Game 1 for Chapter 7)Class limitations: works in any size class

Purpose

This assignment looks at how prices for a small market basket of goods change during the school term. These price changes can be related to the overall rate of inflation. The importance of the choice of market basket is also illustrated.

Instructions

A month after collecting the Price Index Assignment (Game one for Chapter 7), ask the students to return to the stores and find the current prices for the same bundle of products.


Typically some market baskets experience price increases, others decrease and some prices will be unchanged. Students typically pick goods with volatile prices, such as food or gasoline. These sectors typically change faster than the overall market basket used in the CPI.

The large variation in student responses emphasizes the importance of market basket selection. Different market baskets will result in different measures of inflation.


Name____________________ Course ________________

Price Index Assignment II

Changes in the Consumer Price Index are a widely used measure of inflation.Use your personalized student price index to calculate how prices have changed.

1. Use the same products and the same quantities at the same retail outlet.

2. Find the new price for each product.

3. Calculate the total cost of buying these products at their current prices.

4. Calculate the percentage change in price for the entire market basket.


8.4 Prices and Time

Type: Take-home assignmentTopics: InflationTextbook: Chapter 8: Economic Fluctuations, Unemployment, and InflationClass limitations: works in any size class

Purpose

This assignment looks at how prices change over a long period of time. These price changes can be related to the overall rate of inflation.

Instructions

This assignment asks students to compare prices in the year they were born to current prices for the same goods.


Inflation makes comparisons of prices across long periods of time difficult. Old nominal prices may look very low, but nominal wares were low as well.

Price indices can be used to calculate real prices, but product changes over time introduce inaccuracies. Many products are not the same 20 years later. Quality change and technological advances make comparisons more difficult. This can lead to a discussion of the proposed changes in the Consumer Price Index.

Since the minimum wage is not indexed to inflation, its purchasing power can drop significantly between legislated increases. This can be used to introduce indexing or to introduce a discussion of equity.


Name____________________ Course _______________

Date of Birth _______________

Prices and Time

Part I. Historic Prices

1. Find the prices for 5 (or more) products in the year you were born. Be as specific as possible regarding brand names and quantities. Archived newspapers and magazines are good places to find prices from that long ago. (These are frequently stored on microfilm at libraries.)

2. What was the Federal minimum wage, when you were born?

Part II Current Prices

1. Find the current price for each of the products in Part I.

2. What is the Federal minimum wage now?

Part III. Comparisons

1. Do you think there has been a change in the quality of any of these products over this time period?

2. How has technological change affected these products?

3. Calculate the percentage change in price for each good over this time period.

4. Calculate the percentage change in the minimum wage.

5. What has happened to the purchasing power of people earning the minimum wage?



3. (a), (b), and (c) are unemployed; (d) is not in the labor force; and (e) and (f) are employed.

4. Full employment is the maximum level of employment that is both achievable and sustainable in the future given the dynamic change and structural conditions of the economy. When full employment is present, the actual and natural rates of unemployment are equal.

10. a. $646,552; $925,926; $581,395; $417,537; $400,000; b. 1940; c. The real salary rose because the price level fell between 1920 and 1940.

11. The opportunity cost of job search for laidoff workers will drop since unemployment benefits will replace 100 percent of worker’s prior earnings. Other things the same, this lower opportunity cost of job search will result in more lengthy periods of search and higher rates of unemployment.

12. (160-150)/150 = 6.66%

Chapter 9An Introduction to Basic Macroeconomic Markets

OUTLINE

I. Understanding Macroeconomics: Our Game PlanA. As a basic macroeconomic model is developed, we will have some

assumptions.1. The Money Supply is constant.2. Taxes and expenditures are constant.

B. Thus, there is a circular flow of output and income between these two key sectors: businesses and households.

II. Four Key Markets—Resources, Goods and Services, Loanable Funds And Foreign Exchange Markets Coordinate the Circular Flow of IncomeA. Goods and Services Market: In this market, businesses supply goods and services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports) demand goods.B. Resource Market: Highly aggregated market where business firms demand resources because of their contribution to the production of goods and services; households supply labor and other resources in exchange for income.

C. Loanable Funds Market: Coordinates the actions of borrowers andlenders.D. Foreign Exchange Market: Coordinates the actions of Americans demanding foreign currency in order to buy things from foreigners and foreigners supplying foreign currencies in exchange for dollars so they can buy things from Americans.

III. Aggregate Demand for Goods and ServicesA. Aggregate demand curve indicates the various quantities of domestically produced goods and services that purchasers are willing to buy at different price levels.B. AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods and services demanded and the price level.C. Why Does the Aggregate Demand Curve Slope Downward?

1. A lower price level will increase the purchasing power of the fixed quantity of money.2. The Interest Rate Effect: a lower price level will reduce the demand for money and lower the real interest rate, which will stimulate additional purchases during the current period.3. Other things constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.

IV. Aggregate Supply of Goods and ServicesA. When considering the AS curve, it is important to distinguish between the short run and the long run.

1. Short run: time period during which some prices, particularly those in labor markets, are set by prior contracts and agreements. Therefore, in the short run,


households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level.2. Long run: a time period of sufficient duration that people have the opportunity to modify their behavior in response to price changes.

B. Short-Run Aggregate Supply (SRAS)1. Indicates the various quantities of goods and services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market.

2. SRAS curve slopes upward to the right.3. The upward slope reflects the fact that in the short run an unanticipated increase in the price level will improve the profitability of firms. They will respond with an expansion in output.

C. Long-Run Aggregate Supply (LRAS)1. Indicates the relationship between the price level and quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible.

2. LRAS curve is vertical.3. LRAS is related to the economy’s production possibilities constraint. A higher price level does not loosen the constraints imposed by the economy’s resource base, level of technology, and the efficiency of its institutional arrangements.

V. Equilibrium in the Goods and Services MarketA. Short-run Equilibrium.

1. Short-run equilibrium is present in the goods and services market at the price level (P) where the aggregate quantity demanded is equal to the aggregate quantity supplied.

2. Occurs at the output rate where the AD and SRAS curves intersect.3. At the market-clearing price, the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply during the current period.

B. Long-run Equilibrium.1. A second condition is required for long-run equilibrium: the buyers and sellers must have correctly anticipated the consequences of their prior choices.2. Thus, long-run equilibrium requires that decision makers who agreed to long-term contracts influencing current prices and costs must have correctly anticipated the current price level at the time they arrived at the agreements. If this is not the case, buyers and sellers will want to modify the agreements when the long-term contracts expire.

C. When Long-run Equilibrium is present:1. Potential GDP is equal to the economy’s maximum sustainable output consistent with its resource base, current technology, and institutional structure.

2. Economy is operating at full employment.3. Actual Rate of Unemployment = natural rate of unemployment.

D. What Happens When the Economy’s Output Differs from its Long-Run Potential?


Chapter 9/An Introduction to Basic Macroeconomic Markets 113

1. An unexpected change in the price level (rate of inflation) will alter the rate of output in the short run.

114 Chapter 9/An Introduction to Basic Macroeconomic Markets

2. An unexpected increase in the price level will stimulate output and employment during the next year or two.3. An unexpected decline in the price level will cause output and employment to fall in the immediate future.

VI. Resource MarketA. The demand for resources: Business firms demand resources because they contribute to the production of goods the firm expects to sell at a profit.

B. The demand for resources slopes downward to the right.C. The supply of resources: households supply resources in exchange for income.D. Higher wages increase the incentive to supply resources; thus, supply curve slopes upward to the right.E. The equilibrium or market-clearing price brings the amount demanded by business firms into balance with the amount supplied by resource owners.

VII. Loanable Funds MarketA. Interest rate coordinates the actions of borrowers and lenders.

B. From the borrower’s viewpoint, interest is the cost paid for earlier availability. From the lender s viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future.

C. Money and real interest rate1. When the inflation rate is anticipated, lenders will demand (and

borrowers will agree to pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar.

2. This premium for the expected decline in purchasing power of the dollar is called the inflation premium.D. Real interest rate = Money interest rate – Inflation premium

VIII. Foreign Exchange MarketA. When Americans buy from foreigners and make investments abroad (an outflow of capital), their actions will generate a demand for foreign currency in the foreign exchange market.B. On the other hand, when Americans sell products and assets (including bonds) to foreigners, the transactions will generate a supply of foreign currency (in exchange for dollars) in the foreign exchange market.C. The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied.

IX. Long Run EqulibriumA. Macroeconomic equilibrium requires that equilibrium be achieved in all four key macroeconomic markets and that they be in harmony with one another.

OBJECTIVES

This chapter presents the basic model that will be utilized throughout the macroeconomics section of the text. The model consists of three basic, interrelated markets: (1) goods and services, (2) resources, and (3) loanable funds. In contrast with the analysis of Chapter 3, the basic markets of

Chapter 9/An Introduction to Basic Macroeconomic Markets 115

our macroeconomic model are highly aggregated. Nonetheless, prices in these aggregated markets influence the choices of buyers and sellers.

In this chapter we (a) explain the general characteristics of demand and supply in the three basic markets and (b) introduce the concept of macroeconomic equilibrium. The following chapter will focus on the workings of our simple model—that is, how the markets adjust to changing conditions.

IMPORTANT POINTS AND TEACHING TIPS

1. The circular flow diagram of Exhibit 1 illustrates the three basic macroeconomic markets. Use this exhibit to explain the forces contributing to demand and supply in the resources, loanable funds, goods and services, and foreign exchange markets.

2. Initially, we make two important assumptions as the basic macroeconomic model is developed. First, we assume that government expenditure and taxation policies are unchanged. This assumption is relaxed in Chapters 11 and 12 on fiscal policy. Second, the money supply is assumed to be constant. This assumption is relaxed in Chapter 14 on monetary policy. Be sure to remind your students of these two important assumptions.

3. Of course, the aggregate demand curve is inversely related to price (the price level) for different reasons than the inverse relationship between amount demanded and price in a narrowly defined market. The Thumbnail Sketch summarizes the reasons why the aggregate demand curve slopes downward to the right.

4. When discussing saving and the supply of loanable funds, be sure to emphasize that saving is a flow concept—current income that is not spent on consumption. Point out that saving (without the “s”) is not the same thing as savings, a stock concept.

5. Other things constant, an increase in the price level in the goods and services market will (a) improve profit margins since many components of costs are temporarily fixed and (b) lead many producers to believe that the demand for their product has increased. These two factors will result in a short-run aggregate supply curve that slopes upward to the right as Exhibit 3 illustrates.

6. In the long run, output is constrained by the economy’s resource base and the level of technology. Since a higher price level does not loosen these restraints, the long-run aggregate supply curve is vertical.

7. Be sure to link the concepts of long-run aggregate supply and the natural rate of unemployment (sustainable level of employment).

8. Go over Exhibit 5 carefully making sure students understand that long-run equilibrium in the goods and services market requires both (a) a balance between aggregate demand and aggregate supply and (b) an actual price level equal to the price level expected by buyers and sellers.

9. Students have difficulty understanding the connection between interest rates and bond prices. A brief discussion of the boxed feature “Bonds, Interest Rates, and Bond Prices” will enhance student understanding of this issue.

116 Chapter 9/An Introduction to Basic Macroeconomic Markets

10. A useful way of reinforcing the relationship between bond prices and interest rates is with a mountain climbing analogy: To reach a given peak (promised future payment on a bond, the higher your current elevation (present bond price), the less rapidly one has to climb (the smaller the implied rate of interest being compounded).

11. It is worth emphasizing that aggregate supply and demand analysis reflects the generally different speeds of adjustment in different macroeconomic markets. Financial markets tend to adjust most quickly, followed by product markets (both of which are assumed to adjust in the short run), followed by factor markets (whose ultimate adjustment is indicated by the movement from the short-run equilibrium to the long-run aggregate supply curve). On the other hand, with supply shocks, it is input price changes that begin the analysis.

12. To help cement student understanding of why the long-run aggregate supply curve is vertical with respect to the price level, it is often useful to ask them whether a law halving the official length of an inch would affect behavior, once people had time to adjust to the change. They will quickly see that no effects would arise because no “real” relationships will have been changed. Similarly, you show students that a doubling of all prices (a halving of the value of a dollar in terms of goods and services), once people have adjusted, will not change any relative price relationships; since no incentives will have changed as a result, there is no reason to expect a change in the sustainable level of real output (the natural level of real output).


2. In the long run, the major factors influencing aggregate supply are: (1) the size of the resource base, (2) technology, and (3) the institutional arrangements of the economy. The long-run aggregate supply curve is vertical because the production possibilities of the economy are constrained, assuming a given resource base, level of technology, and institutional organization of an economy. In effect, the LRAS reflects the underlying production possibilities of the economy.

8. When the price level is higher than decision makers had anticipated, real wages will be lower and the level of employment higher than would have been the case if the price level had been anticipated accurately. Profit margins will increase; the actual rate of unemployment will fall below the natural rate. The high current rate of output will not be sustainable because real wages will rise as there is opportunity to renegotiate existing contracts.

9. 4 percent; 4 percent; it will fall to 1 percent.

13. Inversely; an increase in interest rates is the same thing as a reduction in bond prices.

16. a. Real GDP = $5,400

b. It will be a long-run equilibrium because the price level was equal to that expected.

c. Actual unemployment will equal the natural rate of unemployment.

d. Unemployment is equal to its natural rate, so it is sustainable.

Chapter 10Dynamic Change, Economic Fluctuations,

and the AD-AS Model

OUTLINE

I. Anticipated and Unanticipated ChangesA. Anticipated changes are foreseen by economic participants. Decision makers have time to adjust to them before they occur.B. Unanticipated changes catch people by surprise.

II. Factors That Shift Aggregate DemandA. An increase (decrease) in real wealthB. A decrease in the real rate of interestC. An increase in the optimism (pessimism) of businesses and consumers about the

future economic conditionsD. An increase (decline) in the expected rate of inflationE. Higher (lower) real incomes abroadF. A reduction (increase) in the exchange rate value of the nation’s currency.

III. Shifts in Aggregate SupplyA. Changes in Long-Run Aggregate Supply

1. An increase (decrease) in the supply resources.2. An improvement (deterioration) in technology and productivity.

3. Institutional changes that increase (reduce) the efficiency of resource use.B. Changes in Short-Run Aggregate Supply1. A decrease (increase) in resource prices—that is, production costs.2. A reduction (increase) in the expected rate of inflation.3. Favorable (unfavorable) supply shocks, such as good (bad) weather or a reduction

(increase) in the world price of an important resource.IV. Steady Economic Growth and Anticipated Changes in Long Run Aggregate Supply

A. Increases in LRAS will make it possible to produce and sustain a larger rate of output.B. Both LRAS and SRAS will shift to the right and output will increase.C. These changes generally take place slowly and therefore they need not disrupt long-

run equilibrium.V. Unanticipated Changes and Market Adjustments

A. In the short run, output will deviate from full employment capacity when prices in the goods and services market deviate from the price level that people expected.B. Impact of Unanticipated Increases in Aggregate Demand

1. Initially, the strong demand and higher price level in the goods and services market will temporarily improve profit margins.


2. Output will increase, the rate of unemployment will drop below the natural rate and output will temporarily exceed the economy’s long-run potential.3. With time, however, contracts will be modified and resource prices will rise and return to their competitive relation with product prices.4. Once this happens, output will recede to the economy’s long-run potential.

C. Impact of Unanticipated Reductions in Aggregate Demand1. Weak demand and lower prices in the goods and services market will reduce profit

margins. Many firms will incur losses.2. Firms will reduce output; the rate of unemployment will rise above the natural rate and output will temporarily fall short of the economy’s long-run potential.

3. With time, long-term contracts will be modified. Eventually, lower resource prices and interest rates will direct the economy back to long-run equilibrium: but this may be a lengthy and painful process.

D. Impact of an Unanticipated Increase in SRAS1. SRAS shifts to the right—temporarily output will exceed the economy’s long-run potential.2. Since the temporarily favorable supply conditions cannot be counted on in the future, the economy’s long-term production capacity will not be altered.3. Recognizing that they will be unable to maintain their current high level of income, individuals will generally save a substantial portion of it for use at a future time that is not nearly so prosperous.4. The increased saving will reduce interest rates, which will encourage investment (capital formation).

E. Impact of Unanticipated Reductions in SRAS1. If an unfavorable supply shock is expected to be temporary, long-run aggregate supply will be unaffected.2. Households will reduce their current saving level (and dip into past savings) to maintain a current consumption level more consistent with their longer-term perceived opportunities.3. The reduction in saving will lead to higher real interest rates and retard current investment.

VI. Price Level, Inflation, and the AD-AS ModelA. Once decision makers anticipate a given rate of inflation and build it into long-term contracts, an actual rate of inflation that is less than expected is essentially the equivalent of a reduction in the price level when price stability (zero inflation) is anticipated.B. Similarly, the impact of an inflation rate that is greater than was anticipated will be like that of an increase in the price level when price stability is anticipated.

VII. Unanticipated Changes, Recessions, and Booms A. There are two forces that underlie the self-corrective mechanism of macro markets:

1. Changes in real resource prices will help direct an economy toward equilibrium. Real resource prices will tend to fall during a recession and rise during an economic expansion.


Chapter 10/Dynamic Change, Economic Fluctuations, and the AD-AS Model 119

2. Changes in real interest rates help stabilize aggregate demand and redirect economic fluctuations. Interest rates will tend to fall during a recession and rise during and economic boom.

B. Expansions and Recessions: the Historical Record1. During the past six decades, economic expansions have been far more lengthy than recessions.2. The depth and severity of the recession that started in December 2007 highlights the issue of economic instability and recovery from a recession.

C. Using the AD-AS Model to Think about the Business Cycle and the Great Recession of 2008-2009

1. Between 2002 and mid-year 2006, housing prices rose by almost 90%. Stock prices also rose rapidly. As a result, wealth expanded and AD increased, leading to an economic boom.2. But the situation changed in the second half of 2006. Housing prices began to fall. Both mortgage default and housing foreclosure rates increased. This reduced aggregate demand.3. Beginning in October 2007, stock prices fell and they plunged during 2008. This also reduced wealth and AD.4. During 2007 and the first half of 2008, crude oil and other energy prices soared, and this generated an unanticipated reduction in SRAS.5. These forces led to a sharp reduction in consumer and investor confidence, further reducing AD.6. The reductions in both AD and SRAS reduced output and employment just as the AD-AS model implies.

OBJECTIVES

This chapter focuses on how the three-market macroeconomic model adjusts in response to economic change. The major factors that shift the aggregate demand and aggregate supply schedules are analyzed. The secondary effects of an economic change in one market are traced into other markets. The chapter also explains why it is important to distinguish between unanticipated and anticipated events.

The chapter also outlines the basic framework of the Keynesian model. It focuses on the role on the multiplier and its role in the Keynesian view of economic instability. The chapter concludes with a discussion of the evolution of the modern view of economic instability.


1. Throughout this chapter we continue to assume that the government’s expenditure, tax, and monetary policies are unchanged. Remind students of these key assumptions, and inform them that they will be relaxed as we proceed. However, in this chapter our focus is on how macroeconomic markets work, rather than economic policy.

2. The initial section of this chapter outlines the primary factors that shift the aggregate demand schedule. The Thumbnail Sketch summarizes these points. Make sure students understand

120 Chapter 10/Dynamic Change, Economic Fluctuations, and the AD-AS Model

why changes in: (a) real wealth; (b) real interest rates; (c) business expectations; (d) the expected rate of inflation; (e) real incomes abroad; and (f) exchange rates shift aggregate demand in the goods and services market.

3. The long-run aggregate supply constraint of our model is based on the concept of the economy’s production possibilities curve. The same factors that cause the economy’s production possibilities curve to shift will also cause a shift in long-run aggregate supply. This is a good time to have students review the material in Chapter two on the production possibilities curve.

4. Be sure to stress that short-run aggregate supply can change temporarily without a change in the economy’s long-run production capacity. Supply shocks and changes in the expected rate of inflation are the primary sources of shifts in the SRAS curve that do not alter LRAS.

5. The Thumbnail Sketch summarizes the major factors that cause shifts in the long-run and short-run aggregate supply curves. Review these factors, making sure students understand why the changes alter aggregate supply.

6. Since the fiscal and monetary policies are unchanged, economic growth will shift both the long-run and short-run aggregate supply curves to the right and lead to a lower price (level) in the goods and services market. See Exhibit 3. However, be sure to note that monetary policy had in fact been expansionary during economic growth of this sort. The logic is no different; expansionary monetary policy just needs to be factored in as well as increases in LRAS.

7. The distinction between anticipated and unanticipated economic changes is central to modern economic analysis. Use illustrations to stress how behavior varies depending on whether an event is anticipated or unanticipated. For example, you might note that when thunderstorms routinely blow up every summer afternoon in an area, local residents anticipate the storm and typically carry an umbrella when they plan to be outside. In contrast, in areas where afternoon summer storms are a sporadic event, people often get caught without umbrellas. Similarly, a cold winter night in Montana fails to catch people by surprise. In contrast, a similar (but unanticipated) cold night in Florida may find many people with inadequate clothing or heating. Illustrations of this type will drive home that it makes a difference whether events are anticipated of unanticipated.

8. Be sure to go over the impact of an unanticipated increase and decrease in aggregate demand. Exhibits 5 and 6 of the text cover these topics.

9. When current output exceeds the economy’s full employment (long-run) capacity, the strong demand will push up resource prices. The higher resource prices will shift SRAS to the left and cause output to return to its long-run level. In contrast, when current output is less than the economy’s long-run capacity, weak demand will place downward pressure on resource prices. In turn, lower resource prices will expand SRAS and direct the economy to its full employment rate of output (and natural rate of unemployment). Use Exhibits 7 and 8 to consider the adjustment of macroeconomic markets when disequilibrium is present.

10. Critical Analysis questions 1 and 2 will enhance student understanding of the major factors that affect aggregate demand and aggregate supply. Critical Analysis question 6 focuses on


why it makes a difference whether decision makers over- or under-estimate the actual rate of inflation.

11. In talking about the effects of supply-side incentives on the long-run aggregate supply curve, it is important to emphasize that supply-side incentives change the “effective” production possibilities curve (determined not only by natural resources, technology, etc., but also by the incentives to make productive use of those resources) by changing long term incentives and institutional arrangements.

12. The difference between an unannounced “pop quiz” and an announced exam will help students grasp the distinction between expected and unexpected macroeconomic changes.

13. In talking about the speed of market adjustment toward an equilibrium on the long-run aggregate supply curve versus the speed of government solutions, it is sometimes helpful to extend the round bottom bowl analogy (see hint number 8 of Chapter 3) to equilibrium by allowing there to be some friction as the marble adjusts. In this case, the tradeoffs involved are whether the market adjustment might need a push from government to adjust faster versus the risk of pushing too hard and causing other problems from overshooting.


3. An outward shift in the production possibilities curve would shift the long run aggregate supply curve to the right. Improvements in computer technology have shifted the production possibilities curve outward by increasing the productivity of labor and capital. As a result, the long-run aggregate supply curve has shifted to the right.

6. At the lower-than-expected inflation rate, real wages (and costs) will increase relative to product prices. This will squeeze profit margins and lead to reductions in output and employment, causing the unemployment rate to rise.

7. The sharp decrease in house prices would tend to reduce aggregate demand and the rise in oil prices would tend to lower aggregate supply. Both shifts would tend to reduce output, but the effect on the price level is uncertain.

10. The increase in demand for exports will increase aggregate demand. In the short run, this unanticipated expansion in demand will tend to increase output and employment while exerting modest upward pressure on the price level. In the long run, the primary impact will be a higher price level, with no change in output and employment.

122 Chapter 10/Dynamic Change, Economic Fluctuations, and the AD-AS Model

11. The graph below shows point E1 as full-employment or long-run equilibrium. The point e2 shows the economy in a boom.

The graph below shows point E1 as full-employment or long-run equilibrium. The point e2 shows the economy in a recession.


12. a. $4.5 trillion.

b. The economy is not in long-run equilibrium because the actual price level is different from the expected price level, entailing further adjustments.

c. Unemployment will be below the natural rate.

d. Resource prices will rise, shifting SRAS left (up) and pushing output back to the natural level at a higher price level.

e. Real GDP is not sustainable at $4.5 trillion; it will tend to fall.

Chapter 11Fiscal Policy: The Keynesian View

and Historical Perspective

OUTLINE

I. The Great Depression and Macro-Adjustment ProcessA. The Great Depression and Keynesian Economics

1. Keynesian economics developed during the Great Depression (1930s).2. Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s.3. Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

4. Keynesian View of Spending and Outputa. Keynes argued that spending induced business firms to supply

goods and services. Thus, if total spending fell, then business firms would respond by cutting back production. Less spending would thus lead to less output.

II. Output, Employment, and Keynesian EconomicsA. The Multiplier and Economic Instability

1. The Multiplier: View that a change in autonomous expenditures investment, for example, generally leads to an even larger change in aggregate income.2. Spending of one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount.3. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume.

B. Adding Realism to the Multiplier 1. In evaluating the importance of the multiplier, one should remember:

a. An increase in government spending will require either higher taxes or additional government borrowing.

b. It takes time for the multiplier to work.c. The multiplier effect implies that the additional spending brings

idle resources into production without price changes -- this is unlikely to be the case during normal times.

2. During normal times, the demand stimulus effect of additional spending is substantially weaker than the multiplier suggests.


Chapter 11/Fiscal Policy, Incentives, and Secondary Effects 125

C. Keynes and Economic Instability: A Summary1. According to the Keynesian view, fluctuations in total spending (AD) are the major

source of economic instability.

2. Keynesians believe that market economies have a tendency to fluctuate between economic booms driven by excessive demand and recessions resulting from insufficient demand.3. The multiplier concept magnifies these fluctuations.

III. The Keynesian View of Fiscal PolicyA. Budget Deficits and Surpluses

1. Budget deficit: present when total government spending exceeds total revenue from all sources2. Budget surplus: present when total government spending is greater than total revenue

3. Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is stimulating or restraining demand.4. Changes in the size of the budget deficit or surplus may arise from either:

a. a change in cyclical economic conditionsb. a change in discretionary fiscal policy

5. The federal budget is the primary tool of fiscal policy.6. Discretionary changes in fiscal policy: deliberate changes in government spending

and/or taxes designed to affect the size of the budget deficit or surplus..B. Fiscal Policy and the Good News of Keynesian Economics

1. Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in AD.2. Prior to the Great Depression, it was widely believed that the government should balance its budget. Keynesians challenged this view.

a. Rather than balancing the budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in AD.

b. This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.

3. Keynesian Policy to Combat Recessiona. When an economy is operating below its potential output, the

Keynesian model suggests that fiscal policy should be more expansionary.4. Keynesian Policy To Combat Inflation

a. When inflation is a potential problem, Keynesian analysis suggests fiscal policy should be more restrictive.

IV. Fiscal Policy Changes and Problems of TimingA. Various time lags make proper timing of changes in discretionary fiscal policy difficult.1. Discretionary fiscal policy is like a two-edged sword; it can both harm and help. If

timed correctly, it may reduce economic instability. If timed incorrectly, however, it may increase rather than reduce economic instability.

126 Chapter 11/ Fiscal Policy: The Keynesian View and Historical Perspective

B. Automatic Stabilizers: without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom.C. Examples of Automatic Stabilizers

1. Unemployment Compensation.2. Corporate Profit Tax.3. Progressive Income Tax.

D. Paradoxes of Thrift and Spending1. The paradox of thrift

a. The paradox of thrift: The idea that when a large number of households increase their saving and reduce consumption, their actions may reduce aggregate consumption and throw the economy into a recession.

b. Keynesians often stress the dangers implied by the paradox of thrift and excessive saving.

c. The paradox of thrift indicates that efforts to save more could reduce the overall demand for goods and services, causing businesses to reduce output and lay off workers.

2. While an increase in consumption might temporarily boost AD, households will face financial troubles if they save little and spend most of what they earn and borrow on current consumption.

3. Even though the incomes of Americans are the highest in history, so too is their financial anxiety.

4. You cannot have a strong and healthy economy when households are heavily indebted and face persistent financial troubles because their saving rate is low.5. Household debt and the 2008-2009 Recession

a. The historically high level of debt meant households were in a weak position to deal with the recession of 2008-2009.

b. As a result of their high debt/income ratio, households were reluctant to spend additional income.

c. Thus the Keynesian tax rebates and federal spending increases of the Bush and Obama administrations were largely ineffective.

d. Even with budget deficits of 10% of GDP, output was sluggish and unemployment remained high in 2009-2011.

ONLINE ADDENDUM:V. The Keynesian Aggregate Expenditure Model

A. Basic Keynesian Model1. Aggregate expenditures = Planned Consumption + Investment + Government Expenditures + Net Exports2. In the Keynesian model, as income expands, consumption increases, but by a lesser amount than the income increase. Both planned investment and government expenditures are independent of income in the Keynesian model. Planned net exports decline as income increases.


B. Keynesian Equilibrium1. In the Keynesian view, equilibrium takes place when planned aggregate expenditures equal the value of current output. When this is the case, businesses are able to sell the total amount of goods and services that they produce. There are no unexpected changes in inventories. Thus, producers have no reason to either expand or contract their output during the next period.2. When total expenditures are less than current output, business firms will accumulate unplanned additions to inventories that will cause them to cut back on future output and employment.3. When total expenditures are greater than output, inventories will fall and businesses will respond with an expansion in output in an effort to restore inventories to their normal levels.4. Keynesian Equilibrium can occur at less than full employment. When it does, the high rate of unemployment will persist into the future.

C. Aggregate Expenditure and AD-AS Models1. The AE model implies that increases in demand will expand output until full employment is reached.

a. Within the AD-AS model, this implies that the SRAS curve is horizontal until full employment is achieved.

2. Once full employment is reached, the AE model implies that additional demand will lead only to a higher price level.

a. Within the AD-AS model, this implies that the SRAS curve is vertical at the full employment level of output.

3. An important implication of Keynesian analysis within the AD-AS framework:a. When substantial idle resources are present, increases in AD

will lead primarily to an expansion in output and the impact on the general level of prices will be small.

b. When an economy is at or near full employment, increases in AD will lead primarily to a higher price level rather than a substantial increase in output.

4. Keynesian Equilibrium can occur at less than full employment. When it does, the high rate of unemployment will persist into the future.

OBJECTIVES

This chapter focuses on fiscal policy, one of the two macroeconomic weapons available to policy makers. In recent years, macroeconomists have reevaluated both the potential and limitations of fiscal policy. The impact of fiscal policy is a major point of controversy among macroeconomists. This chapter presents the Keynesian view and provides an historical perspective of the development of macroeconomics.


1. Be sure to clarify the terms “budget deficit” and “budget surplus.”

128 Chapter 11/ Fiscal Policy: The Keynesian View and Historical Perspective

2. Exhibits 2 and 3 present the Keynesian view of counter-cyclical fiscal policy. As Exhibit 1 illustrates, Keynesians believe that the self-corrective mechanism of a market economy works slowly. Thus, an economy will often operate below its full employment capacity. Given the assumptions of the Keynesian model, expansionary fiscal policy is a potent weapon capable of directing an economy to its full employment output rate more rapidly than market forces. Similarly, restrictive fiscal policy is capable of restraining aggregate demand, thereby retarding potential inflationary pressures.

3. Be sure to emphasize that the Keynesian view implies that economic conditions replace the

concept of a balanced budget as the measuring rod for the determination of prudent budgetary policy. During a recession, the Keynesian view indicates that a budget deficit is sound policy. Similarly, Keynesian analysis implies that a budget surplus is appropriate during an inflationary boom.

4. Critical Analysis question 1 provides both an interesting and useful homework assignment. The other Critical Analysis questions will help students integrate the basic concepts of this chapter.

5. Be sure students see that the crucial underlying issue in analyses of the government deficit is “how well was the money spent?” If the resources transferred to government control by a deficit are better spent than they would otherwise have been, the deficit has facilitated an improvement in efficiency (though the question still remains as to whether deficit financing is less costly to society than taxation would be); if those resources are utilized in less-valuable ways, then society is made worse off as a result. (Ask your students how many think the government spends money smarter than they do—you will get interesting answers.) This issue seems to become clearest when you point out that most of the students in the class are currently running deficits, but those deficits do not make them worse off as long as the resources are being invested in human capital worth more than the cost of borrowing them.


4. A budget deficit is a situation in which total government spending exceeds total government revenue during a specific time period, usually one year. When this happens, the government must borrow funds to finance the excess of its spending relative to revenue. It borrows by issuing interest-bearing bonds that become part of the national debt .Keynesian believe that increased budget deficits due to increased government spending will directly increase aggregate demand. If the increased budget deficit is due to reduced taxes, aggregate demand will increase due to increased consumption (if personal income taxes are lowered) or business investment (if business taxes are lowered).

8. Tightness in resource markets will result in rising resource prices relative to product prices, causing the SRAS to shift to the left. Profit margins will decline, output rates will fall, and long-run equilibrium will be restored at a


higher price level. The above-normal output cannot be maintained because it reflects input prices that people would not have agreed to and output decisions they would not have chosen if they had anticipated the current price level (and rate of inflation). Once they have a chance to correct these mistakes, they do so; output returns to the economy’s long-run potential.

10. Keynesians would favor the sending of checks to households which were financed by debt. Most Keynesians believe the market-adjustment method of lower resource prices to increase aggregate supply back to full-employment will be slow and uncertain. Keynesians argue that that sending the checks would increase consumption and thus increase aggregate demand. This expansionary fiscal policy would guide the economy to full-employment.

Chapter 12Fiscal Policy, Incentives, and Secondary Effects

OUTLINE

I. Fiscal Policy, Borrowing, and the Crowding-Out EffectA. Crowding-out Effect indicates that the increased borrowing to finance a budget deficit will increase real interest rates and thereby retard private spending. Thus, fiscal policy is not very potent.B. The implications of the crowding-out analysis are symmetrical. Restrictive fiscal policy will reduce real interest rates and “crowd in” private spending.C. Crowding-out Effect in an open economy: Larger budget deficits and higher real interest rates may also lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

II. Fiscal Policy, Future Taxes, and the New Classical ModelA. The new classical view stresses that debt financing merely substitutes higher future taxes for lower current taxes. Thus, budget deficits affect the timing of taxes, but not their magnitude.B. Argues that when debt is substituted for taxes, people will save the increased income so they will be able to pay the higher future taxes. Thus, the budget deficit does not stimulate aggregate demand.C. Similarly, the real interest rate is unaffected by deficits since people will save more in order to pay the higher future taxes.

D. According to the new classical view, fiscal policy is completely impotent.III. Political Incentives and the Effective Use of Discretionary Fiscal Policy

A. Public choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters.

B. Given the political incentives, budget deficits will be far more attractive than surpluses.

C. As a result, deficits will be far more common than surpluses and discretionary fiscal policy is unlikely to be instituted in a counter-cyclical manner.

IV. Is Discretionary Fiscal Policy an Effective Stabilization Tool?A. Proper timing of discretionary fiscal policy is both difficult to achieve and crucially

important. B. Automatic stabilizers reduce fluctuations in aggregate demand and help keep the

economy on track..C. Fiscal policy is much less potent than the early Keynesian view implied

V. The Supply-Side Effects of Fiscal Policy A. From a supply-side viewpoint, the marginal tax rate is of crucial importance. A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less-heavily taxed.



B. High marginal tax rates will tend to retard total output because theywill:1. Discourage work effort and reduce the productive efficiency of

labor.2. Adversely affect the rate of capital formation and the efficiency of

its use.3. Encourage individuals to substitute less-desired tax-deductible goods for more desired nondeductible goods.

C. Thus, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance.D. Impact of Supply-Side Effects

1. Are likely to take place over a lengthy time period.2. While the significance of supply-side effects is controversial, there is evidence they are important for taxpayers facing extremely high rate, say rates of 40 percent and above.

VI. Fiscal Policy and Recovery From RecessionsA. Will Fiscal Stimulus Speed Recovery?

1. Keynesians believe that increases in government spending financed by borrowing will speed recovery from a severe recession because:

a. the expansion in government spending will offset reductions in private spending,

b. interest rates will be extremely low during a severe recession and therefore crowding out of private spending will be minimal, and

c. increased government spending will trigger a substantial multiplier effect when widespread unemployment is present.

2. Non-Keynesian critics argue that increased government spending and expanded debt will adversely affect both recovery and long-term growth because:

a. The expansion in government debt will mean higher future interest payments and tax rates that will retard future growth.

b. Recessions reflect a coordination problem and increases in government spending are likely to worsen this problem, thereby slowing the recovery process.

c. More politically directed spending will lead to more rent-seeking and less productive activity.

B. Tax Cuts Versus Spending Increases1. Some argue that increases in government spending will expand GDP by more than tax reductions, because 100% of an increase in government purchases will be pumped into the economy, whereas part of the tax reduction will be saved or spent abroad.2. Tax cuts can generally begin to exert an impact on the economy more rapidly than spending increases.3. Further, rate reductions and permanent rate changes will exert a larger impact than tax rebates and temporary tax cuts.

132 Chapter 12/Fiscal Policy, Incentives, and Secondary Effects

VII. U.S. Fiscal Policy: 1990-2013 A. Fiscal Policy Indicators, 1990-2013.

1. Changes in government expenditures and the budget deficit (or surplus) provide evidence on the direction of fiscal policy. 2. Both real government spending and federal spending as a share of GDP grew far more rapidly during 2000–2010 than during the 1990s. 3. The federal budget moved from deficit to surplus during the 1990s, but it shifted in the opposite direction during 2000–2010.4. Thus, both government spending and the federal budget indicate that fiscal policy moved toward restriction during the 1990s and expansion during the years following 2000.

B. Fiscal Policy During the Great Recession 1. As the economy dipped into the recession of 2008-2009, both the Bush and Obama administrations moved to increase federal spending and enlarge the deficit just as Keynesian analysis proscribes. 2. Was the expansionary fiscal policy effective?

a. Keynesians answer “Yes.” They believe the recession would have been much worse in the absence of the expansionary fiscal policy.b. Critics respond “No.” The recovery was the weakest of the post WWII

era.C. Is the U.S. on the Path to a Debt Crisis?

1. Total federal debt as a share of GDP rose to more than 100% in 2012, its highest level since World War II. 2. Privately held debt (net federal debt), is comprised of funds the federal govt. has borrowed from private investors. This measure has also increased sharply in recent years. 3. Even if it is never paid off, higher future taxes will be required to pay the interest on the privately held debt. 4. Federal borrowing from foreigners increased from 10% of GDP in 2000 to 35% in 2012. In contrast with domestically held debt, the interest payments on foreign debt will be paid to foreigners.

OBJECTIVES

The Keynesian perspective indicates that fiscal policy is highly potent, but there are alternativeviews on this topic. The chapter discusses alterative views including the effects of interest rate crowding-out, and the new classical model. The chapter also considers the political incentives associated with discretionary fiscal policy and the role of fiscal policy as a stabilization tool.

While the chapter focuses on the demand-side effects of fiscal policy, the supply-side effects are also integrated into the analysis. An overview of fiscal policy in the United States during the past two decades is also presented.



1. Exhibit 1 presents the interest rate crowding-out theory of fiscal policy. According to this theory, a budget deficit increases the demand for loanable funds and, during normal times, leads to a higher real interest rate. Thus, the theory stresses the potential importance of a secondary effect of fiscal policy that the Keynesian model ignores. The interest rate crowding-out theory implies that the net effects of a change in fiscal policy will be less powerful than indicated in the Keynesian model.

2. Exhibit 3 provides a graphic illustration of the new classical theory. According to this view, decision makers will anticipate the impact of the higher future taxes on their wealth. Thus, they will increase their saving (and reduce their current spending) in order to pay the higher expected future taxes. This view argues that current taxes and debt (future taxes) are essentially equivalent in terms of their impact on aggregate demand.

3. While macroeconomists have developed alternative theories of fiscal policy during recent years, nonetheless, many points of agreement have emerged. Be sure to stress the emerging modern synthesis outlined in the text.

4. Note to students that one of the difficulties in implementing supply-side fiscal policy changes is the difficulty of making binding long-term political commitments to the effect that the incentives being improved today will stay improved tomorrow. If, say, taxes are only expected to be temporarily lower, few gains in long-term output will result because the incentives for long-term investments (including human capital investments) will have been little affected (e.g., point out to students that the tax rates that dominate their incentives to invest in human capital today are largely those of 20 years from now). One of the selling points behind attempts to impose Constitutional restrictions on fiscal policy is that such changes would be very hard to undo.

5. Emphasize that supply-side economics is broader than just arguing for lower tax rates. It argues that wherever incentives toward production and mutually beneficial exchange are most adverse, they should be made less adverse. In addition to lowered tax rates, supply-side economists argue for legal and regulatory reforms, removal of government price controls, and restrictions on economic activity, etc.


4. The answer to this question is a point of contention among economists. Keynesians argue that the answer to this question is “yes.” The crowding-out and new classical economists say “No.” The crowding-out theory argues that the additional government spending financed with borrowing will lead to higher interest rates, which will crowd out private spending, either directly or through appreciation of the dollar in the foreign exchange market. The new classical theory argues that the borrowing will mean higher future taxes and people will anticipate these higher taxes and therefore reduce their current spending so they will be better able to pay them. Thus, both the crowding-out and new classical

134 Chapter 12/Fiscal Policy, Incentives, and Secondary Effects

theories indicate that the increase in government spending financed by borrowing will fail to promote a more rapid recovery.

6. Today, most economists do not believe that persistent discretionary shifts in fiscal policy are likely to help promote stability, particularly in a country like the United States with checks and balances built into the political system. The problem is timing. If changes in fiscal policy are going to promote stability, they must add demand stimulus during recessions and restraint during booms. But it will take time for Congress and the President to institute fiscal changes and even more time before they begin to impact aggregate demand. Moreover, our ability to forecast the future direction of the economy is limited. Given these time lags and forecasting limitations, it is unlikely that fiscal changes will be timed in a manner that will effectively promote economic stability.

8. It will increase the amount of rent seeking and thus harm long-term economic growth. When taxes take a larger share of a firm’s income, the reward derived from innovation is reduced. As public policy redistributes a larger share of income, more resources flow into rent-seeking. Higher taxes to finance income transfers induce firms to focus less on income-generating activities and more on actions to protect their income.

9. Keynesians believe that fiscal policy exerts a strong impact on aggregate demand, but both the crowding-out and new classical economists disagree. The transition from budget deficits to surpluses during the 1990s occurred without weakening, at least not much, either aggregate demand or the growth of the economy. In the aftermath of the 2008-2009 recession, the economy remained weak even though government spending increased sharply and the budget deficits were the highest of the post WWII era.

11. The unemployment in 2011 was 8.9 percent. The growth rate in real GDP was -3.5% in 2009, +3.0% in 2010, and +1.7% in 2011. The low rate of economic growth, in spite of the very expansionary fiscal policy, is not consistent with Keynesian view.

12. The lower marginal tax rates increased the share of taxes paid by high-income taxpayers. The lower rates increased economic output because they encouraged work effort and capital formation.

Chapter 13Money and the Banking System

OUTLINE

I. What is Money?A. Medium of ExchangeB. Store of ValueC. Unit of Account

II. How the Supply of Money Affects Its ValueA. The main thing that makes money valuable is the same thing that generates value for other commodities: Demand relative to supply.B. People demand money because it reduces the cost of exchange. When the supply of money is limited relative to the demand, money will be valuable.

III. How is the Money Supply Measured?A. Components of M1 Money Supply

1. Currency2. Checking Deposits (including demand deposits and interest-earning checking deposits)

3. Traveler’s checksB. M2 money supply: broader measure that includes savings and time deposits and money market mutual fundsC. Credit Cards versus Money

1. Money is an asset; credit card balances are a liability. Thus, credit card purchases are not money.

IV. The Business of BankingA. The banking industry includes savings and loans and credit unions as well as commercial banks.B. Banks accept deposits and use part of them to extend loans and make investments.C. Banks are profit-seeking institutionsD. Banks play a central role in the capital (loanable funds) market. They help to bring together people who want to save for the future with those who want to borrow in order to undertake investment projects.E. The banking system is a fractional reserve system: Banks maintain only a fraction of their assets in reserves to meet the requirements of depositorsF. Compared to other businesses, banks are more vulnerable to failure (and abuse) and the consequences of failure exert a larger impact on the economy.

G. The bank failures of the 1920s and 1930s led to the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934.1. The FDIC restored confidence in the banking system and reduced bank failures.


V. How Banks Create Money by Extending LoansA. Under a fractional reserve system, an increase in reserves will permit banks to extend additional loans and thereby expand the money supply (create additional checking deposits)B. The lower the percentage of the reserve requirement, the greater is the potential expansion in the money supply resulting from the creation of new reserves.C. The fractional reserve requirement places a ceiling on potential money creation from new reserves.D. The actual deposit multiplier will be less than the potential because:

1. Some persons will hold currency rather than bank deposits.2. Some banks may not use all their excess reserves to extend loans.

VI. The Federal Reserve SystemA. The Fed is a central bank responsible for the conduct of monetary

policyB. Bankers’ BankC. Structure of the FedD. Independence of the Fed

1. Stems from the lengthy terms—14 years—of members of the Board of Governors and the fact that its revenues are derived from interest on the bonds it holds rather than allocations from Congress.

E. How the Fed Controls the Money Supply1. Reserve requirements.

a. When the Fed lowers the required reserve ratio, it creates excess reserves and allows banks to extend additional loans, expanding the money supply. Raising the reserve requirements has the opposite effect.2. Open Market operations.

a. The buying and selling of bonds in the open market.b. Primary tool used by Fed.c. When the Fed buys bonds, the money supply will expand

because the bond buyers will acquire money and bank reserves will increase (placing banks in a position to expand the money through the extension of additional loans).

d. When the Fed sells bonds, the money supply will contract because bond buyers are giving up money in exchange for securities and the reserves available to banks will decline (causing them to extend fewer loans).

3. Extension of Loans a. Historically, member banks have borrowed from the Fed

primarily to meet temporary shortages of reserves..b. The discount rate is the interest rate the Fed charges banks for

short-term loans needed to meet reserve requirements..c. Other things constant, an increase in the discount rate will

reduce borrowing from the Fed and thereby exert a restrictive impact on the money supply. Conversely, a lower discount rate will make it cheaper for


Chapter 13/Money and the Banking System 137

banks to borrow from the Fed and exert an expansionary impact on the supply of money.

138 Chapter 13/Money and the Banking System

d. Discount Rate and Federal Funds Rate(1) The discount rate is closely related to the interest rate

in the federal funds market, a private loanable funds market where banks with excess reserves extend short-term loans to other banks trying to meet their reserve requirements.

e. Controlling the Federal Funds Rate(1) Announcements after the regular meetings of the

Federal Open Market Committee often focus on the Fed’s target for the fed funds rate..

(2) The Fed can reduce the fed funds rate by buying bonds, which will inject additional reserves into the banking system.

(3) The Fed can increase the fed funds rate by selling bonds, which will darin reserves from the banking system.

f. Longer Term Loans Extended by the Fed(1) Prior to 2008, the Fed extended only short-term

discount rate loans, and they were extended only to member banks.(2) In 2008, the Fed established several new procedures

for the extension of credit and began extending longer-term loans, including some to non-banking institutions.

(3) In 2008, the Fed also began making loans to non-bank financial institutions such as insurance companies and brokerage firms and these loans have often been for lengthy time periods (5-10 years).

(4) Like the discount rate loans, these new types of loans inject additional reserves into the banking system and thereby exert an expansionary impact on the money supply.

4. Interest Rate Fed Pays on Reserves.a. The Fed began paying banks interest on their reserves in October 2008.b. As of June 2011, the Fed was paying member banks an interest rate equal to the

target federal funds rate on both required and excess reserves.c. The payment of interest on reserves provides the Fed with another tool it can

use to control the money supply.d. If the Fed wants banks to extend more loans and thereby expand the money

supply, it will set the interest rate it pays on excess reserves very low, possibly even zero.

e. In contrast, if the Fed wants to reduce the money supply, it will increase the interest rate paid banks on excess reserves. This will provide them with an incentive to hold more reserves, which will reduce the money supply..

F. Recent Fed Policy, the Monetary Base, and the Money Supply1. Recent Fed Policy

a. Prior to the financial crisis of 2008, the Fed controlled the money supply almost exclusively through open market operations – the buying and selling of Treasury Securities.


b. During 2008, the Fed reduced its holding of Treasury Securities, but vastly expanded its purchase of corporate bonds, mortgage backed securities, and commercial paper issued by private businesses.

c. Moreover, there was a huge increase in Fed loans to non-banking institutions such as brokerage firms and insurance companies.

d. As Ex shows, Fed assets ballooned from 2008 to 2013.e. This vast increase in the purchase of assets and extension of

loans by the Fed led to a sharp increase in bank reserves and the monetary base.2. Monetary Base

a. The monetary base is equal to the currency in circulation plus the reserves of commercial banks (vault cash and reserves held at the Fed).

b. The monetary base is important because it provides the foundation for the money supply.

c. The currency in circulation contributes directly to the money supply, while the bank reserves provide the underpinnings for checking deposits.

d. The expansion in Fed purchases and extension of loans caused the monetary base to approximately double during the 9 months following August 2008.

3. Why Didn’t the Banks Use the Excess Reserves to Extend Loans? a. Because of the recession and sluggish growth, the demand for

loans was weak.b. The Fed pushed the interest rate on Treasury bills and other

short-term loans to near zero.c. There was considerable uncertainty about the future and

therefore banks were reluctant to make long-term commitments.G. The Difference Between the Fed and the Treasury

1. U.S. Treasury.a. Concerned with the finance of the Federal Governmentb. Issues bonds to the general public to finance the budget deficits of the federal

government.c. Does not determine the money supply.

2. Federal Reserve.a. Concerned with the monetary climate for the economy.

b. Does not issue bonds.c. Determines the money supply—primarily through its buying and

selling of bonds issued by the U.S. Treasury.VII. Ambiguities in the Meaning and Measurement of the Money Supply

A. Interest Earning Checking Deposits1. Less costly to hold than currency and demand deposits.

2. Their introduction changed the nature of the M1 money supply in the 1980s.B. Widespread Use of the U.S. Dollar Outside of the United States


1. More than one-half and perhaps as much as two-thirds of this currency is held overseas.

2. This reduces the reliability of the M1 money supply measure.C. Sweeping of various interest-earning checking accounts into Money Market Deposit Accounts.D. Substitution of electronic payments for checks and cashE Summary:1. Historically, the rate of change of the money supply has been used to judge the

direction and intensity of monetary policy. However, recent financial innovations and other structural changes (for example, the widespread use of U.S. currency in other countries) have blurred the meaning of money and reduced the reliability of the various money supply measures.

OBJECTIVES

This chapter focuses on the supply of money—how it is defined and what determines its value. The heart of this chapter is an outline of the monetary institutional arrangements for the United States that explains how monetary planners control the money supply. This material lays the foundation for Chapter 14, which analyzes how changes in the money supply affect economic activity.

It is important that the student gain an understanding of a fractional reserve banking system and how the actions of the central bank (the Federal Reserve System in the United States) can alter the deposit levels of member banks (and the money supply). However, this is not a text on money and banking. Historical information about banking institutions and endless detail about the banking industry add little to the student’s understanding of monetary policy and how it works. Therefore, material of this sort, often included in introductory texts, was kept to a minimum.


1. It is advisable to let students know what lies ahead. Therefore, you may want to explain that Chapter 13 contains a discussion of money and how public policy can control the money supply. Chapter 14 will explain how policies that alter the money supply affect aggregate economic activity.

2. Students often tend to believe that money has intrinsic value. Others may feel that the value of money is determined almost by chance or historical precedent. Be sure to emphasize that money is valuable primarily because of its scarcity relative to the quantity of goods and services involved in the exchange process.

3. The M1 concept of money incorporates the idea that money is what a society generally uses as a means for payment. Since both currency and checks are broadly used for payment in the United States, the money supply (M1) is comprised of: (a) currency, (b) demand deposits, (c) interest-earning checking deposits, and (d) travelers’ checks. As our recent experience indicates, the concept of money as the generally accepted means for payment is influenced by structural changes in the financial industry.


4. In addition to the narrowly defined money supply (M1), we have chosen to emphasize the broader concept of money (M2). The text clearly defines the alternative concepts of money, as well as difficulties in the definition and measurement of money.

5. Deregulation and the growth of interest-earning checkable deposits has changed the nature of money significantly in recent years. As Exhibit 1 illustrates, interest-earning deposits now account for about one-third of the checkable deposit potion of the money supply (M1). Be sure to point out that the interest-earning characteristic makes this component of the money supply similar to a savings account while still providing for the “medium of exchange” function of money.

6. Deregulation legislation has, in effect, eliminated the meaningful distinctions between: (a) commercial banks, (b) savings and loan associations, (c) mutual savings banks, and (d) credit unions. Therefore, the banking industry now encompasses all of these financial institutions.

7. Our past experience suggests that an explanation of how the goldsmiths of the past altered the money supply when they began to issue loans helps the student to understand the link between loans and money creation under a fractional reserve banking system.

8. Exhibit 2 illustrates that the creation of $1,000 of new reserves can potentially expand the money supply fivefold when the required reserve ratio is 20 percent. Work the same example, assuming that the required reserve ratio is 10 percent. Of course, the potential expansion in the money supply would be tenfold in the latter case.

9. Be sure to explain that profit-maximizing banks have an incentive to minimize their idle reserves since excess reserves are not earning any interest. Therefore, the actual bank reserves will only slightly exceed the legally required reserves. Small amounts of excess reserves, however, may be less costly to “live with” than to move into interest earnings forms, as in the federal funds market.

10. Carefully explain how changes in the Fed’s: (a) open market operations, (b) required level of reserves, (c) extension of loans, and (d) interest paid on excess bank reserves alter the money supply. Exhibit 6 gives the reader a thumbnail summary of the four major weapons that can be used to alter the supply of money.

11. Students invariably confuse the U.S. Treasury and the Federal Reserve System. Carefully explain the distinction between these two institutions of the government.

12. Critical Analysis questions 4, 9, and 13 provide suitable material for a lively classroom discussion on what can and cannot be accomplished with more money.

13. It is often helpful to use a money multiplier formula to help students understand how the Fed controls the money supply. You can show them that in a highly simplified world, the money supply (M) is equal to total reserves (TR) multiplied by the inverse of reserve requirements (rr). This formula can be used to highlight how each of the Fed’s policy tools affect the money supply (open market operations, foreign currency transactions, and discount rate changes operating on TR; reserve requirements on the money multiplier). It can also be extended to include currency and different reserve requirements for different M components. Such an approach seems to give students something more solid to hold onto in an unfamiliar area.


14. It is helpful to use several illustrations about money to make sure students understand money and the functions it performs. For instance, you can discuss with students whether rubles or any other former eastern bloc currency was money (not without connections or unless it was combined with large amounts of time waiting in line); or you can illustrate the fallacy of composition with it (if more money for me is good, more money for society must also be good).

15. In introducing the measurement and analysis of money, it is important for students to see that money is valuable to a society because the presence of a reliably valued money allows a dramatic reduction in transaction costs, leading to greatly increased levels of mutually beneficial trade and ability to exploit comparative advantage (especially for complex products that involve large numbers of trades), thereby creating value for society. This is why all societies create something to serve as money. However, inflation (deflation as well, but that does not seem to be much of a current threat) reduces money’s ability to lower transactions costs and all the gains that go with it—this is in essence why we worry about inflation: because it takes away from money’s ability to further social coordination.

16. Emphasize that while credit cards are not part of the supply of money, their degree of availability and acceptance will change the demand for money, since credit cards are substitutes for money in conducting transactions.

17. It is useful to show students why a change in reserve requirements is a blunt instrument for controlling the money supply. For example, a one-point change in reserve requirements from 10 percent to 9 percent would increase the money multiplier by 11.1 percent, sharply changing the money supply.

18. It is useful to tell students that while discount rate changes have little direct effect on the money supply, they may be valuable as indicators of future Federal Reserve policy (e.g. if the Fed lowers the discount rate, it is unlikely it will soon push up the federal funds interest rate). This indicator function may help students understand the attention paid to the discount rate.

19. The issue of foreign holdings of U.S. currency can be illustrated by the Federal Reserve’s decision to continue to accept “old” $100 bills as well as new ones, because of the turmoil it would cause in other countries if the “old” $100 bills were no longer legal tender in the United States.

20. Game 1 examines how the fractional reserve system was developed. Game 2 shows students an open market purchase by the Federal Reserve expands the money supply, while Game 3 familiarizes students with the structure of the Federal Reserve.

RELATED MATERIALS AVAILABLE FREE TO INSTRUCTORS

1. Federal Reserve District Bank Publications. The regional Federal Reserve banks publish monthly and quarterly reviews available to instructors upon request. For those particularly interested in money supply and related economic data, the following publications from the Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166, are recommended.

a. Review. Published monthly; contains articles and analyses on current monetary topics.


b. Monetary Trends. Issued monthly. Presents current data on member bank reserves and the money supply with a brief discussion.

c. International Economic Conditions. Issued monthly. Contains monetary and aggregate income data for major industrial countries.

d. National Economic Trends. Issued monthly. Contains charts and tables with analytical comment on the national business situation.


GAMES

1. Gold and Knights

Type: In-Class demonstrationTopics: Money, fractional reserve bankingTextbook: Chapter 13 Money and the Banking SystemMaterials Needed: 3 coins, a receipt, a volunteerTime: 10 minutesClass limitations: works in any size class

Purpose

This activity illustrates the development of paper currency and the modern banking system.

Instructions

Explain to the class that they are going back in time, back to a time when knights roamed the countryside and money was gold. Since gold was so important, the student volunteer will play the role of a goldsmith.

“In those days, bandits also roamed the countryside and people with money looked for a safe place to keep their gold. Goldsmiths had safes and strong rooms to protect their product. People turned to the “goldsmith to protect their gold, as well.”

Give the coins to the goldsmith and ask for a receipt.

“In the early days, putting money away for safe-keeping was like a coat check: your coins were stored and the same exact coins would be returned. Eventually the goldsmiths came up with an early financial innovation: depositors didn’t care if they got their own coins back, as long as they received the proper amount of money.”

“Now, let’s look at a transaction in those olden days.” Walk to the back of the class a choose a student. This student is in the horse trading business. You make an agreement to buy a horse from the student.

Walk back to the goldsmith. Present your receipt and withdraw your coins. Walk back to the horse trader. Give the student the coins. Explain that the horse trader needs to deposit these coins for safe-keeping. Take the coins back to the goldsmith and get a receipt. Give the receipt to the trader.

Explain, “As you can see there is a lot of unnecessary travel involved in this transaction. I started with a receipt for gold and the horse trader ended up with a receipt for the same amount of gold. There was no reason to travel back and forth with the actual coins. Eventually people realized this and simply made purchases with the receipts.”

This is the origin of paper currency, or bank notes.

“Now the goldsmith, who by this time is truly a banker, notices that very few withdrawals of gold are made from his safe. Money was still a valuable commodity and it seemed wasteful to let it sit


idle in storage. A more important financial innovation loomed. The banks realized they could loan this idle money to investors. The investors were willing to pay to use the money. This provided a new profit source for the bank as well as financing to fund new mills and factories.”

This is the development of fractional reserve banking.


Fractional reserve banking has many economic benefits. Depositors could now earn interest on their money, encouraging savings. Bank funding allowed borrowers to create new factors of production. This increased investment allows faster economic growth.

The main problem with fractional reserve banking is the inability to pay all depositors at a given time. Bank runs can lead to bank failures. Even healthy banks will not survive a bank run. This makes a good introduction to Federal deposit insurance as a way to prevent bank runs.

2. Money Creation

Type: In-Class demonstrationTopics: The banking system and deposit expansionTextbook: Chapter 13 Money and the Banking SystemMaterials Needed: 2 volunteers, a paper with “$1000” written on it.Time: 25 minutesClass limitations: works in any size class

Purpose

This activity demonstrates the role of the banking system in expanding the money supply.

Instructions

The two volunteers are bankers. Have each of them draw a balance sheet on the board.

BankTwo AmerBankCorpAssets Liabilities Assets Liabilities

0 0 0 0

The rest of the class is the public. They are all eager borrowers and depositors.

The instructor is the Federal Reserve. The Federal Reserve sets the reserve requirement at 20 percent of deposits.

The Federal Reserve also conducts open-market operations. Use the $1000 paper to buy a baseball cap from a student. (Explain that the Fed actually buys government bonds from the public since the market for used baseball caps is small.)

The capless student now has $1000 to spend with any other member of the class. This student receives $1000 and puts it in the bank of his or her choice.


The bank now has $1000 in deposits (a liability) and $1000 in cash (an asset). The bank needs to keep $200 in reserve (20 percent) but can loan the other $800. Have the banker tear off 20 percent of the bill and give the rest to another student.

The banks’ balance sheets becomes:


$200 (reserves) $1000 (deposits) 0 0$800 (loans)

Now the borrower spends the $800 and the recipient deposits it in a bank. This bank now has $800 in deposits and $800 in cash. Of that, $160 dollars needs to be kept in reserve and $640 can be lent. Have the banker save 20 percent of the paper and give the rest to another eager borrower.


$200 (reserves) $1000 (deposits) $160 (reserves) $800 (deposits)$800 (loans) $640 (loans)

Continue this process for a few more iterations.

At the end, ask everyone who has money in the bank to stand. The total deposits in the bank will far exceed the initial $1000 that the Fed put into the economy.

If the process continued indefinitely the banks balance sheets would look something like this:BankTwo AmerBankCorp

Assets Liabilities Assets Liabilities$500(reserves) $2500 (deposits) $500 (reserves) $2500(deposits)

$2000 (loans) $2000 (loans)

In practice the game will end with one bank holding some excess reserves.


Banks are important to the process of money creation. The banking system, as a whole, literally expands the money supply.

If the process is carried on far enough you can derive the money multiplier.

The time involved in this demonstration helps students understand the time lags associated with monetary policy.


3. What Can Be Learned from a Dollar?

Type: In-Class demonstrationTopics: Money, Federal ReserveTextbook: Chapter 13 Money and the Banking SystemMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class

Purpose

This activity introduces the role of the Federal Reserve in controlling the money supply.

Instructions

Ask the class to take a dollar bill from their wallets (or a $5, $10, $20, or $100). Students without any currency can share with someone who does. Ask the class to read the bill.

After a minute, ask them what they have learned.


Most students focus on the statement “This note is legal tender for all debts, public and private.” This statement is the only “backing” U.S. currency has—the note is not convertible into gold or silver. This can be used to introduce the difference between fiat money and commodity money.

Someone will usually point to the phrase printed at the top of the face of each bill: “Federal Reserve Note.” Explain the Fed functions as the United States central bank— controlling the money supply and supplying currency to banks.

Information about the structure of the Federal Reserve can be found in the seal to the left of Washington’s portrait. The writing around the seal says “Federal Reserve Bankof ___________.”

If the class is big enough, all 12 Federal Reserve Banks will be represented: Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

This is a good place to introduce the Federal Reserve Districts, and the Banks’ roles in those regions. These include check clearing, holding commercial bank reserves, supplying currency, lending to commercial banks, and collecting and analyzing regional economic data.

The discussion of the structure of the Fed can be expanded to include the Board of Governors, the Federal Open Market Committee, and the importance of the Chairman of the Federal Reserve.



2. The narrowly defined money supply M1 includes only assets that are widely used as a means of payment. Checking deposits meet this criterion, but savings deposits and Treasury bills do not. Thus, the former are included and the latter are not.

5. While the customers of a bank are constantly making deposits and withdrawals, these will tend to roughly balance out. Therefore, at any point in time, the bank will be able to satisfy the demands of its customers by maintaining only a fraction of its assets in the form of vault cash and deposits with the Fed. As long as the bank uses the funds of its customers to extend loans and undertake investments that generate earnings sufficient to cover its operating cost, the deposits of its customers are safe.

9. Challenge students to think about the following questions: Is printing more paper money the usual way in which the U.S. government alters the money supply? Does a budget deficit always increase the money supply? Is an increase in the money supply always inflationary?

11. In federal funds market, banks with excess reserves extend short-term loans to other banks seeking additional reserves. If the Fed wishes to lower the federal funds rate through an open market operation, it should purchase bonds.

13. a. False; from time to time, individuals might want to reduce their money balances and hold more wealth in other forms. People often use “money” when they are really speaking about wealth (or income).

b. False; the checking deposit also counts as money. In addition, the deposit increases the reserves of the receiving bank and thereby places it in a position to extend additional loans that would increase the money supply.

c. False; only an increase in the availability of goods and services valued by people will improve Americans’ standard of living. Without an additional supply of goods and services, more money will simply lead to a higher price level.

15. a. The currency outstanding is included in both the M1 and M2 money supply, regardless of whether it is held domestically or abroad. Thus, this will not directly impact either M1 or M2. However, if more currency is held abroad, this could reduce the deposits in domestic banks and thereby reduce their ability to expand the money supply by extending additional loans. Thus, movement of currency overseas might indirectly reduce both M1 and M2.

b. M1 will decline because money market mutual funds are not included in the M1 money measure. There will be no impact on M2.


c. If the public holds less currency and has more of their funds in bank deposits, this will provide banks with additional reserves, which can be used to extend more loans and thereby expand both the M1 and M2 money supply. Thus, if the Fed does not take offsetting action, a reduction in the holding of currency by the general public will tend to expand both the M1 and M2 money supply figures.

d. There is no impact on M1, because neither are included in the M1 money supply. The M2 money supply will decline because money market mutual funds are included in M2, but funds in stock and bond mutual funds are not.

17. a. Required reserves = $20,000; excess reserves = $30,000.

b. $30,000, equal to the level of excess reserves.

c. Excess reserves, whether held as vault cash or deposits at the Fed, would be converted to interest earning loans.

d. With a 20 percent required reserve ratio, required reserves would be $40,000, leaving $10,000 of excess reserves which could then be loaned out.

Chapter 14Modern Macroeconomics and Monetary Policy

OUTLINE

I. The Impact of Monetary Policy: A Brief Historical BackgroundA. A Brief Historical Background

1. Keynesian View: Dominated during the 1950s and 1960s, Keynesians argued that money supply does not matter much.2. Monetarists challenged Keynesian view during 1960s and 1970s. According to monetarist, changes in the money supply are the cause of both inflation and economic instability.3. Modern view emerged from this debate: While minor disagreements remain, both modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy.

II. Demand and Supply of MoneyA. The quantity of money people want to hold is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earnings assets like bonds.B. The supply of money is vertical because it is determined by the Fed.C. Equilibrium: The money interest rate will gravitate toward the rate where the quantity of money people want to hold is just equal to the stock of money the Fed has supplied.

III. How Does Monetary Policy Affect the Economy?A. The impact of a shift in monetary policy is generally transmitted through interest rates, exchange rates, and asset prices.B. Shift to a more expansionary monetary policy—Fed generally buys bonds, which will both increase bond prices and create additional bank reserves, placing downward pressure on real interest rates. As a result, an unanticipated shift to a more expansionary policy will stimulate aggregate demand and thereby increase output and employment.C. Shift to a more restrictive monetary policy—Fed sells bonds, which will depress bond prices and drain reserves from the banking system. An unanticipated shift to a more restrictive monetary policy will increase real interest rates and reduce aggregate demand, output, and employment in the short run.D. Effects of an Unanticipated Expansionary Monetary Policy

1. When instituting a more expansionary monetary policy, the Fed generally increases the reserves available to banks and pushes interest rates downward. 2. In the short run, an unanticipated shift to a more expansionary policy will stimulate aggregate demand and thereby increase output and employment.

E. Effects of an Unanticipated Restrictive Monetary Policy1. When instituting a more restrictive monetary policy, the Fed drains reserves from the banking system and pushes interest rates upward.


2. In the short run, an unanticipated shift to a more restrictive monetary policy will increase real interest rates and reduce aggregate demand, output, and employment.

IV. Monetary Policy in the Long RunA. The Quantity Theory of Money: MV=PY

1. If V (velocity) and Y (output) are constant, an increase in M (money supply) would lead to a proportional increase in P (price level).

B. Long-Run Impact of Monetary Policy: The Modern View1. In the long run, the primary impact will be on prices rather than on real output.2. When expansionary monetary policy leads to rising prices, decision makers eventually anticipate the higher inflation rate and build it into their choices. As this happens, money interest rates, wages, and incomes will reflect the expectation of inflation, so real interest rates, wages, and output will return to their long-run normal levels.

C. Money and Inflation1. Countries with persistently low rates of growth in their money supply tend to

experience low rates of inflation.2. In contrast, countries with persistently high rates of growth in the money supply

tend to experience high rates of inflation.D. Time Lags, Monetary Shifts, and Economic Stability

1. While the Fed can institute policy changes rapidly, there will be a time lag before the change exerts much impact on output & prices

a. This time lag is estimated to be 6 to 18 months in the case of output

b. In the case of the price level, the lag is estimated to be 12 to 30 months.

V. The Potential and Limitations of Monetary PolicyA. Two Important Points About Monetary Policy

1. Expansionary monetary policy cannot loosen the bonds of scarcity and therefore it cannot promote long-term economic growth. Rapid growth of the money supply will lead to inflation.2. Shifts in monetary policy will influence the general level of prices and real output only after time lags that are long and variable.

B. Why Proper Timing of Monetary Policy Changes is Difficult1. The long and variable time lags between a monetary policy shift and their impact on the economy will make it difficult for policy-makers to institute changes in a manner that will promote economic stability.2. Given our limited forecasting ability, policy errors are likely.3. If monetary policy makers are constantly shifting back and forth, policy errors will occur. Thus, constant policy shifts are likely to generate instability rather than stability. Historically this has been the case.

VI. Recent Monetary Policy of the United StatesA. Three Key Indicators of Monetary Policy 1. Short-term interest rates,


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2. The growth rate of the money supply, 3. The growth rate of the monetary base

A. Monetary Policy 1990-20131. 1990s: Monetary policy was relatively stable and it kept the inflation rate low.2. 2002-2004: Monetary policy pushed interest rates to historic lows and M2 grew

rapidly. a. This expansionary monetary policy contributed to the 87%

increase in housing prices between 2002 and mid-year 2006.3. 2005-2007: As the inflation rate rose in 2005, the Fed shifted to a more restrictive

monetary policy. M2 growth slowed and interest rates rose. a. This shift contributed to the housing price bust and the recession

that followed2. There were other causal factors of the 2008 crisis including:

a. government regulations that eroded lending standards and promoted the purchase of housing with little or no down payment government regulations that eroded lending standards and promoted the purchase of housing with little or no down payment (that began in the latter half of the 1990s)

b. heavily leveraged borrowing for the financing of mortgage-backed securitiesc. the rising world price of oil during 2007d. a sharp decline in stock prices during 2008.

e. But, monetary policy was a contributing factorB. Fed Policy During and Following the 2008 Financial Crisis 1. Fed response to 2008 financial crisis:

a. Fed policy during 2008-2013 injected approximately $3 trillion of additional reserves into the banking system, nearly half held as excess reserves.

b. Short-term interest rates were pushed to near zero.2. But the demand for investment was weak and therefore, expansion in credit was

small and banks held huge excess reserves. As a result, M2 expanded much less than the monetary base.

3. The Fed now faces a dilemma: when the economy begins to recover, banks will use their excess reserves to extend loans, which will expand the money supply.a. If the Fed moves toward restriction too quickly, it is likely to throw the

economy back into recession.c. But, if it moves to slowly, the expansion in the money supply will lead to

inflation.4. We are in the middle of another great monetary policy experiment.B. Impact of Stop-Go Monetary Policy

154 Chapter 14/Modern Macroeconomics and Monetary Policy

1. Monetary policy has been on a stop-go path throughout most of the past decade. As both theory and past experience indicate, continuation of this policy is likely to increase economic instability in the years ahead.

2. Given the long and variable lags, it is hard for monetary policy-makers to institute stop-go policy in a stabilizing manner

OBJECTIVES

This chapter integrates money into our basic aggregate demand/aggregate supply model. The evolution of the modern view of monetary policy—including the quantity theory of money and the early Keynesian view—is presented. The modern view of money indicates that monetary policy may be transmitted to the goods and services market by changing consumption and investment spending, exchange rates, asset prices, and credit rationing. These mechanisms are illustrated.

The modern view of monetary policy also stresses the importance of whether a change in monetary policy is anticipated or unanticipated. Only the latter will exert an impact on real interest rates, output, and employment. Similarly, the impact of monetary policy in the long run may differ from its impact in the short run. This chapter focuses on each of these issues and discusses recent Federal Reserve policy.


1. To give the student a historical perspective, review the positions of both classical and early Keynesian economists on the quantity theory of money before presenting the modern view. When you discuss the modern view, emphasize that, unlike the classical economists, modern macroeconomists do not believe that prices and wages will quickly adjust to the quantity of money.

2. Students tend to confuse fiscal and monetary policy. Instructors should indicate clearly that fiscal policy involves the altering of tax rates and the level of government expenditures. On the other hand, monetary policy involves changes (e.g., open market operations, reserve requirements, and the discount rate) that alter the money supply. The rate of change in the money supply is the single best indicator of monetary policy. Monetary policy is determined by the Board of Governors and the Open Market Committee of the Federal Reserve System.

3. Students also easily confuse the issuing and sale of bonds by the Treasury to the public (which will not change the money supply) and the sale of bonds by the Fed to the public (which will have a restrictive effect on the money supply). Point out that U.S. bonds are always issued by the Treasury. The Fed merely buys and sells these bonds (usually from the public rather than directly from the Treasury). The Treasury either increases or decreases the amount of bonds that it has outstanding (the national debt), depending on whether it is running a deficit or surplus. The Fed, however, buys and sells government bonds, depending on the monetary policy it is pursuing. Thus, budgetary conditions and fiscal policy objectives underlie Treasury policy, whereas monetary policy objectives underlie the Fed’s decision to buy or sell bonds.

4. Review Exhibit 3 to make sure students understand the mechanics by which changes in monetary policy are transmitted to the goods and services market.

5. Exhibits 7 and 8 will help students grasp the interrelationships among the basic macroeconomic markets and the importance of expectations. Be sure to note the relationship

Chapter 14/Modern Macroeconomics and Monetary Policy 155

between inflation in the goods and services market (Exhibit 7) and high money interest rates in the loanable funds market once decision makers anticipate a high rate of inflation (Exhibit 8).

6. Modern macroeconomics stresses the importance of whether the effects of a monetary change are anticipated or unanticipated. As Exhibit 9 illustrates, expansionary monetary policy will fail to affect real economic variables when the inflationary side effects are anticipated. Contrast this case with the impact of monetary policy when the effects are unanticipated (as illustrated by Exhibit 3).

7. The Thumbnail Sketch illustrates the expected effects of monetary policy under alternative circumstances. Instruct students to make sure they understand why the effects of a monetary change vary between the short and long runs and depending upon whether the change is anticipated or unanticipated.

8. Class discussion of the Critical Analysis questions will help students better understand the material of this chapter. The authors have found questions 8, 10, and 11 to be particularly good “discussion starters.” Question 6 might be used as a homework assignment.

9. In presenting monetary transmission mechanisms, an interesting classroom discussion topic is why a two asset (money and government bonds) “story” for the effects of money supply on interest rates makes sense during a depression/ongoing deflation situation. Note that depression and deflation make virtually all other financial assets bad investments, reducing the direct transmission mechanisms’ ability to work. During normal times, however, the existence of other good financial assets besides money and government bonds allows the direct transmission mechanisms to be quite powerful.

10. Brief “modern” examples that can be used to introduce the classroom discussion of what beside interest rates affects the quantity of money demanded include asking the class what effect the introduction of widespread overdraft protection would have on the demand for money, asking what the effect would be of canceling all credit cards, and asking what the effect of lowered transactions fees in the stock and bond markets would be.

11. It is useful to mention to students that the equation of exchange will be closely linked to the various monetary growth rules (e.g., 3 percent money growth, national income, and price level rules) that have been proposed, and that will be discussed in Chapter 15.

12. Although the effects on real variables of reducing the money supply or reducing the growth rate of the money supply will be the same, it is important to distinguish for students between the effects of these two different changes on nominal variables (in one case they fall; in the other they rise but at a reduced rate).

13. Remind students that stable monetary policy and prices are important ultimately because it reduces uncertainty and related mistakes and expands the scope of mutually beneficial trade.


5. Expansionary monetary will reduce interest rates in the short run. However, in the long run, interest rates will rise due to a rise in the expected inflation rate.

156 Chapter 14/Modern Macroeconomics and Monetary Policy

6. In 2011, M1 grew 15.4% and M2 grew 7.2%. Whether the money supply growth rate should be increased or decreased depends on the state of the economy as well as the length of lags in the effects of monetary policy.

9. Price stability is important because it will reduce the uncertainty accompanying investment and other time dimension activities and transactions. If monetary policy results in approximate price stability, this is the most important thing it can do to create an environment for economic growth and prosperity. In contrast, if monetary policy-makers are constantly shifting back and forth in an effort to smooth the ups and downs of the business cycle, they will make errors and their actions are likely to generate more rather than less instability. Limitations on our ability to forecast the future and the long and variable time lags of monetary policy substantially reduce their ability to institute policy shifts in a stabilizing manner. Thus, constant shifts in monetary policy are likely to increase, rather than reduce, economic instability.

Chapter 15Stabilization Policy, Output, and Employment

OUTLINE

I. Economic Fluctuations—The Historical RecordA. Historically, the United States has experienced substantial swings in real output.B. Prior to the Second World War, year-to-year changes in real GDP of 5 percent to 10 percent were experienced on several occasions.C. During the last five decades, the fluctuations of real output have been more moderate.

II. Can Discretionary Policy Promote Economic Stability?A. Goals of Stabilization Policy

1. Economists of almost all persuasions favor the following goals:a. a stable growth of real GDPb. a relatively stable level of pricesc. a high level of employment (low unemployment)

2. But there is disagreement about how these goals can be achieved.B. Activist and Non-Activist Views

1. If monetary and fiscal policies could inject stimulus during economic slowdowns and apply restraint during inflationary booms, this would help reduce the ups and downs of the business cycle.

a. Activists believe that policy-makers can respond to changing economic conditions and institute policy in a manner that will promote economic stability.

b. Non-activists argue that the discretionary use of monetary and fiscal policy in response to changing economic conditions is likely to do more harm than good.

2. Both activists and non-activists recognize that conducting macro policy in a stabilizing manner is not an easy task..

B. Practical Problems with Timing1. The time lag problem: It takes time to identify when a policy change is needed, additional time to institute the policy change, and still more time before the change begins to exert an impact on the economy.2. The forecasting problem: Because of the time lag problem, policy makers need to know what economic conditions will be like 12 to 24 months in the future. But, our ability to forecast future economic conditions is limited.

a. Forecasting tools like the index of leading indicators can help, but they sometimes give incorrect signals.

3. The political problem: Policy changes may be driven by political considerations rather than stabilization needs


III. Forecasting Tools and Macro PolicyA. Index of Leading Indicators

1. Composite statistic based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of a business expansion.2. Can forecast future and help policy makers, but it is an imperfect forecasting devise.

B. Forecasting Models C. Other Forecasting Information D. Is Accurate Forecasting Feasible?

IV. How Are Expectations Formed?A. Adaptive Expectations: individuals form their expectations about the future on the basis of data from the recent past.B. Rational-expectations: Assumes that people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future.

V. Macro Implications of Adaptive and Rational ExpectationsA. With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment.B. With rational expectations, expansionary policy will not generate a systematic change in output.C. Both expectations theories indicate that sustained expansionary policies will lead to inflation without permanently increasing output and employment.

VI. The Phillips Curve: The View of the 1960s versus TodayA. The Phillips Curve outlines the relationship between inflation and unemployment.B. In the 1960s, it was widely believed that higher rates of inflation could be used to reduce the unemployment rate.1. This view provided the foundation for the expansionary policies and inflation of

the 1970s.C. Once expectations are integrated into macro analysis, it is clear that this early view of

the Phillips Curve is fallacious.VII. What Have We Learned About Macro Policy

A. Areas of Agreement 1. Proper timing of monetary and fiscal policy changes is difficult. Therefore, constant policy swings are likely to do more harm than good. 2. Expansionary policies that generate strong demand and inflation will not reduce the rate of unemployment below the natural rate – at least not for long. 3. Price stability is the proper goal of monetary policy. When the Fed keeps the inflation rate at a low and therefore easily predictable rate, it lays the groundwork for the smooth operation of markets and long-term healthy growth.

B. Areas of Continued Debate1. Does fiscal policy exert much impact on AD?


Chapter 15/Stabilization Policy, Output, and Employment 159

2. During a severe recession, will an increase in government spending be more effective than a reduction in taxes to promote recovery? 3. Is economic instability the result of the natural tendencies of a market economy or the errors of policy-makers?

C. Current Policy and Implications for the Future1. Macroeconomic policy in the Aftermath of the Crisis of 2008

a. Fiscal policy was highly expansionary during 2008-2011: (1) budget deficits were approximately 9 percent of GDP during

2009-2011, the largest since WWII.(2) 40 percent of federal spending was financed by borrowing(3) There were several “stimulus” packages during this period And

federal spending rose from about 20 to 25 percent of GDPb. Monetary policy was also highly expansionary during 2008-2011

(1) Between July 2008 and June 2011, the Fed tripled its purchase of assets and injected nearly $2 trillion of additional reserves into the banking system.

(2) The monetary base grew at an historically high rate But, 1983-2007 was the most stable quarter of a century in American history.

2. Impact of the 2008-2011 Expansionary Policy1. Comparison of the recessions of 1981-1982 and 2008-2009 provide insight on this issue.

a. These recessions were the most severe of the post WWII erab. In both cases, unemployment soared above 10%c. Policy response was dramatically different:(1) government spending was reduced as a share of the economy and monetary

policy was restrictive during the ‘81-82 recession. (2) In contrast, government expenditures increased as a share of

GDP and monetary policy was highly expansionary during the ‘08-09 recession.

d. How did the Strength of the Two Recoveries Compare?(1) The unemployment rate rose to 10.8% during the ‘81-82 recession and to

10.1% during the ‘08-09 recession.(2) Two years after the end of the ‘82-82 recession, the

unemployment rate had receded to pre-recession levels (nearly 7%). (3) Two years after ‘08-09 recession, the unemployment rate

remained high (9.2%).(4) During the two years of recovery from the ’81-82 recession, real GDP grew

at an annual rate of 6.5%.(5) In contrast, annual GDP growth was only 2.7% during the most recent

recession (less than half that of the ’81-82 recession). (6) The recovery phase of the most recent recession is the weakest of any since

the great depression.D. Why Has the Fiscal and Monetary Stimulus Failed to Promote a Stronger Recovery?

160 Chapter 15/Stabilization Policy, Output, and Employment

1. Why has the fiscal ‘stimulus’ failed to promote a stronger recovery?a. The fiscal stimulus spending was largely temporary.

(1) Programs of this type exert less impact on aggregate demand and output because they fail to provide recipients with income they can count on in the future.b. Politically directed spending will result in counterproductive

programs (e.g. ethanol subsidies, wind and solar energy, and high-speed rail).

(1) The political process does not have anything like profit and loss that will consistently direct resources towards productive projects.c. Expansionary fiscal policy and the accompanying large budget

deficits drove the federal debt to dangerously high and unsustainable levels generating uncertainty and fear of another financial collapse.

d. Constant policy changes create uncertainty, undermining investment. Robert Higgs refers to this as ‘regime change.’

2. Why has the monetary ‘stimulus’ failed to promote a stronger recovery? a. Huge increases in bank reserves led to fear and uncertainty

about future inflation.b. Household spending was not very responsive to the fed’s low

interest rate policy because of their large outstanding debt and their wealth reductions accompanying the decline in housing prices.

c. Low interest rates reduced household earnings from savings making it more difficult to accumulate a down payment for big-ticket purchases such as automobiles and houses.

d. Low interest rates fueled the growth of government and politically driven spending. But, predictably, interest rates will rise as the economy recovers. This will mean higher future interest payments and taxes

OBJECTIVES

This chapter focuses on a major area of current controversy among economists: what policy strategy is most likely to minimize economic instability? Activists believe that discretionary changes in macroeconomic policy in response to economic indicators and forecasting tools will moderate economic instability. In contrast, nonactivists believe that it is a mistake for policy makers to change course in response to current economic conditions. The nonactivists argue rigid rules and guidelines requiring policy makers to follow a stable economic course, independent of current economic conditions, are most likely to minimize instability. This chapter also gives students both a historical perspective of the Phillips curve as well as the modern view of the Phillips curve. It concludes with a discussion of what we have learned about macro policy. IMPORTANT POINTS AND TEACHING SUGGESTIONS

1. Exhibit 1 provides historical perspective on fluctuations in real GDP. Of course, we continue to observe economic instability. However, as the exhibit illustrates, the swings in real GDP have been more moderate during the last four decades.

Chapter 15/Stabilization Policy, Output, and Employment 161

2. The index of leading indicators is an important forecasting device available to policy makers. Exhibit 2 presents the forecasting record of the index during the 1959–2011 period

3. Many laypersons believe that training in economics permits one to forecast the future accurately. Economists, particularly those marketing forecasting services, have also promoted this view. In our judgment, both the ability of economists and the implications of economic theory as a forecasting tool are often oversold. This topic can provide an interesting classroom discussion.

4. Critical Analysis question 1 provides a project suitable for assignment as a short paper. Critical Analysis questions 2, 3, 5, 8, and 10 can be used to stimulate student discussion of the major topics covered by this chapter.

5. There are several useful analogies to the problem facing policy activists in their attempt to reduce macroeconomic instability. One of the best is to that of an ocean liner captain. Ocean liners turn only with a lag, so to pilot it well you need to know how long the lag is and how quickly it will then turn (and it may keep turning after you want it to stop). You need good charts to know where you are trying to go and how to get there, and you need to know where you are at any given point. You need information about currents, etc., and weather introduces many complicating variables (and weather forecasting is imperfect). Another useful one is the Fed chairman trying to drive the econo-car (economy) when the front and side windows are blackened and the rear mirror information is subject to retroactive modification; you get conflicting advice and forecasts; you don’t know which money lever to use or how long it will be before results will appear, or exactly how strong these effects will be.

6. It can sometimes be helpful to talk about why forecasting models are reasonably accurate in times of “smooth sailing” when not much is changing but not at turning points, when we really want to know, because something is going on that is different than that captured in the input-output model coefficients (largely estimated from data from the recent past).

7. Take note in class of the relationship between the central bank and monetary stability; this question is being hotly debated in many parts of the world.


3. According to the adaptive expectations hypotheses, individuals base their expectations on the immediate past. Thus, expectations in the short run lag behind actual events, and decision makers will systematically make errors. The rational expectations hypothesis assumes that individuals take all available information into account in the decision-making process. Thus, decision makers not only consider past information but comprehend the impact of macropolicy changes on price and employment and adjust their choices accordingly. Under rational expectations, decision makers will make errors, but they will not make them systematically. Once people have fully adapted to a policy (the long run), they aren’t fooled, even under adaptive expectations. Therefore, long-run results are the same in both cases. People can be fooled in the short-run under adaptive, but not rational expectations, so short-run results will differ.

6. With adaptive expectations, an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. In contrast, with rational expectations,

162 Chapter 15/Stabilization Policy, Output, and Employment

expansionary policy will not generate a systematic change in output. The long-run results are the same under both theories (i.e., sustained expansionary policies will lead to inflation without permanently increasing output and employment). The short-run results differ because people can be fooled in the short-run under adaptive, but not rational expectations. However, once people have fully adapted to a policy (the long run), they aren’t fooled, even under adaptive expectations.

7. Here are three practical problems that limit the effectiveness of discretionary macro policy as a stabilization tool: (1) inability to forecast the future direction of the economy with a high degree of accuracy, (2) lengthy and uncertain time lags between when a policy change is instituted and when the primary effects are felt, and (3) political factors that make it difficult to alter fiscal policy quickly.

12. The tendency of the self-corrective mechanism to restore full employment can be offset by perverse monetary and fiscal policy. Most economists believe that this happened during the Great Depression. See the special topic on the Great Depression in the text.

Chapter 16Creating an Environment for Growth and Prosperity

OUTLINE

I. History of Economic GrowthA. Per Capita Income: The Last 1000 years

1. Income stagnated for the 800 years following year 1000, but growth has exploded during the last 200 years.

a. (Measured in 1990 dollars) world per capita income was $667 in 1820 – only about 50% higher than year 1000. By 2003, however, income had risen to $6,516 – 10 times the level of 1820.

b. During the past 200 years, the income growth of the high-income industrial countries (West) has been even higher – nearly 20 fold

B. Life expectancy: The last 1000 years1. The pattern of the life expectancy data is similar to that of per capita income.

2. Life expectancy at birth for the world rose from 24 to 26 years between 1000 and 1820, but it soared to 64 by 2003.

3. Life expectancy in the high-income industrial countries followed a similar pattern

II. Economic Growth, Production Possibilities, and the Quality of LifeA. Economic growth expands the productive capacity of an economy.B. Differences in sustained growth rates over two or three decades will substantially alter the relative incomes of countries.C. The rule of 70: dividing 70 by a country’s average growth rate gives about the number of years required for an income level to double

III. Key Sources of Economic Growth and High IncomesA. Gains from TradeB. Entrepreneurship, Technology, and the Discovery of Better Ways of Doing Things

C. Investment in Physical and Human Capital D. The Institutional Environment

IV. What Institutions and Policies Will Promote GrowthA. Legal System: Secure Property Rights, Rule of Law, and Even-Handed Enforcement of ContractsB. Competitive Markets

C. Stable Money and PricesD. Minimal Regulation

E. The Avoidance of High TaxesF. Trade Openness

G. Other Factors That May Influence Growth and Income 1. Growth of the Population


164 Chapter 16/ Creating an Environment for Growth and Prosperity

2. Natural Resources 3. Foreign Aid 4. Climate and Location

H. Institutions, Policies, and Prosperity1. Institutions and policies matter because they shape incentives

and thereby influence whether individuals engage in productive, unproductive, or even counterproductive activities.

2. When institutions and policies provide secure property rights, a fair and balanced judicial system, monetary stability, and effective limits on government’s ability to transfer wealth through taxation and regulation, individuals are encouraged to engage in productive activities.

3. When the legal and regulatory environment fails to protect property rights and often favors some at the expense of others, individuals are instead encouraged to engage in rent-seeking, lobbying, bribes, and other counterproductive activities.

4. Unless countries adopt institutions and policies supportive of trade, entrepreneurial discovery, and private investment, they will be unable to sustain long-term growth and achieve high income levels

OBJECTIVES

Over time, growth rates are crucial to economic well-being, and we do know a few things about conditions that promote growth and factors that are obstacles to growth. Investment in human and physical capital, technological progress, and efficient economic organization are important determinants of growth. Institutional arrangements that encourage investment, technological innovation, and efficient use of resources will simultaneously encourage growth. These include (1) private ownership, (2) competitive markets, (3) stable prices, (4) on open economy, (5) minimal regulation, and (6) avoidance of high marginal tax rates. On the other hand, nations that save and invest only a small proportion of their current income, impose high marginal tax rates, and follow polices that undermine property rights and cause inflation experience slower rates of economic growth.


1. Review with students the data of Exhibit 2. This exhibit highlights the impact of long-term differences in growth rates.

2. Discuss the significance of each of the following as a source of economic growth:a. investment in human capitalb. investment in physical capitalc. technological progressd. efficiency of economic organizatione. institutional environment

3. Indicate how each of the following aids the growth of income:a. secure private property rights, and even-handed enforcement of contracts b. competitive marketsc. stable money and prices

Chapter 16/ Creating an Environment for Growth and Prosperity 165

d. an open economye. minimal regulationf. avoidance of high marginal tax rates

4. The connection between marginal tax rates and growth provides material for an interesting class discussion. Ask students to consider why high marginal tax rates might cause a nation to have a “brain drain.” How do they affect the incentive to earn?

5. Review the non-institutional factors that are often thought to influence growth: a. Growth of the Population b. Natural Resources c. Foreign Aid d. Climate and Location

6. Question 14 is a topic suitable for assignment as a short research paper. The other Critical Analysis Questions will help stimulate classroom discussion of the major topics included in this chapter.

7. Additional topics to discuss with students:

a. What type(s) of investment in human capital would be most likely to promote the development of poor nations?

b. Do trade restrictions help or hinder the development of poor counties?

c. What measures might less-developed nations take in order to attract additional private capital formation?

8. One way to help students to visualize the importance of incentives to growth and development, and especially the ability of moving toward free markets to accelerate both, is to have them think of an effective production possibility curve that is inside the normally defined one because of adverse incentives in a country. When moves toward free markets are adopted (once the costs of the disruption due to the change have been borne), it moves the effective production possibilities curve outward, allowing more rapid economic growth than before.

9. An interesting classroom discussion topic for this chapter is to ask students whether children are assets or liabilities; then guide the discussion toward what the answer depends on as an introduction to the issues of growth and development.

10. Foreign aid as a weapon to encourage economic growth is an interesting topic to discuss in class as an application of the principles of this chapter. In particular, the question of whether aid should be given, and if so, whether it should go to other governments (who may use those resources to either help or hurt their citizens) or directly to individuals can start a lively discussion.


1. Even seemingly small differences in growth rates sustained over two or three decades will substantially alter relative incomes. For example, if Country A and Country B have the same

166 Chapter 16/ Creating an Environment for Growth and Prosperity

initial income but the growth rate of A is 2 percentage points greater than that of B, after thirty-five years the income level of Country A will be twice that of B.

5. Competition is important because it encourages producers to supply goods that consumers value highly relative to cost, and to do so efficiently. Firms that fail to do so will be unable to compete effectively, and eventually they will be driven out of business. In turn, this will release the resources for use in the production of other things that are more highly valued.

10. Resources clearly give some nations an advantage. For example, oil-rich countries like Saudi Arabia, Bahrain, and the United Arab Emirates have substantially higher per capita incomes than other similar countries with few natural resources. On the other hand, many resource rich countries such as Nigeria, Venezuela, and Russia have both low income levels and poor records of economic growth. It is clear that resource endowments are not the primary source of cross-country differences in growth and income. Rather institutions are far more important than natural resources. Resource poor countries can have rapid growth if they follow sound policies. They are able to import the resources required for growth and prosperity.

14. As Exhibit 4 of this chapter indicates, economic growth is primarily about gains from trade, discovery of new products and lower cost production methods, and investment in physical and human capital. Institutions and policies that promote gains from these sources are the key to growth and prosperity. The following are particularly important: 1. legal system that protects property rights and enforces contracts in an even-handed manner2. competitive markets3. monetary and price stability4. minimal regulation5. avoidance of high tax rates6. openness to international trade

See Chapter16, section “What Institutions and Policies Will Promote Growth?” for details.

Chapter 17Institutions, Policies, and Cross-Country Differences in

Income and GrowthOUTLINE

I. How Large are the Income Differences Across Countries?A. Purchasing power parity comparisons indicate that the per person income in wealthy countries such as the United States, Ireland, and Norway is about fifty times the income level of the world’s poorest countries.

1. While these figures may result in some overstatement because GDP excludes production within the household sector, it is clear that the income differences between high and low income countries are huge.

II. How Do Growth Rates Vary Across Countries?A. The fastest growing countries in the world are LDCs although other LDCs are doing very poorly.B. The growth picture of LDCs is clearly one of diversity.

III. Economic Freedom as a Measure of Sound Institutions A. Economists since the time of Adam Smith have generally argued that freer economies are likely to be more productive.B. Economic freedom is complex and very difficult to measure.C. Measure of economic freedom developed by Fraser Institute indicates consistency of the legal structure and policies with secure property, monetary stability, free trade, and reliance on markets.

1. Rating developed by more than 100 countries.2. Country ratings vary substantially.

IV. Institutions, Policies, and Economic Performance A. Countries with more economic freedom, as measured by the Freedom Index in 1990-

2009 also had both a higher average per capita GDP in 2009 and more rapid average growth rates during 1990-2009.1. The 2009 per capita income in the persistently free quartile of countries was

approximately seven times the figure for the least free quartile.V. Economic Freedom, Institutions, and Investment

A. Even though wages are lower and capital less abundant in low-income countries, both private investment rates in countries with less economic freedom.B. The productivity of investment is lower in countries with less economic

freedom.VI. Is Institutional Change Possible?

A. Countries that have substantially improved the quality of their institutions in recent decades have registered impressive growth rates.

1. Ireland, Botswana, Chile, Estonia, and even China are examples.


B. In contrast, countries such as Zimbabwe and Venezuela that have moved toward policies that conflict with economic freedom have performed poorly.

VII. The Declining Economic Freedom of the United StatesA. The Economic Freedom of the United States

1. During the 1980-2000 period the U.S. had the 3rd highest economic freedom rating, ranking behind only Hong Kong and Singapore.

2. The Economic Freedom of the World rating of the US has declined from 8.62 in 2000 to 7.70 in 2010.

3. The U.S. ranking has slipped from 3rd to 17th in 2011.B. Implications of the Decline in the U.S. EFW Rating

1. Between 2000 and 2010 the U.S. rating fell by almost a full point. While a one unit change may sound small, research indicates that it is associated with a 1% decline in the long-term, annual growth rate of real GDP.

2. The following elements contributed to the decline in the US EFW rating: higher levels of government spending, a reduction in the quality of the legal environment, higher non-tariff trade barriers, a smaller share of credit allocated to the private sector, and more restrictive regulation of business activity.

VII. Rich and Poor Nations RevisitedA. Countries with low per capital income in 1990 dominate the list of both (1) those that

have grown most rapidly and (2) those that have regressed and experience falling incomes since 1990.

B. When low-income economies have sound institutions, they can grow rapidly because:1. they can merely copy or emulate technologies and business practices that have

been successful in high-income countries 2. the rate of return on investment in these low-income countries will generally be

higher than in capital-rich, more advanced economies3. In order for a low-income country to benefit from the borrowing of technologies

and inflow of investment capital, it must have sound institutions. 4. Many low-income economies continue to perform poorly and even regress because

their institutions and policies stifle gains from trade, entrepreneurship, and investment.

IX. Economic Rules and Political Decision MakingA. Economic institutions and policies will reflect political choices.

1. The political environment often conflicts with the adoption of sound economic policy.

2. Even democratic politics will sometimes lead to the adoption of policies that reduce growth and prosperity.

OBJECTIVES

We discuss the size of the current economic gap among nations. The text points out the income differences across countries are huge. However, the fastest growing countries are less developed countries. The chapter next points out of measuring income differences among countries are presented.


Chapter 17/ Institutions, Policies, and Cross-Country Differences in Income and Growth 169

The chapter next analyzes the role of economic freedom in determining economic growth. More economic freedom is present when people are permitted to choose for themselves, trade freely with others in both domestic and international markets, and live in an environment where property rights are secure and money has a stable value. Countries with more economic freedom tend to grow more rapidly and have greater investment rates.

The text next points out that a legal structure that protects property rights and enforces contracts in an evenhanded manner is vitally important. Without such a legal system, people will not be able to derive the benefits of depersonalized trade with people living in distant locations. Without the gains from a vast network of depersonalized exchanges coordinated by markets, high income levels and living standards will be unattainable.

Lastly, the chapter notes that economic institutions and policies will reflect political choices. The political environment often conflicts with the adoption of sound economic policy. Even democratic politics will sometimes lead to the adoption of policies that reduce growth and prosperity.


1. Review with students the data of Exhibits 1 and 2. These exhibits highlight the differences across countries in both the level and growth rates in income.

2. Review Exhibits 4 and 5, which show that countries with more economic freedom tend to have higher income levels and grow faster. Point out that economic freedom is greater when people are allowed to choose for themselves, trade freely with others in both domestic and international markets, and have secure property rights and money has a stable value.

3. Review Exhibit 7 which show that countries with more economic freedom tend to have higher investment levels and more productive investment.

4. Critical Analysis Questions 1, 3, 6, 8, 9, 12, and 14 should provide ample material with which to stimulate student participation in a discussion of the major points of this chapter.


3. The statement is false. The world’s fastest-growing economies during the past two decades were almost all low-income less-developed countries in 1990. China and India, with a third of the world’s population, are included in the fast-growing group of LDCs. But there is also a large number of LDCs that have experienced falling incomes in recent decades.

4. In order to make a high score on the EFW index, a country must rely extensively on markets, protect property rights and enforce the law in an even-handed manner, provide for monetary/price stability, refrain from policies that restrict trade, and keep taxes low.

5. The five freest economies are Hong Kong, Singapore, New Zealand, Switzerland, and Australia. More free economies have higher income levels and higher growth rates.

7. According to the Economic Freedom of the World measure, the economic freedom of the United States has fallen from 8.62 in 2000 to 7.70 in 2010, a reduction of almost one full unit on a ten-point scale. (See Exhibit 9 of

170 Chapter 17/ Institutions, Policies, and Cross-Country Differences in Income and Growth

Chapter 17.) The United States was ranked as the third freest economy in the world throughout 1980-2000, but by 2011, its ranking had declined to 17th.

This reduction in economic freedom will tend to slow economic growth. Research on this topic indicates that a one-unit reduction in the EFW measure is associated with approximately a one-percentage point decline in long-term real economic growth. This implies that rather than achieving its long-term historic growth rate of real GDP of approximately 3 percent, if the economic freedom of the United States remains at the lower level, the U.S. economy is likely to grow at an annual rate of only about 2 percent in the decade immediately ahead.

Chapter 18 (16 Micro)Gaining From International Trade

OUTLINE

I. The Trade Sector of the United StatesA. The size of the trade sector has grown rapidly in recent years.

B. Both exports and imports were approximately 10 percent of the economy in 1980. In 2012, exports accounted for 14 percent of GDP output, while imports summed to 18 percent.C. Canada, China, and Mexico are the leading trading partners of the United States.

II. Gains from Specialization and TradeA. Law of comparative advantage: A group of individuals, regions, or nations can produce a larger joint output if each specializes in the production of the goods for which it is a low opportunity cost producer and trades for those goods for which it is a high opportunity cost producer.

1. International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best.2. Trade permits each country to use more of its resources to produce those goods that it can produce at a relatively low cost.3. With trade, it will be possible for the trading partners to consume a bundle of goods that it would be impossible for them to produce domestically.

B. As long as relative production costs of the two goods differ between two countries—for example, United States and Japan—gains from trade will be possible.C. In addition to the gains derived from specialization in areas of comparative advantage, international trade leads to gains from:

1. Economies of Scale: International trade allows both domestic producers and consumers to gain from reductions in per-unit costs that often accompany large-scale production, marketing, and distribution.2. More Competitive Markets: International trade promotes competition in domestic markets and allows consumers to purchase a wide variety of goods at economical prices.

III. Supply, Demand, and International TradeA. Impact of trade on markets where U.S. producers have a comparative advantage.

B. Impact of trade in markets where foreigners have a comparative advantage.C. Summary: Supply, Demand, and Gains from Trade

1. International trade and specialization result in lower prices (and higher domestic consumption) for imported products and higher prices (and lower domestic consumption) for exported products.2. Trade permits the residents of each nation to concentrate on the things they do best (produce at a low cost), while trading for those they do least well.


IV. The Economics of Trade RestrictionsA. Trade restrictions promote inefficiency and reduce the potential gains from exchange.


Chapter 18 (16 Micro)/Gaining From International Trade 173

1. Import restrictions, such as tariffs and quotas, reduce foreign supply to the domestic market thereby causing the domestic price to rise. Thus, such restrictions are subsidies to producers (and workers) in protected industries at the expense of (a) consumers and (b) producers (and workers) in export industries.

2. Jobs protected by import restrictions are offset by jobs destroyed in export industries.

V. Why Do Nations Adopt Trade Restrictions?A. National Defense ArgumentB. Infant Industry ArgumentC. Dumping: The sale of goods abroad at a price below their cost (and below their price in the domestic market of the exporting nation)

1. Dumping is illegal under U.S. law.2. When considering the merits of anti-dumping restrictions, it is important to remember that (a) firms with large inventories may find it in their interest to offer goods at prices below their cost of production, (b) domestic firms are permitted to engage in this practice, and (c) the lower prices associated with dumping benefit domestic purchasers.

D. Special Interests and Trade Restrictions1. Trade restrictions provide highly visible, concentrated benefits for a small group of people, while imposing widely dispersed costs that are often difficult to identify on the general citizenry.2. Politicians have a strong incentive to favor special interest issues, even if they conflict with economic efficiency.3. The power of special-interest groups provides the primary source for trade restrictions.

VI. Trade Barriers and Popular Trade FallaciesA. Trade Fallacy 1: Trade restrictions that limit imports save jobs and expand

employment.1. Trade restrictions do not “save” jobs; they merely reshuffle them. Restriction will

mean more Americans working in areas where we do not have a comparative advantage.

B. Trade Fallacy 2: Free trade with low-wage countries like Mexico and China will reduce the wages of Americans.1. Wages are relative high in the United States because American workers are more

productive than those in other countries. They are not the result of trade restrictions.

VII. The Changing Nature of Global TradeA. The growth of the trade sector has been propelled by technological advancements,

lower transport cost, and more liberal trade policies.B. GATT and the WTO.C. NAFTA and Other Regional Trade Agreements.D. The Future.

174 Chapter 18 (16 Micro)/Gaining From International Trade

OBJECTIVES

This chapter focuses on the microeconomic aspects of international trade. The law of comparative advantage and the concept of gaining from specialization and trade are central to the analysis. These tools were introduced in Chapter 2. Thus, instructors may want to have their students review that material prior to their reading of this chapter.

After analyzing the impact of international trade on export and import markets, various trade restrictions are discussed. The impact of trade restrictions on aggregate output is considered. Tariff legislation is analyzed. While there are a few partially valid arguments for trade restrictions, protectionist legislation for most industries is based on fallacious reasoning (remember the secondary effects) and the special-interest effect. The text discusses both the economic and political consequences of protectionist policies.


1. Exhibit 1 indicates the size of trade sector as a share of the economy in the United States rose substantially between 1960 and 2012. By 2012, imports and exports combined were equal to over 30 percent of GDP.

2. It is important that students see the link between exports and imports. Exports provide the purchasing power (foreign currencies) with which U.S. consumers purchase foreign goods, services, and assets. Without exports, we would be unable to import. Similarly, our imports provide foreigners with the dollars with which they purchase our exports. If foreigners did not sell to us, they would lack the purchasing power with which to buy U.S.-made goods (U.S. exports). Thus, policies limiting imports to the United States will, in the long run, also limit the demand for our exports.

3. Students have trouble distinguishing between absolute and comparative advantage. Numerical examples help to illustrate this distinction. Exhibits 4 and 5 use a numerical example to illustrate that total output can be expanded and both trading partners can gain from trade even when the productivity per worker-hour for all goods is greater in one country than another. Since this important concept is so difficult for students to understand, we recommend that you take a class period to go through these exhibits or a similar numerical example.

4. Exhibits 6 and 7 illustrate how trade influences domestic markets. Emphasize that when the United States has a comparative advantage in production, domestic producers will be able to compete effectively in the international market. Trade will permit the U.S. producers to expand output and obtain a higher price when they a have a comparative advantage in production. Simultaneously, trade permits a nation to obtain goods at a lower cost when it is at a comparative disadvantage in production. Thus, compared to the no-trade situation, international trade permits a nation to (a) sell at a higher price when it is a relatively efficient producer of a good and (b) buy at a lower price when it is relatively inefficient producer of a good. The process also permits an expansion in the joint output of the trading partners.

5. Tariffs and quotas nearly always pit the welfare of well-organized, concentrated, industrial and labor interests of a protected industry against the unorganized consumer. Thus, the special interest effect explains why trade restrictions will be commonplace even though they typically promote economic inefficiency.


6. The argument that trade restrictions save jobs fails to consider the secondary effects. Although jobs are saved in the protected industries, the decline in our imports reduces the demand for our exports and increases the costs of exporters, reducing their international competitiveness. Thus jobs are destroyed in export-based industries. The latter effect typically goes unnoticed.

7. Many laypersons believe that the United States cannot compete in international markets because wage rates are higher in the United States than in most other countries. Of course, if output per hour is high, high wage rates need not mean high labor costs. The myth on free trade and low wages deals with this topic. Many instructors may want to use it as the focal point for a classroom discussion.

8. An interesting classroom application for this chapter is to ask students whether grades reflect absolute or comparative advantages in the classroom. Your grade in a given class represents your absolute advantage in that class since grades are usually based on achievement, not the work put in to obtain it. For your college career as a whole, your GPA is a measure of your absolute advantage or disadvantage compared with other students. Your comparative advantage is (imperfectly) revealed as areas where your grades are higher than your overall GPA, and symmetrically for comparative disadvantages.

9. Critical Analysis Questions 1, 2, 3, 4, 8, 9, 12, and 16 should provide ample material with which to stimulate student participation in a discussion of the major points of this chapter.

10. It is helpful to go back to the earlier circular flow diagram to show the linkage between exports and imports. Another help in visualizing the financial market effects of trade flows is to think in terms of dollars piling up on the shores of countries with trade surpluses, then asking what people in those counties will do with the dollars.

11. Since the logic of the gains from trade to individuals is the same as that for international trade, one helpful way to frame the issues of import restrictions is to ask when it would be in an individual’s interest to impose similar restrictions on his own personal trades with others and then ask what difference it makes when we are talking about countries rather than individuals. Similarly, the text discussion of trade barriers between the states can be linked to a discussion of the commerce clause of the Constitution.

12. Game 1 helps students understand the debate regarding free trade and protectionism.


GAMES1. Free Trade or Protection?

Type: In-Class AssignmentTopics: effects of protectionism, free tradeTextbook: Chapter 17 Gaining from International TradeMaterials Needed: noneTime: 60 minutesClass limitations: works in any size class

Purpose

This assignment leads the students through several trade issues. Many students, including those who can make an economic argument for free trade, have an emotional attachment to protectionism. This exercise examines the rationale for protecting jobs and looks at the direct and indirect costs.

Instructions


Question 4 is the hardest for students to answer; some additional explanation can help. If consumers pay a total of $100,000 extra to save 100 U.S. jobs, then the cost of saving a job is $1000.

1. Which to do you favor, free trade or protection? Explain why.

2. Assume you are voting on a request before the U.S. International Trade Commission to raise the tariff on imports of rubber thread. Rubber thread is made from latex and is a relatively small industry. It is used in the manufacture of elastic in items like socks, underwear, and bungee cords. Increasing the tariff would allow the U.S. producers to avoid layoffs and to invest in technology.

Would you vote for the tariff increase, or against it?

3. More generally, what are the benefits of keeping a job in the United States?

4. The costs of protectionism are paid by consumers in the form of higher prices. The obvious question is, “at what point do these costs exceed the benefits?” In your opinion, how much extra should consumers pay to keep a job in the United States? (Express this figure in dollars/per job.)


1. Which to do you favor, free trade or protection? Explain why.Many classes will split about evenly on this question. Many points can be presented but the argument usually comes down to economic efficiency versus jobs.

2. Assume you are voting on a request before the U.S. International Trade Commission to raise the tariff on imports of rubber thread. Rubber thread is made from latex and is a relatively small industry. It is used in the manufacture of elastic in items like socks, underwear, and bungee cords. Increasing the tariff would allow the U.S. producers to avoid layoffs and to invest in technology.


Would you vote for the tariff increase, or against it?Many students, including those who generally favor free trade, will vote to increase the tariff in this particular case.

3. More generally, what are the benefits of keeping a job in the United States?Workers pay taxes and purchase goods from other companies. Social service costs are avoided. Companies earn higher profits. Communities are healthier.

4. The costs of protectionism are paid by consumers in the form of higher prices. The obvious question is, “at what point do these costs exceed the benefits?” In your opinion, how much extra should consumers pay to keep a job in the United States? (Express this figure in dollars/per job.)

A complete free trader would say “Zero. It’s worth nothing to protect a job in my country.” A few students will take this stand.

Most students will choose a dollar figure from $100 to $10,000. A few may go somewhat higher.

These figures are dwarfed by the actual costs of saving American jobs through trade barriers. Estimates range from $60,000 per worker (in the bicycle industry) to $750,000 per worker (in the steel industry.)

This is far above the actual earning of these workers. It would be cheaper to pay them a lump sum to retire. Subsidizing workers through trade laws is a very inefficient method of helping them. The benefits students list in question 3 are real, but very small compared to the costs.

Returning to Question 2, do we really save American jobs by increasing tariffs? Increasing the price of inputs hurts the competitiveness of U.S. businesses. In the rubber thread case, 10 times as many U.S. workers are employed in industries that use rubber thread as an input. Voting to protect workers in the rubber thread industry puts workers in the sock, underwear, and bungee cord industries at risk.

More generally, increases in U.S. trade barriers cause other countries to retaliate. This puts workers in our export industries at risk. Our most efficient industries are hurt by efforts to protect our least efficient industries.


7. The high tariff on imported steel would raise the price of steel and thus the cost of producing U.S. manufacturing automobiles. The higher price for U.S. automobiles would reduce the quantity demanded of U.S. automobiles and thus employment in the U.S. automobile industry.

8. a. No. Americans would be poorer if we used more of our resources to produce things for which we are a high-opportunity-cost producer and less of our resources to produce things for which we are a low-opportunity-cost producer. Employment might either increase or decrease, but the key point is that it is the value of goods produced, not employment, that generates income and provides for the wealth of a nation. The answer to (b) is the same as (a).


13. Challenge students to think about the following questions: (1) Are we harmed by an increase in imports? (2) Would we be better off if stereo equipment, automobiles, clothing, and other products produced by foreigners were more expensive? (3) Are low opportunity cost producers driven out of business by foreign producers? (4) Does the availability of economical goods from abroad reduce the efficiency of resources used at home? and (5) What do foreigners do with the excess dollars they derive when we import more than we export?

14. The quota reduces the supply of sugar to the domestic market and drives up the domestic price of sugar. Domestic producers benefit from the higher prices at the expense of domestic consumers (see Exhibit 9). Studies indicate that the quota expanded the gross income of the 11,000 domestic sugar farmers by approximately $130,000 per farm in the mid-1980s, at the expense (in the form of higher prices of sugar and sugar products) of approximately $6 per year to the average domestic consumer. Because the program channels resources away from products for which the United States has a comparative advantage, it reduces the productive capacity of the United States. Both the special-interest nature of the issue and rent-seeking theory explain the political attractiveness of the program.

Chapter 19 (17 Micro)International Finance and the Foreign Exchange Market

OUTLINE

I. Foreign Exchange MarketA. Market where one currency is trade for another.B. The exchange rate enables people one country to translate the prices of foreign goods into units of their own currency.C. Appreciation of a nation’s currency will make foreign goods cheaper. Depreciation will make foreign goods more expensive.

II. Determinants of the Exchange RateA. Under a flexible rate system, exchange rate is determined by supply and demand.

1. The dollar demand for foreign exchange originates from the demand of Americans for foreign goods, services, and assets (either real or financial).2. The supply of foreign exchange originates from sales of goods, services, and assets from Americans to foreigners.3. The foreign exchange market will bring the quantity demanded and quantity supplied into balance. As it does so, it will also bring the purchases by Americans from foreigners into equality with the sales by Americans to foreigners.

III. Why Do Exchange Rates Change?A. The following factors will cause a currency to depreciate:

1. Rapid growth of income (relative to trading partners) that stimulates imports relative to exports.

2. Higher rate of inflation than one’s trading partners.3. Reduction in domestic real interest rates.4. A shift toward sound policies that attract an inflow of capital

B. The following factors will cause a currency to appreciate:1. Slow growth relative to one’s trading partners.2. Lower inflation than one’s trading partners.3. Increase in domestic real interest rates.4. A shift toward unsound policies that cause an outflow of capital.

IV. International Finance and Alternative Exchange Rate RegimesA. There are three major types of exchange rate regimes: (1) flexible rates, (2) fixed- rate, unified currency, and (3) pegged exchange rates.B. Examples of Fixed Rate, Unified System. Eleven nations of the European Union have recent adopted a unified currency system. Countries can also use a currency board to unified their currency with another. The currencies of Hong Kong, Argentina, and Panama are unified with the U.S. dollar.C. Pegged Rate Systems


1. A nation can either (a) follow an independent monetary policy and allow its exchange rate to fluctuate or (b) tie its monetary policy to the maintenance of the fixed exchange rate. It cannot, however, maintain the convertibility of its currency at the fixed exchange rate while following a monetary policy more expansionary than that of the country to which the domestic currency is tied.2. Attempts to pegged rates and follow a monetary policy that is too expansionary have led to several recent financial crisis—a situation where falling foreign currency reserves eventually force the country to forego the pegged exchange rate.

V. Balance of PaymentsA. Any transaction that creates a demand for foreign currency (and a supply of the domestic currency) in the foreign exchange market is recorded as a debit, or minus, item. Imports are an example of a debit item.B. Transactions that create a supply of foreign currency (and demand for the domestic currency) on the foreign exchange market are recorded as a credit, or plus, items. Exports are an example of a credit item.C. Under a pure flexible system, the quantity demanded will equal the quantity supplied in the foreign exchange market. Thus, the total debits will equal the total credits in the balance of payments accounts.D. Current Account Transactions

1. Current Account: All payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period.

2. The four categories of current account transactions are:a. merchandise trade--import and export of goods.b. service trade--import and export of services.c. income from investments.d. unilateral transfers--gift to and from foreigners.

E. Capital Account Transactions1. Capital Account: transactions that involve changes in the ownership of real and financial assets.2. Both (1) direct investments by foreigners in the United States and by Americans abroad and (2) loans to and from foreigners are counted as capital transactions.

F. Under a pure flexible-rate system, official reserve transactions are zero; therefore, a current-account deficit implies a capital-account surplus. Similarly, a current-account surplus implies a capital-account deficit.

VI. Exchange Rates, Current Account Balance, and Capital Inflow A. Are Trade Deficits Good or Bad?

1. With flexible exchange rates, an inflow of capital implies a trade (current account) deficit.2. If a nation’s investment environment is attractive, it is likely to result in a net inflow of capital and trade deficit.

a. When this inflow of capital channeled into productive investments, this is a positive development.


Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market 181

3. However, if the inflow of capital is used to finance current consumption or for the finance of unproductive projects, it will exert an adverse impact on future income.

a. In recent years a substantial share of the U.S. trade deficits have arisen from this source.

E. Should Trade Between Countries Balance?1. Political leaders often imply that U.S. exports to a country, China or Japan for example, should be approximately equal to our imports from that country.

a. This is a fallacious view.2. Under a flexible exchange rate system, overall purchases from foreigners will balance with overall sales to foreigners, but there is no reason why bilateral trade between any two countries will balance.3. Rather than balance, economics indicates that a country will tend to experience …

a. trade surpluses with trading partners that buy a lot of goods that it supplies at a low cost, and,b. trade deficits with trading partners that are economical suppliers of

goods that can be produced domestically only at a high cost.

OBJECTIVES

Trade between nations involves the exchange of currencies as well as the exchange of goods. This exchange of currencies gives rise to a special market—the foreign exchange market. In this chapter, we analyze the major factors affecting the price of a nation’s domestic currency relative to other currencies (the exchange rate) on the foreign exchange market.

This chapter analyzes the operation of a flexible exchange rate system. The impact of changes in the growth of income, inflation rates, and interest rate on the foreign exchange market are considered. The effects of monetary and fiscal policy under a flexible exchange rate system are discussed.

The chapter also provides a discussion of the other two types of exchange-rate regimes: (1) fixed-rate, unified currency, and (2) pegged exchange rates.

The chapter also includes an exploration of balance of payments accounts—the classification of debit and credit items in the balance of payments accounts. The major purpose of this chapter is to promote student understanding of the special problems that arise when goods are exchanged by trading partners who use different currencies.


1. The Wall Street Journal publishes current exchange rate information in each issue. Some instructors will want to update the exchange rate data of Exhibit 1.

2. When you explain the determination of exchange rates, frequent examples will promote student understanding. Use them freely. When U.S. customers purchase cars, steel, ownership shares (stocks), bonds, foreign travel, or any other good, service, or asset abroad, their actions supply dollars to the foreign exchange market. Similarly, when foreigners purchase goods, services, or assets supplied by U.S. sellers, their actions create a demand for dollars on the

182 Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market

exchange market. Describe several exchanges, explaining how they influence the supply and demand for a nation’s currency on the exchange market.

3. Depreciation (and appreciation) are easily confused. When the dollar price of a foreign currency increases, more dollars will be needed to buy units of the foreign currency (and foreign goods). Therefore, the dollar has depreciated. Its purchasing power abroad has declined. A depreciation (appreciation) in the value of the dollar means that the dollar price of the foreign currency has risen (fallen).

4. Students sometimes confuse a currency depreciation with inflation. A 10 percent depreciation in the value of the dollar increases the price of foreign goods and services by 10 percent, but leaves the purchasing power of the dollar for domestic goods unchanged. Thus, a currency depreciation is not the same thing as inflation.

5. In order to avoid confusion, it is easiest to visualize investment abroad not as the export of capital but rather as the import of a stream of future income (from a bond or stock). Thus, the importation of future income has the same impact on a nation’s balance of payments as the importation of goods and services.

6. The Thumbnail Sketch summarizes the major factors that will cause either an appreciation or depreciation of a nation’s currency under a flexible rate system. Carefully explain how: (a) different rates of economic growth, (b) differential inflation rates, (c) differential real interest rates, and (d) differential investment climates influence the exchange rate market.

7. With the shift from fixed to flexible exchange rates, the balance of trade and balance on current account assumes greater significance. Explain why the balance on current account helps to determine how international trade influences a nation’s debtor-creditor status. (Note: With flexible exchange rates, the significance of an overall balance of payments deficit or surplus is minimized since intervention is not required to bring about a balance in the exchange market.)

8. Any transaction that supplies a nation’s domestic currency to the foreign exchange market is recorded as a debit in the nation’s balance of payments account. Similarly, transactions that create a demand for the nation’s currency on the foreign exchange market are entered as credits. Thus, the importation of goods, services, bonds, and stocks from foreigners are all debits, whereas the exportation of these items is considered a credit.

9. Be sure to emphasize that the balance of payments must balance. Under a flexible exchange system (official reserve balance equals zero), this means that a nation running a capital account surplus must also run a current account deficit. Thus, a nation with a low saving rate and rapidly growing workforce that attracts substantial investment funds from abroad will tend to run a capital account surplus and a current account deficit under a flexible rate system. Many economists believe this situation is descriptive of the U.S. economy in recent years.

10. It is important to note that exchange rates are always moving in the wrong direction for someone, so there are always complaints about government policy in this area. For example, exporters and the import-substitute industries want a weaker dollar, but importers want a stronger one.


11. One interesting classroom illustration involves the impact of a change in oil prices on exchange rates. Oil is priced internationally in dollars. In the early 1980s, as oil prices in dollars went down, the exchange rate value of the dollar rose sharply. For a period, oil was getting cheaper in the United States (a positive supply shock) but more expensive in many other countries (a negative supply shock), with important differential effects between countries.

12. Be sure to review the non-flexible exchange rate regimes. It is worth mentioning that eleven nations of the European Union have recently adopted a unified currency system. An alternative method of unifying the currencies is to use a currency board. The currencies of Hong Kong and Panama are unified with the U.S. dollar. It is important to note that, in order to be effective, pegged rate systems require that a nation follow a monetary policy consistent with the maintenance of the pegged rate. Political pressure often makes this difficult to do.

13. Games 1 to 3 will help reinforce the material in chapter 18.

14. Critical Analysis Question 5 provides material that should help students understand the determinants of exchange rates. Questions 2, 7, 9, 13, and 15 provide material suitable for a classroom discussion on the major topics of this chapter.


GAMES

1. International Beer Consumption

Type: In-Class demonstrationTopics: exchange ratesTextbook: Chapter 18 International Finance and the Foreign Exchange Market Materials Needed: three imported beers, foreign currencyTime: 3 minutesClass limitations: works in any size class

Purpose

This demonstration introduces exchange rates.

Instructions

Tell the class this story, “I went to the bar the other night with two friends. We each ordered a beer: a Corona, a Beck’s, and a Molson. The bartender brought us our drinks.”

Put the beers on the podium.

“Then he said, ‘That’ll be 100 pesos, 3 marks, and 2 Canadian dollars.’”

“Luckily, we had it.” Drop the currency on the podium.

Ask the class, “What could we have done if we didn’t have those currencies?”


The answer is obviously: pay in U.S. dollars, but the markets behind that are interesting.

The beers were produced in Mexico, Germany, and Canada. The brewers’ expenses were incurred in pesos, marks, and Canadian dollars. Their workers don’t want to be paid in a foreign currency, nor do their suppliers.

The only reason we can buy these products with U.S. dollars is that someone is willing to trade marks, pesos, and Canadian dollars for U.S. currency. This demand for dollars, together with the supply of dollars, determines the exchange rate.


2. A Profitable Opportunity

Type: In-Class AssignmentTopics: exchange rates, arbitrageTextbook: Chapter 18 International Finance and the Foreign Exchange MarketMaterials Needed: noneTime: 20 minutesClass limitations: works in any size class

Purpose

This assignment requires students to practice calculating prices with exchange rates and looking for profit opportunities. The numbers used in this example are actual transaction prices from 1990.

Instructions

Explain the following situation to the class. Labatt’s beer is produced in Canada, and sold in many countries. In the province of Ontario, a six-pack of Labatt’s beer sold for $6.60 Canadian. Across the border in Michigan, a six pack of the same beer was on sale for $2.75 U.S. At the time, the exchange rate was $0.75 U.S. = $1.00 Canadian.

Ask the class to make the following calculations.

1) How much would it cost in U.S. currency to buy the beer in Ontario?

2) How much would it cost in Canadian currency to buy the beer in Michigan?

3) Is there an arbitrage opportunity?

4) If there is an arbitrage opportunity where would you buy and where would you sell? How much profit could you expect on a six-pack?

5) Why might the price differential exist?


1) How much would it cost in U.S. currency to buy the beer in Ontario?6.60 x 0.75 = $4.95 U.S.

2) How much would it cost in Canadian currency to buy the beer in Michigan?2.75/0.75 = $3.67 Canadian

3) Is there an arbitrage opportunity?Yes. A price differential exits. The beer is more expensive in Canada, cheaper in the United States.

4) If there is an arbitrage opportunity where would you buy and where would you sell? How much profit could you expect on a six-pack?


Buy in Michigan, sell in Ontario. The profit per six-pack would be the difference between the price in Ontario, $4.95, and the price in Michigan, $2.75, which equals $2.20 U.S. (Or, measured in Canadian currency, a profit of $2.93 Canadian.)

5) Why might the price differential exist?This is a substantial price difference. Neither transportation costs, nor duties and tariffs can explain the difference. The beer is produced in Canada, yet is cheaper after being brought across the border.

Other explanations must be sought. In Ontario, beer retailing is a monopoly. Beer can only be bought at “The Beer Store” (formerly called, “Brewer’s Retail.”) Taxes are certainly different in the two locations.

Transportation costs and import regulations, as well as restrictions on retail sales in Ontario, may prevent arbitrage from eliminating the price difference.

3. Comparing International Prices

Type: Take-home AssignmentTopics: exchange rates, arbitrage, purchasing power parityTextbook: Chapter 18 International Finance and the Foreign Exchange MarketClass limitations: works in any size class

Purpose

This assignment has students practicing working with exchange rates and comparing prices in two countries. The numbers used in this example are actual prices from 1997.

Instructions

Ask the class to find retail prices for goods from the following list. They should convert prices to a common currency to compare the relative costs between the two countries. Most students will find comparisons easier if Dominican prices are converted into U.S. dollars. Ask them to explain the biggest price differentials.


Name ___________________________________ Principles of Economics

International Price Comparisons1. Go to a local store and find prices for ten (or more) of the goods shown below.2. Use the exchange rate of $1.00 US = 14 Dominican Pesos to compare the prices in each

country.3. Circle the three items with the largest price differences.4. Why might prices differ?

Price in Santo Calculate local priceDomingo, DR (U.S. dollars) for price

Product (Dominican Pesos) comparison

avocado 5.45 ___________

rice, 1 pound 5.45 ___________

beer, 6-pack 59.95 ___________

rum, 700 cc 42.75 ___________

Tanquery Gin, 750 ml 189.00 ___________

Campbell’s tomato soup 15.95 ___________

Kellogg’s Corn Flakes, 11.2 oz 29.95 ___________

Pepperidge Farm Cookies, 6 oz 36.95 ___________

corn oil, 96 oz 75.95 ___________

butter, 1/4 pound 7.95 ___________

hot dog rolls, 8 rolls 14.00 ___________

coffee, 1 pound 29.95 ___________

sugar, 1 pound 4.30 ___________

Chiclets gum, 3 boxes 14.45 ___________

milk, 1/2 gallon 24.95 ___________

chicken, pound 13.95 ___________

large eggs, 1 dozen 16.95 ___________

unleaded gasoline, gal 32.00 ___________


Common Answers and points for discussion

Price in Santo Calculate local priceDomingo, DR (U.S. dollars) for price

Product (Dominican Pesos) comparisonavocado 5.45 $0.39rice, 1 pound 5.45 0.39beer, 6-pack 59.95 4.28rum, 700 cc 42.75 3.05Tanquery Gin, 750 ml 189.00 13.50Campbell’s tomato soup 15.95 1.14Kellogg’s Corn Flakes, 11.2 oz 29.95 2.13Pepperidge Farm Cookies, 6 oz 36.95 2.63Corn oil, 96 oz 75.95 5.45butter, 1/4 pound 7.95 0.56hot dog rolls, 8 rolls 14.00 1.00coffee, 1 pound 29.95 2.14sugar, 1 pound 4.30 0.31Chiclets gum, 3 boxes 14.45 1.03milk, 1/2 gallon 24.95 1.78chicken, pound 13.95 1.00large eggs, 1 dozen 16.95 1.21unleaded gasoline, gal 32.00 2.28

The items with the largest price differences are typically:Avocados, rum, and coffee are cheaper in the Dominican Republic.Gasoline is cheaper in the United States.

Some goods do seem to seem to confirm “the law of one price,” but substantial price differences do exist, particularly for the goods mentioned above. Purchasing power parity does not hold consistently.

Reasons for these price differentials include: trade barriers, taxes, and government price controls. All three of these exist in the United States (particularly for alcohol and agricultural products) and in the Dominican Republic (high tariffs on many imports, government control of gasoline prices). Cartels may also interfere with price adjustments for some products (such as coffee) and multinational firms may establish price differentials for branded products. If free trade and internal free markets don’t exist, arbitrage will not eliminate price differences.


1. The Japanese cameras will become more expensive, and the quantity purchased by Americans will decline.

6. Under a flexible exchange rate system, a deficit on current account implies a surplus on capital account. Is it a dangerous thing if the United States runs a surplus on its capital account transactions (and therefore a deficit on current account) because foreigners find investment opportunities in the United States attractive?

11. The current-account balance will move toward a larger deficit (or smaller surplus), and the dollar will appreciate.


12. Not necessarily. It depends on the source of the trade surplus. When a country has a high rate of saving, a strong export sector will be required for the profitable investment of the saving. In this case, the trade surplus is perfectly consistent with a strong economy. The experience of the Japanese economy during the last several decades is an example of this case. A trade surplus, however, may also arise because a serious recession retards imports or because unsound policies (e.g., high taxes, insecure property rights, or political instability) pose a threat to capital formation. Few would consider a trade surplus arising from these sources as a positive development.

Chapter 20 (7 Micro)Consumer Choice and Elasticity

OUTLINE

I. The Fundamentals of Consumer ChoiceA. Fundamentals of Consumer Choice

1. Limited income necessitates choice.2. Consumers make choices purposefully.3. One good can be substituted for another.

4. Consumers must make decisions without perfect information, but knowledge and past experience will help.

5. The law of diminishing marginal utility applies.1. As the rate of consumption increases, the marginal utility

derived from consuming additional units of a good will decline.II. Marginal Utility, Consumer Choice, and the Demand Curve of an Individual

A. The Demand Curve1. The height of an individual’s demand curve is equal to the maximum price the consumer would be willing to pay for that unit—its marginal benefit.

2. A consumer’s willingness to pay for a unit of a good is directly related to the utility derived from consumption of the unit.3. The law of diminishing marginal utility implies that a consumer’s marginal benefit, and thus the height of their demand curve, falls with the rate of consumption.

B. Consumer Equilibrium with Many Goods1. Consumer will maximize his/her satisfaction by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility.

C. Price Changes and Consumer Choice1. The demand curve shows the amount of a product that consumers would be willing to purchase at alternative prices during a specific time period.2. The law of demand states that the amount of a product purchased is inversely related to its price.

3. Reasons for downward slope of demand curve.a. Substitution effect: as the price of a product declines, consumers

buy more of it and less of other now more expensive products.b. Income effect: as product price falls, consumer’s real income

rises and this induces them to buy more of the product and other goods.D. Time Cost and Consumer Choice

1. The monetary price of a good is not always a complete measure of its cost to the consumer.2. Consumption of most goods requires time as well as money; and time, like money, is scarce to the consumer.


a. So a lower time cost, like a lower money price, will make a product more attractive.

b. Time costs, unlike money prices, differ among individuals.III. Market Demand Reflects the Demand of Individual Consumers

A. Individual and Market Demand Curves1. The market demand curve for a product is the horizontal sum of people’s individual demand curves.

IV. Elasticity of DemandA. Elasticity of Demand

1. Price elasticity reveals the responsiveness of the amount purchased to a change in price.

B. Determinants of Price Elasticity of Demand1. Availability of substitutes.

a. When good substitutes for a product are available, a price rise induces many consumers to switch to other products and demand is elastic.2. Share of total budget expended on product.

a. As the share of the total budget expended on the product rises, demand is more elastic.

C. Time and Demand Elasticity1. If the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run.

a. Thus, the demand for most products will be more elastic in the long run than in the short run.

b. This relationship is often referred to as the second law ofdemand.

V. How Demand Elasticity and Price Changes Affect Total Expenditures (or Revenues)on a Product

A. When the demand for a product is elastic, a price change will cause total spending on it to change in the opposite direction.

B. When demand for a product is inelastic, a change in price will cause total spending on it to change in the same direction.

VI. Income ElasticityA. Income Elasticity

1. Income elasticity indicates the responsiveness of the demand for a product to a change in income.

2. A normal good is any good with a positive income elasticity of demand.a. As income expands, the demand for inferior goods will rise.

3. Goods with a negative income elasticity are inferior goods.a. As income expands, the demand for inferior goods will decline.

VII. The Price Elasticity of SupplyA. Price Elasticity of Supply


Chapter 20 (7 Micro)/Consumer Choice and Elasticity 193

1. The price elasticity of supply is the percent change in quantity supplied divided by the percent change in the price causing the supply response.

a. It is analogous to the price elasticity of demand.b. However, the price elasticity of supply will be positive because

the quantity producers are willing to supply is directly related price.

OBJECTIVES

This chapter focuses on the demand for specific products. The basic postulates of demand theory are presented. The downward-sloping individual demand curve for a specific product merely reflects the law of diminishing marginal utility. Since the market demand is the horizontal sum of the individual demand curves, it, too, will be a downward-sloping curve.

When constructing a demand curve, economists assume that: (a) income and its distribution, (b) prices of related products, (c) consumer preferences, (d) demographics, and (e) expected future prices remain constant. Changes in any of these factors cause demand to change—a shift in the entire schedule.

The concepts of price elasticity of demand and income elasticity of demand are presented, and the major determinants of price elasticity of demand are analyzed. Also included is discussion of the relationship between elasticity and total expenditures/revenue. In the addendum, the application of indifference curves to demand theory is illustrated.


1. Students should be familiar with Chapter 3 before Chapter 20 is assigned. Instructors who have presented text chapters in sequence should remind students to review Chapter 3 in preparation for their study of Chapter 20.

2. The demand curve simply isolates the impact of a change in price on the quantity demanded, assuming that other factors are unchanged. A change in price will alter the amount demanded. Changes in such factors as consumer income and the price of related products will cause the entire curve to shift. Remind students that failure to distinguish between (a) a change in demand and (b) a change in quantity demanded in response to a change in price is a very common error. The Thumbnail Sketch summarizes this important distinction.

3. Discuss the relationship between the mutual gains from trade introduced in Chapter 2 and consumer surplus. Explain that the difference between the maximum price that the buyer-consumer would be willing to pay for a unit of a product and the price actually paid for the unit is called consumer surplus. This surplus is the buyer’s share of the mutual gains from voluntary exchange.

4. Advertising has dual function—it provides information and it influences consumer preferences. The text gives a balanced presentation in which both are highlighted.

5. Students have trouble distinguishing between the terms elastic and inelastic. An elastic demand curve is one for which the amount purchased is highly “responsive” (purchasers are flexible) to a change in price. In contrast, when the amount purchased is “unresponsive” (purchasers are inflexible) to a change in price, we say that it is inelastic. Thus, the meaning of the words is exactly what one would expect. This can also be illustrated with a rubber band analogy where p represents pressure and q represents length.

194 Chapter 20 (7 Micro)/Consumer Choice and Elasticity

6. Referring to the text, discuss the estimated coefficients of demand elasticity presented in Exhibit 5. Explain why the availability of substitutes and the expenditures on an item relative to one’s total budget are important determinants of price elasticity of demand.

7. Many instructors will want to explain the difference between arc elasticity and point elasticity. The chart below provides a hypothetical example that might be used to clarify this distinction.

Amount Demanded Total RevenuePrice of Shirts (weekly) (weekly)

$5 100 $5006 90 5407 75 525

What is the arc price elasticity of demand as the price of shirts increases from $5 to $6? Answer: [(100 – 90)/1/2(100 + 90)] divided by [($5 – $6)/1/2($5 + $6)] or (10/95)/(–1/5.5) = –.58 What is the estimated point price elasticity of demand at $5 for the same price rise? Answer: (10/100)/(–1/5) = –.5. Go through similar calculations for a price rise from $6 to $7. Point out that when the absolute value of the price elasticity coefficient is greater than 1, demand is elastic, and the price and total revenue will change in opposite directions. On the other hand, when the elasticity coefficient is less than 1 (as for a price change from $5 to $6), demand is inelastic, and price and total revenue change in the same direction.

8. Students often confuse elasticity with the slope of the line. Since elasticity is a relative concept, it will vary for a straight line. This point is illustrated clearly in Exhibit 4.

9. The Critical Analysis questions at the end of this chapter may be used in a variety of ways. Question one should help students to understand the relationship between elasticity and total revenue.

10. The addendum provides coverage of indifference curves for those instructors wishing to introduce their students to this topic. Others may safely proceed to the next chapter. Although we believe that this material is presented clearly, we recommend that instructors choosing to cover this topic set aside at least two class periods for the topic.

11. It is worthwhile to try games 1 to 5 so that students will better see not only the tools involved but also the power and wide range of useful applications for these tools.

12. It is worth emphasizing to students that elasticity questions are just extensions of supply and demand analysis to “how far” types of questions (if you want to know how much price and quantity change rather than just in which direction, or which direction total revenues move when price and quantity move in opposite directions), and that they, in essence, just reflect underlying incentive stories with respect to the costs of changing behavior.

13. Since a lot of new technical terms are beginning to be thrown at students in this chapter, this is a good time to emphasize that economics, like every other scientific field, has a specialized language because certain forms of preciseness are crucial to the proper application of the principles involved (e.g., changes in demand versus changes in quantity demanded). It is necessary for students to understand this specialized language, but they also need to be able to explain what they mean in non-specialized language (e.g., can they explain their analysis to a plumber?).


14. It is important to stress to students that indifference curves are not something totally different than the other tools they are learning but are just another technique for focusing on marginal incentives facing decision makers.

GAMES

1. How the Ball Bounces

Type: In-Class demonstrationTopics: elastic, inelasticTextbook: Chapter 19 Demand and Consumer ChoiceMaterials Needed: one rubber ball and one “dead” ball. The “dead” ball ismade of shock-

absorbing material, and doesn’t bounce. Museum stores and magic shops carry them.

Time: 1 minuteClass limitations: works in any size class

Purpose

This quick, but memorable, demonstration can be used to introduce the concepts of elastic and inelastic.

Instructions

Bring two students to the front of the class. Give each of them a ball and ask them to bounce it off the floor and catch it. The student with the rubber ball can do this easily. The student with the “dead” ball will not be able to bounce it high enough to catch, no matter how hard they throw it.

Explain that one ball is elastic; it is responsive to change. The other ball is inelastic; it responds very little to change. These physical properties of elastic and inelastic are analogous to the economic concepts of elastic and inelastic.

2. Ranking Elasticities

Type: In-Class assignmentTopics: the determinants of price elasticity of demandTextbook: Chapter 19 Demand and Consumer ChoiceMaterials needed: noneTime: 20 minutesClass limitations: works in any size class

Purpose

The intent of this exercise is to get students to think about varying degrees of elasticity and to think about the factors that determine demand elasticity

Instructions

Give the students the following list of goods. Ask them to rank them from most to least elastic.


1. beef2. salt3. European vacation4. steak5. Honda Accord6. Dijon mustard

If they have difficulty, these hints can be helpful:1. How much would a 10 percent price increase for the good affect a consumers total

budget?2. What substitutes are available for the good?3. Do consumers think of this good as a necessity or a luxury?


A typical ranking:1. European vacation (luxury, many other vacation destinations, expensive)2. Honda Accord (expensive, many substitutes including used cars)3. steak (perceived luxury, moderate expense, other cuts of beef are close substitutes)4. Dijon mustard (perceived luxury, inexpensive, other types of mustard may be close

substitutes.)5. beef (moderate expense, pork & chicken are substitutes)6. salt (inexpensive, necessity, no close substitutes)

3. The Utility Meter

Type: In-Class DemonstrationTopics: diminishing marginal utility, increasing total utilityTextbook: Chapter 19 Demand and Consumer ChoiceMaterials Needed: 3 donuts, an apple, a “utility meter,” a screwdriver (A utility meter is any

box with a wire sticking out of it. Electronic components can be added for realism.)

Time: 15 minutesClass limitations: works in any size class

Purpose

This activity demonstrates how economists view consumption. The idea of diminishing marginal utility is vividly illustrated.

Instructions

Place one donut, the apple, and the utility meter on a table. Explain that the utility meter measures satisfaction, or happiness, from consuming a good. More specifically it shows the marginal utility, or the happiness from consuming an additional unit of a good.

Stick the utility meter’s wire into the donut. Pretend to read the utility meter and announce to the class, “I would get 30 units of satisfaction from consuming this donut.”


Plug the wire into the apple. Look at the meter again and tell them, “I would get 10 units of satisfaction from consuming the apple. This means the donut would give me three times more happiness than the apple.”

“The utility meter was an incredibly useful invention. If we could measure everyone’s happiness from consuming various goods, we could allocate goods to maximize social well-being.”

Pretend to adjust the utility meter with the screwdriver. Tell the class, “The problem comes when trying to compare numbers for different people. I have adjusted my meter; now the meter shows 100 units of satisfaction for the apple.”

Plug the wire back into the donut. “Now the meter shows 300 units of satisfaction from the donut. The relative satisfaction remains the same, but we can’t compare across individuals since the meters do not give absolute measures of satisfaction.”

Place the other two donuts on the table. Explain that economists are interested in how satisfaction changes as consumption increases. Put a chart on the board with these headings

Quantity Marginal Utility Total Utility0 0 —123

Use the utility meter to “test” the three donuts to show they are identical. Each donut should give a utility reading of 300. This means the marginal utility from consuming any one of the donuts is 300.

Eat a donut. Fill in 300 units of satisfaction for the marginal utility from the first donut.

Quantity Marginal Utility Total Utility0 0 —1 300 30023

Now “remeasure” the satisfaction from eating an additional donut. Stick the wire into a donut and announce it reads 210 units of satisfaction. Explain that the meter has not been adjusted and the donut has not changed. What has changed is the professor’s hunger and desire. Eating the second donut will not give as much pleasure as the first donut gave.

Eat the second donut. Record the marginal utility and calculate the total utility from consuming the two donuts.

Quantity Marginal Utility Total Utility0 0 —1 300 3002 210 5103


Now measure the marginal utility of consuming a third donut. Announce that the meter now reads 75 units of satisfaction. Happiness would increase by eating this donut, but not by as much as either the first or second donuts.

Fill in the final Marginal and total utilities.

Quantity Marginal Utility Total Utility0 — 01 300 3002 210 5103 75 585


Utility comparisons give the relative satisfaction from consuming one good versus another good.

Utility comparisons are not valid across individuals.

Total utility increases as consumption increases.

Marginal utility diminishes as consumption increases.

The idea of negative marginal utility will undoubtedly arise. Consumers can eat so many donuts that they get sick. Explain that economists assume rational consumers will not pay to make themselves feel worse.

4. You Can’t Always Get What You Want

Type: In-Class activityTopics: budget constraintsTextbook: Chapter 19 Demand and Consumer ChoiceMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class

Purpose

This activity shows consumers are restricted by their limited incomes and by the prices of goods.

Instructions

Ask the students to think about maximizing their own utility.

Specifically, ask them to assume that billionaire Bill Gates offers to buy them the one thing that would increase their happiness by the greatest amount. It can’t be money, or a financial instrument, but he will buy them any single thing they feel would make them happy. Have them write their requested item.

Ask a few students what they chose. Then ask the class, “Why don’t you buy that item for yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why not buy it today?”

The answer, of course, is they can’t afford it. Consumer purchases are constrained by their incomes.


But, that’s not the only constraint. Ask them to estimate the cost of their selected item and write it next to the item. Now, have them assume Bill Gates is too busy to go shopping, so he gives them the money instead. He doesn’t put any restrictions on the use of the cash; all he wants is to see them maximize their happiness.

This eliminates the income barrier. Ask the class how many of them would spend the entire amount of money buying that single good.

Some students would buy that item, but most would buy a variety of things. Using the money for a single expensive item may not be the best way to allocate their newfound wealth. Buying several cheap things may give a higher level of happiness.


1) Consumers have limited income.2) Goods have prices.

Together these things determine the consumer’s budget constraint.

5. Do Something New

Type: Take-home AssignmentTopics: Consumer choiceTextbook: Chapter 19 Demand and Consumer ChoiceClass limitations: works in any size class

Purpose

This assignment helps students relate the abstract ideas of consumer theory and optimization to their own lives. The first part asks them to speculate about the kinds of things that make people happy. The second part asks them to do something they feel would increase their happiness.

Instructions

Ask the students to complete the following assignment. Explain that Part 1 is contemplative and that Part 2 is active. The new activity does not have to be exotic or expensive.


Consumer satisfaction and utility can be increased by things other than narrowly defined, material consumption. “Self-interest” is not identical to selfishness. Helping others may be something that increases one’s own satisfaction.

Imperfect information makes consumer decisions difficult. Some students may try activities and not like them, or find the initial costs are higher than the benefits. This can be used to introduce decision-making under uncertainty or to introduce information problems.

Individuals have different tastes. Activities that appeal to some students won’t appeal to others. Comparing happiness across people isn’t possible.


Name _________________________________ Course __________________

Utility and Consumer Behavior

Consumer theory focuses on maximizing individual satisfaction. This assignment gives an opportunity to consider activities and experiences you feel would increase your personal utility.

Part I. For each of the following categories, list an action that you find appealing but that you haven’t experienced.1. Travel destination. Where would you like to go?

2. Volunteer. What group would you like to help?

3. Activity. What would you like to try?

4. Personal Goals. What would you like to accomplish?

Part II. Do something new. Choose an activity that you have never done before, but one you want to try. It can be anything you like, as long as you feel it would be enjoyable. It does not have to be an activity you listed in Part I.

Part III. Do it.

Part IV. Report on your activity. What did you do? What were the costs involved in your activity? Did it meet your expectations? Would you recommend it to your classmates?



1. Revenue will rise (fall) if students who enroll pay more (less) extra revenue than is lost due to lower enrollment. Revenue will remain the same if those who enroll pay just enough more to offset the loss from reduced enrollment. A price elasticity of –1.2 implies that raising tuition rates would reduce tuition revenue.

4. The consumer is not maximizing her utility. The marginal utility of a dollar spent on jeans is 2 (60/$30), while the corresponding number for t-shirts is 3(30/$10). Thus, the consumer should spend less on jeans and more t-shirts.

8. Consumption of medical services increases. Some units valued less than their costs will be consumed. (Assume positive marginal costs that are constant, and use graphic demand and cost analysis to illustrate this point.) In addition, you might want to ask your class to consider the impact of “absenteeism insurance” whereby everyone contributed grading points to cover personal losses on quizzes and exams due to “absences with reason.” Propose the following questions: How would this method of organization influence absenteeism? Might it lead to fraud and controversy over what constitutes an “absence with reason”? Are any of these the same problems present with medical insurance?

9. All three statements are true.

Chapter 21 (8 Micro)Costs and the Supply of Goods

OUTLINE

I. Organization of the Business FirmA. Incentives, Cooperation, and Nature of the Firm

1. In a market economy, firm owners are residual claimants.a. They have right to any revenue after costs have been paid.(1) Provides a strong incentive for owners to keep costs of

producing output low.2. Methods of Production

a. Contracting.(1) Owner contracts with individual workers who work independently.

b. Team Production.(1) Workers are hired by a firm to work together under

supervision.3. Shirking

a. With team production, owners must reduce the problem of shirking employees working at less than normal rate of productivity.

(1). Example: Long coffee break.b. Control with incentives and monitoring.

4. Principal-Agent Problema. The incentive problem caused by when the buyer has less

information than the seller about purchased services.(1). Firm owners face this problem when dealing with

workers.B. Types of Business Firms

1. Proprietorshipa. Owned by a single individual.b. Numerous, but account for a small share of business revenue.

2. Partnershipa. Owned by a two or more persons acting as co-owners.b. Account for a small share of business revenue.

3. Corporationa. Owned by stockholders.b. In contrast to the unlimited liability of proprietorships and

partnerships, the owner’s liability is limited to their explicit investmentc. Account for 88 percent of business revenue


II. Costs, Competition, and the CorporationA. Three major factors in a market economy promote cost efficiency and customer service within the corporation, thus limiting the power of corporate managers to shirk on their duties to shareholders.


Chapter 21 (8 Micro)/Costs and the Supply of Goods 205

1. Competition Among Firms for Investment Funds and Customers2. Compensation and Management Incentives3. Threat of Corporate Takeover

B. How Well Does the Corporate Structure Work?1. There is strong evidence that, despite its defects, the corporation is generally a cost-efficient, consumer-sensitive form of organization.

III. The Economic Role of CostsA. Role of Demand and Production Costs

1. The demand for a product indicates the intensity of consumer’s desires for an item.2. The (opportunity) cost of producing the item indicates the desire of consumers for other goods.

B. Explicit and Implicit Costs1. Costs may explicit or implicit.

a. Explicit costs result when a monetary payment is made.b. Implicit costs involve resources owned by the firm and don’t

involve a monetary payment.(1) e.g.: Owners time running the firm or the normal rate of return

on the owner’s financial investment (opportunity cost of equity capital).C. Total Cost

1. Total Cost = explicit + implicit costsD. Accounting and Economic Profit

1. Economic profit is total revenues minus total costs (including all opportunity costs).2. Economic profit requires an above normal rate of return, a rate of return greater than the opportunity cost of capital.

a. Firms earning zero economic profit are earning exactly the market rate of return.

3. Accounting profit is total revenue minus expenses of firm over a designated time period.

a. Often excludes implicit costs such the opportunity cost of equity capital.

b. Accounting profit is generally greater than economic profitIV. Short Run and Long Run Time Periods

A. Short Run1. The short run is a period of time so short that at least one factor of production is fixed.2. In the short run, output can only be altered by changing the usage of variable resources, such as labor and raw materials.

B. Long Run1. The long run is a period of time sufficient for the firm to alter all factors of production.

2. In the long run, firms can enter and exit the industry.

206 Chapter 21 (8 Micro)/Costs and the Supply of Goods

3. The actual short run and long run differ by industry


V. Categories of CostsA. Total Fixed Costs

1. Total Fixed Costs (TFC) are costs that remain unchanged in the short run when output is altered.

a. Examples: insurance premiums, property taxes, opportunity cost of fixed assets.

B. Average Fixed Costs1. Average Fixed Costs (AFC) are fixed costs per unit (i.e., TFC/output).

a. Decline as output expands.C. Variable Costs

1. Total Variable Costs (TVC) are the sum of costs that rise as output expands.a. Examples: cost of labor and raw material.

2. Average Variable Costs (AVC) are variable costs per unit (i.e., TVC/output).D. Total Cost

1. Total Cost (TC) = Total Fixed Cost + Total Variable Cost.2. Average Total Cost (ATC) = Average Fixed Cost + Average Variable

Cost.E. Marginal Cost

1. Marginal Cost (MC) is the increase in total cost associated with a one-unit increase in production.

a. MC will decline initially, reach a minimum, and then rise.VI. Output and Costs in the Short Run

A. Shape of ATC Curve1. The ATC curve is U-shaped.

a. ATC is high for an underutilized plant because AFC is high.b. ATC is high for an overutilized plant because MC is high.

B Law of Diminishing Returns1. Law of Diminishing Returns: as more units of a variable resource are applied to a fixed resource, output will eventually increase by a smaller and smaller amount.

C Product Curves1. Total Product: total output of a good associated with different levels of a variable input.2. Marginal Product: change in total product with a one more unit of a variable input.3. Average Product: Total product divided by the number of the units of the variable input.

D. Diminishing Returns and Cost Curves1. If a firm faces diminishing returns, MC will rise with additional

output.a. As MC continues to rise, it will eventually exceed ATC and raise ATC.

(1) Before that point, MC is below ATC and is bringing down ATC


VII. Output and Costs in the Long RunA. Long-Run ATC


1. The long-run ATC shows the minimum average cost of producing each output level when a firm is able to choose plant size.

B. Planning CurveC. Economies of Scale

1. Economies of Scale: Reductions in per unit costs as output (plant size) expands can occur for three reasons.

a. Mass production.b. Specialization.c. Improvements in production as a result of experience.

D. Diseconomies of Scale1. Diseconomies of Scale: rises in per unit costs as output (plant size) expands can occur.

a. Bureaucratic inefficiencies may result as size expands.E. Constant Returns to Scale

1. Constant Returns to Scale: Unit costs that are constant as plant size is changed.VIII. What Factors Cause the Firm’s Cost Curves to Shift?

A. Cost Curve Shifters1. Prices of resources.2. Taxes.3. Regulations.4. Technology.

IX. Economic Way of Thinking About CostsA. Sunk Costs

1. Sunk costs are historical costs associated with past decisions that can’t be changed.

a. Sunk costs may provide information, but are not relevant to current choices.

(1) Current choices should be made on current and future costs and benefits.

B. Cost and Supply1. In the short run, when making supply decisions, the marginal cost of producing additional units is the relevant cost consideration.

2. In the long run, the average total cost is vital to the supply decision.

OBJECTIVES

In this chapter, we discuss the organization of the firm and analyze the decision process that determines production costs. By means of the traditional approach, the general shapes of the firm’s cost curves are developed for both the short and long runs.

In the short run, the firm’s fixed factors limit the ability of the producer to expand output. Given the law of diminishing returns, the general shape of the total, average, and marginal product curves is derived. The corresponding cost curves are then presented. In the short run, diminishing returns will eventually cause the firm’s marginal costs to rise. The firm’s short-run average total cost curve will be U-shaped for small outputs; ATC will be high because AFC is high. For large


outputs (relative to plant size), ATC will be high because marginal costs, reflecting diminishing returns, are high. Our approach emphasizes the relationship between production theory and the general shape of the firm’s cost curves.


In the long run, the firm’s ATC can be expected to decline initially. There are three major reasons why the opportunity to plan a larger output (both rate and volume) will initially generate economies: (a) greater opportunity to adopt mass production techniques, (b) specialization, and (c) learning by doing. Managerial diseconomies are behind the eventual rise of long run ATC.

When cost curves are constructed, it is assumed that the prices of resources, taxes, and level of technology are constant. Changes in any of these factors will cause the firm’s cost curves to shift. Other important determinants of costs include the organizational structure of the firm and its ability to minimize problems arising from principal-agent relationships.


1. Be sure to relate cost analysis to the decisions of producers. Whereas the choices of consumers underlie demand analysis, the choices of producers form the foundation for cost (and supply) analysis.

2. Students often fail to consider adequately the opportunity cost of a factor owned (or supplied) by the producer. Be sure to distinguish carefully between explicit and implicit costs. A common illustration is to look at the cost of a college education.

3. The boxed feature on economic and accounting costs will help students better understand the concepts of explicit and implicit costs, as well as the difference between accounting and economic costs. Many instructors will want to go over this feature or a similar example in class.

4. This chapter contains more new definitions of key terms than any other chapter of the text. Reviewing the Thumbnail Sketch and going over Exhibit 5 will ensure student understanding of these new terms.

5. Exhibits 3 and 4 illustrate the implications of the law of diminishing returns for the firm’s product curve. The interrelationships among these curves are often difficult for students to grasp. Most instructors will want to spend some class time discussing the interrelation among the firm’s product curves using numeric examples.

6. Building on the data presented in Exhibits 3 and 4, Exhibit 6 illustrates the implications of production theory for the firm’s short-run cost curves. Explain that the firm’s cost curves are merely the reverse of the firm’s short-run product curves. For example, when the firm’s marginal product curve is rising, marginal cost will be falling. However, once the marginal product of the firm’s variable factor begins to decline (as diminishing returns set in), the firm’s short-run marginal cost will begin to rise.

7. Be sure to note that the long-run ATC curve is a planning curve. No single firm could achieve the alternative cost-output relationships outlined by the long-run cost curve. The long-run curve simply outlines the expected cost of producing alternative output levels before the firm has chosen a specific plant size.

8. The traditional economies of scale can more properly be thought of as cost reductions that stem from the ability of the producer to plan a large volume (rather than rate) of output. Accordingly, in the text it is assumed that firms producing at high rates are also planning to produce large volumes. Reality appears to approximate this situation. (See Armen Alchian,


“Cost and Output,” in The Allocation of Economic Resources by Moses Abromovitz, and Jack Hirshleifer, “The Firm’s Cost Function: A Successful Reconstruction,” Journal of Business [July 1962], for two interesting articles that focus on the distinction between the rate and volume of output.)

9. Textbooks have traditionally discussed costs in a mechanistic fashion. The section on costs and the economic way of thinking seeks to add more realism to the analysis. Be sure to explain sunk costs and why they are irrelevant (except for the content of their information) to current decision making. Also emphasize that costs at the time decisions are made are expected costs.

10. Decision making under uncertain conditions, the role of time, and sunk costs are all points emphasized in the myth, which explains why decision makers sometimes sell at a loss. Although business decision makers will not knowingly undertake projects that fail to generate revenues sufficient to cover costs, this sometimes happens as the result of error. Many instructors may wish to use the short Myths of Economics feature as the focal point of a classroom discussion.

11. Question 2 illustrates common sources of economic confusion due to the failure of decision makers to understand the concept of cost. Discuss these examples with your students.

12. The quotation by Thomas Sowell at the beginning of the chapter contains much food for thought. This statement might be used to coordinate discussion of the material presented in this chapter.

13. Our experience has shown that, since a large number of new terms and concepts are introduced in Chapters 19 and 20, a short examination on these two chapters may help students pull this material together.

14. There are many good illustrations of the theory of the firm, shirking, principle-agent problems, etc., that students are more familiar with than traditional business application and that can be useful ways of helping students to see the intuition involved. Perhaps the two most useful areas to find these illustrations are family life (e.g., how does your mom get you to do those chores?) and group projects for school (e.g., how do you control for shirking by those group members with lower GPAs, who have less to lose from poor individual performance?).

15. A good way to focus on the monitoring problem facing firms is to talk about the differences in monitoring incentives between profit and non-profit companies (like universities).

16. With all the new material being introduced in this chapter, which is then built upon in subsequent chapters, it is important to emphasize student understanding of the verbal logic (intuition) in the concepts and illustrations. If you do not, many students will memorize the definitions and the graphs but be unable to understand the material well enough to apply it to real world situations.

17. A useful example for discussing production functions, fixed and variable factors, etc., is to talk about production functions for grades in your course. You can talk about varying the proportions of different inputs (e.g., time in class versus time studying at home, study guides,


tutors, etc.); about increasing and decreasing returns to the number of hours invested (at first, some work is required to “get it,” but beyond some point the payoff to added studying starts to fall); and about implicit costs (which TV show are you giving up to study this half hour?).

18. A good classroom illustration of implicit versus explicit costs is to ask students whether it is cheaper to drive on a freeway or a tollway, and then guide them to see that, under some circumstances, it is cheaper to drive on a tollway.

19. Games 1 to 3 provide some ways to demonstrate the concepts stressed in Chapter 21.

GAMES

1. Growing Rice on a Chalkboard

Type: In-Class DemonstrationTopics: diminishing returns and increasing costsTextbook: Chapter 20 Costs and the Supply of GoodsMaterials Needed: 2 volunteers, chalkboard, chalk, 2 “loans”Time: 25 minutesClass limitations: works in classes with more than 15 students

Purpose

Students often have difficulty understanding why diminishing returns exist in short run production. This activity vividly demonstrates how fixed factors constrain the returns to variable inputs. Then, the cause of increasing marginal cost is obvious.

Instructions

Each “loan” is a sheet of paper with a large dollar sign ($) written on one side and the word “LOAN” on the other. Prepare the game by selecting two volunteers and outlining two rectangular areas on the chalkboard, approximately 2x3 feet. Next to each area, label a column “Labor” and another “Total Output.” Give each volunteer one piece of chalk and hide any other pieces. The chalk is a fixed factor of production.

The volunteers are farmers and the outlined areas are their farm fields. They produce rice by writing the word “RICE” in large letters inside their own field. The letters need to be at least three inches high. They want to produce as much rice as possible in each 15 second time period.

Of course, it takes big bucks to farm (show the class the large $) and the money comes in the form of a loan (show them the other side of the paper). Tell the volunteers, “Before you can start producing, you will need to run to the back of the classroom and get a loan from me.”

The variable input in this example is labor. The game is played repeatedly, adding another student each period. Eventually five students will be crowded around each “field” trying to write with a tiny piece of chalk.


The constraints from the fixed factors are physically demonstrated.

Start the game with zeros in both the labor and total output columns; with no labor, no rice is produced. Then have the two volunteers race to see how much they can produce in 15 seconds. Record their production under “Total Output” with 1 “Labor.”

Now have each volunteer choose a classmate as a farm worker and replay the game. The students will need to share the piece of chalk, but only one student needs to run for the loan. The other can start writing immediately. At the end of 15 seconds record their output.

Repeat the game until there are five students on each farm. By this point, diminishing and perhaps negative returns will be exhibited. Thank the students and have them return to their seats.

A typical result would look like thisLabor Total Output

0 01 32 153 254 325 33


Marginal product can be calculated to show the contribution of additional workers.

Labor Total Output Marginal Product 0 0 —1 3 32 15 123 25 104 32 75 33 1

The costs of producing additional units depends on labor costs and marginal productivity. Initially, marginal costs fall. Then as the constraints of the fixed factors become limiting, marginal costs will rise.


2. Intensive Production

Type: In-Class activityTopics: marginal costTextbook: Chapter 20 Costs and the Supply of GoodsMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class

Purpose

This example illustrates how fixed factors cause short-run costs to increase as output increases. Using an agricultural example with a very tight constraint helps make the idea clear.

Instructions

Explain to the class that you are interested in growing wheat on a very small plot of land, a plot the size of an average dorm room. This amount of land is fixed, but any other factors can be added to increase production. The current method of production involves throwing seeds on the land and returning months later to harvest the grain. Ask the students to list techniques and inputs that could be used to maximize production from this plot. Graph the relation between output and marginal cost.

Common Answers:plant more seedcultivatefertilizeuse herbicideirrigatetransplant seedlingsuse a greenhouseheat the greenhouseadd high-intensity grow lights in the greenhouse


Increasing production by adding more and more inputs increases the marginal costs of production. Extra wheat can be produced from this small plot only at higher cost per bushel.

The maximum production possible on a given amount of land is far greater than first imagined. Julian Simon argues a family could produce enough food to feed itself for a year in a bedroom using stacked hydroponic beds. Of course this maximum production goes far beyond the economically optimal use of inputs.

This can be used to introduce elements of profit maximization. We don’t grow wheat in greenhouses because the price of wheat is too low to cover the cost. If the value of the product is high enough, any of these agricultural methods could be profitably employed. Commercial greenhouses produce high-priced products like tomatoes and specialty lettuces.


3. Average and Marginal Grades

Type : In-Class demonstrationTopics: Relation of marginal and average costTextbook: Chapter 20 Costs and the Supply of GoodsMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class

Purpose

This quick exercise uses an analogy to illustrate to students that they already know the relation between marginals and averages.

Instructions

Tell the class that two twins are enrolled in Principles of Economics. They each had a “B” average (GPA = 3.0) before taking the class.

Twin One gets a “C” in the course. What happens to her GPA?

Twin Two gets an “A” in the class. What happens to her GPA?


The entire class will know that Twin One will have a lower GPA and Twin Two a higher GPA. A “marginal” grade lower than the average will pull down the average. A “marginal” grade higher than the average will increase the average.

The same is true of marginal cost and average costs. If marginal cost is less than average cost, the average cost will fall. If marginal cost is higher than average cost the average cost will rise.


2. a. The amount paid for the course is a sunk cost. It is not directly relevant to whether one should attend the lectures. b. There is an opportunity cost of one’s house even if it is paid for. c. The decline in the price of the stock is a sunk cost and therefore it is not directly relevant to whether or not to sell at this time. d. There is an opportunity cost of public education even if it is provided free to the consumer.

7. At low output, the firm’s plant (a fixed cost) is underutilized, implying a high average cost. As output rises toward the designed output level, average cost falls, but then rises as the designed or optimal output for that size plant is surpassed and diminishing returns set in.


9. Diminishing marginal returns to the variable factor reflect the fact that another factor is fixed in quantity so that the variable factor eventually produces less at the margin when, as the variable factor is added, each unit has less of the fixed factor to work with. Economies and diseconomies of scale refer to the situation where all factors are variable, so changes in scale need not change relative amounts of inputs.

13. Normal returns are a cost because they are necessary to keep the resources in the industry. If normal returns are not earned, the resources will flow into other activities. In contrast, economic profit is a return above the return necessary for the continued employment of the capital in the activity.

16. Implicit costs are costs associated with the use of resources owned by the firm. Since they are owned by the firm, an explicit payment for their services generally does not accompany their employment. Nonetheless, the resources have alternative uses; thus there is an opportunity cost associated with their employment, and therefore they should be included as costs. Labor services provided by a business owner, rent forgone on buildings and equipment owned by the firm, and interest forgone on equity capital provide three examples of implicit costs. Since the use of resources owned by the firm generally does not involve a financial transaction, accounting statements often fail to account for these costs.

Chapter 22 (9 Micro)Price Takers and the Competitive Process

OUTLINE

I. Price Takers and Price SearchersA. Price Takers

1. Price Takers produce identical products and each seller is small relative to the market.

B. Price Searchers1. Price Searchers face a downward-sloping demand curve for their product.C. Why Study Price Takers?

1. Model applies to some markets such as agriculture.2. Model helps us understand the relationship between individual firms and market supply.

3. Increases our knowledge of competition as a dynamic processII. What are the Characteristics of Price-Taker Markets?

A. Conditions for a Market of Price Takers1. All firms must produce an identical product.2. A large number of firms are in the market.

3. Each firm supplies only a small portion of the total supplied to the market.4. No barriers to entry or exit exist.

B. Price Taker’s Demand Curve1. A price-taker firm will face a perfectly elastic demand for its product.

III. How Does the Price Taker Maximize Profit?A. Marginal Revenue

1. Marginal Revenue is the change in total revenue divided the change in output.B. Profit Maximization

1. In the short run, the price taker will expand output until marginal revenue (price) is just equal to marginal cost.

a. This will maximize the firm’s profits (or minimize its losses).b. If price > marginal cost increase output.c. If price < marginal cost decrease output.

C. Losses and Going Out of Business1. A firm experiencing losses, but covering its average variable costs, will operate in the short run.2. A firm will shut down in the short run whenever price falls below average variable cost.3. A firm will shut down in the long run whenever price falls below average total cost.


IV. The Firm’s Short-Run Supply CurveA. A firm maximizes profits when it produces at P = MC and variable costs are covered.

B. A firm’s short-run supply curve is its marginal cost curve above average variable cost.V. The Short-Run Market Supply Curve

A. The short-run market supply is the horizontal sum of the all firms’ short-run supply curves.

VI. Price and Output Adjustments in Price Taker MarketsA. Economic Profits and Entry1. If price exceeds average total cost, firms will earn an economic profit.

2. Economic profits induce entry of new firms and induce existing firms to expand output.

3. As market supply increases, price will fall to average total cost.4. Thus, in long-run equilibrium, firms earn zero economic profit.

B. Economic Losses and Exit1. If average total cost exceeds price, firms will suffer an economic loss.

2. Economic losses induce exit of firms and reduction in output for remaining firms.

3. As market supply decreases, price will rise to average total cost.4. Thus, in long-run equilibrium, firms earn zero economic profit.

C. Long-Run EquilibriumD. Long-Run Supply

1. Constant-Cost Industry: Industry where factor prices remain unchanged as market output is expanded.

a. The long-run market supply curve is horizontal.b. Occurs when the industry’s demand for resource inputs is small

relative to the total demand for these resources.2. Increasing-Cost Industry: Industry where factor prices rise as market output is expanded.

a. The long-run market supply curve is upward sloping.b. Most common type of industry.

3. Decreasing-Cost Industry: Industry where factor prices decline as market output is expanded.

a. The long-run market supply curve is downward sloping.b. Rare type of industry.

E. Supply Elasticity and Role of Time1. In the short run, fixed resources such plant size limit the ability of firms to expand output quickly.2. In the long run, firms can alter the size of their plants and other fixed resources.3. In the long run, the market supply curve will be more elastic than in the short run.

VII. Role of Profits and LossesA. Profits and Losses


Chapter 22 (9 Micro)/Price Takers and the Competitive Process 221

1. Firms earn an economic profit by producing goods that can be sold for more than the cost of the resources required for their production.

222 Chapter 22 (9 Micro)/Price Takers and the Competitive Process

2. Profit is a reward for actions that increase the value of resources.3. Losses are a penalty imposed on firms that reduce the value of resources.

VIII. Competition Promotes ProsperityA. Competitive Process

1. The competitive process provides a strong incentive for producers to operate efficiently and heed the views of consumers.2. Competition and the market process harness self-interest and use it to direct producers to wealth-creating activities.

OBJECTIVES

The next three chapters analyze the decision making of the firm under alternative industrial structures. In this chapter the price-taker model is developed and utilized to explain how competitive market forces respond to changing conditions. The following chapter analyzes decision making for price searchers with low barriers to entry. Chapter 24 focuses on price takers with high barriers to entry.

Even though conditions necessary for sellers to be literally price takers are seldom realized in the real world, the price-taker model is highly significant. By understanding the workings of a world of price takers, students can understand more fully the role of prices and economic incentives under varying market conditions. This chapter should help the student better understand market forces even in cases when some of the price-taker conditions are absent.

This chapter also analyzes the mechanics of profit maximization. While this material is not very exciting, it is, nonetheless, important. Unless students understand the mechanics of profit maximization, they will never fully appreciate the interaction between market forces and firm decision making.


1. Be sure to point out that the word competition is not without ambiguity. Both laymen and economists may use the term to describe any situation involving rivalry among producers. In contrast, the price-taker analysis of pure competition describes a model of industrial structure typified by a large number of small, independent producers operating in a free (entry barriers are absent) market.

2. Use the price taker model to explain how the pricing mechanism adjusts to changing market conditions. Explain what happens when a long-run market equilibrium is disrupted by such things as: (a) and increase (or decrease) in the demand for a product, (b) higher factor prices, and (c) the imposition of an excise tax. Do not fail to emphasize the role of time in the adjustment process. Sometimes, economists behave as though the adjustment process takes place instantaneously. Point out that market prices, profits, losses, and changes in inventories carry messages to both consumers and producers. The importance of market signals in transmitting information is sometimes overlooked.

3. Remember that two conditions are necessary for long-run competitive (price searcher) equilibrium. First current supply and demand must be in balance. Second, producers must be earning the normal rate of return, and only the normal rate, on their investment capital. Exhibit 7 illustrates these conditions.


4. Fixed factors have alternative uses. The opportunity cost of utilizing a factor that is fixed in the short run is the revenue lost because of the factor’s involvement in the production process. Do not mistakenly define fixed costs as the costs incurred when the fixed factors were purchased. In all likelihood, such costs are sunk costs and may bear little relationship to the firm’s current fixed costs.

5. Since it includes both long-run and short-run supply curves, Exhibit 8 may be slightly confusing. The increase in market demand causes price to rise to Ps P2. In the short run, producers respond by expanding output along their marginal cost curves. In frame (b), this is indicated by the increase in quantity supplied from Q1 to Q2 along the short-run supply curve S1. At market price P2, the firms are earning economic profit. This attractive opportunity will induce established firms to expand their plant capacity and new firms to enter the industry. Thus, with time, the short-run supply curve will shift from S1 to S2, moderating the initial price increase. This shift in short-run supply merely reflects the expansion in the industry’s fixed capital resource base. Be sure to emphasize the role of time when discussing Exhibits 8, 9, and 10.

6. In the long run, in a price-taker industry, the market price of a product will be dependent upon per unit costs. Therefore, the long-run supply curve will slope upward to the right only if production costs rise as industry output is expanded. Since the demand for the factors of production used intensely by the industry increases as output expands, higher factor prices and production costs generally result. This will cause an upward-sloping supply curve for the product. Indicate the linkage between production cost and the long-supply curve, while discussing increasing, decreasing, and constant cost industries.

7. Be sure to discuss the “nice” efficiency incentives faced in a price taker world. However, it should be emphasized that these conditions apply to a static world. They do not consider such things as technological change, introduction of new products and production techniques, and other dynamic factors.

8. Students often have difficulty understanding the mechanics of profit maximization. Exhibits 3 and 4 provide a simple numeric (and graphic) example that should help students to understand how a competitive firm decides how much to produce. Most instructors will want to go over this example (or one similar to it) in class.

9. The ability of competition to align the self-interest of individuals with economic efficiency should be discussed. Many instructors will want to recall the views of Adam Smith on this topic. For example, Smith wrote in The Wealth of Nations:

a. “Monopoly, besides, is a great enemy to good management, which can never be universally established but in consequence of that free and universal competition which forces everybody to have recourse to it for the sake of self defense.” (Cannan’s edition, Book I, p. 165).

b. “It [competition] can never hurt either the consumer, or the producer; on the contrary, it must tend to make the retailers both sell cheaper and buy dearer, than if the whole trade was monopolized by one or two persons.” (Cannan’s edition, Book I, p. 383).


c. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” (Cannan’s edition, Book I, p.144).

10. Critical Analysis question 1 tests student understanding of an important concept. Note that for price takers, a reduction in factor prices will not increase the long-run profitability of the firms in an industry. Would government subsidies increase the long-run profitability in an industry, for example, farming? Interestingly, the answer is no.

11. Problem solving will help the student understand the mechanics of profit maximization. The “Problems and Projects” section of the Coursebook provides several selections that might be used.

12. It is crucial to communicate to students that the price taker model works well at the industry level (supply and demand implications) because there are large numbers of people searching to make all the mutually beneficial trades possible. It is this search that drives real world results toward the implications of the competitive model. This is true even though at the firm level the model is descriptively and analytically inaccurate in some ways (e.g., how many nonfarmers can sell all they want at a given price without incurring added selling costs but have no power over price or other terms of trade?).

13. An excellent place to find examples of how real world markets correspond to competitive model results is in the “Commodities” section in Part Two of The Wall Street Journal.

14. It is worthwhile to note to students how important market institutions are for understanding real world market behavior. Organizes exchanges, which are designed to standardize all aspects of trading except the price and quickly clear the market (because traders have profit incentives to maximize the number of mutually beneficial trades that take place for a given commission structure), may work far differently in the details than less well-organized markets (e.g., retail furniture stores), even if there are large numbers of participants in each case.

15. It is worth emphasizing that predicting the actual adjustment path in a particular market in response to a particular change is far more difficult than the stylized results of our standard comparative statics model indicates. The real world involves many more variables and all sorts of dynamic issues. The comparative statics models are only a starting point for discussing such issues, not the final word.

16. It is important to emphasize that firms are in fact profit seekers, not profit maximizers, in a world of uncertainty. In a world of certainty (i.e., the standard models), these reduce to the same thing, but in the real world, we cannot ignore the importance of uncertainty to real world actions. It is important to develop some “wisdom” as to what are the valid implications of models that assume away uncertainty in an uncertain world.

17. Games 1 to 2 will help reinforce the material in Chapter 22.


GAMES

1. Think of a Firm

Type: In-Class assignmentTopics: market structureTextbook: Chapter 21 Price Takers and the Competitive Process

Chapter 22 Price-Searcher Markets with Low Entry BarriersChapter 23 Price-Searcher Markets with High Entry Barriers

Materials Needed: noneTime: 15 minutesClass limitations: works in any size class

Purpose

This assignment helps students relate the concept of market structure to the real world.

Instructions

Ask the class to answer the following questions. After they have answered all of them ask the students to share their answers with a neighbor. Ask the neighboring student to evaluate the answer to the last question. List the four market structures on the board and ask for examples that fit each category

1. Write the name of a specific firm. It should be a real company, not hypothetical.

2. What product or service does this firm sell? If the firm sells a wide variety of goods, choose a single item to answer the following questions.

3. What other firms compete with this company? Are there many competitors, only a few, or none?

4. Do the competing firms sell exactly the same product or does each company produce goods with special characteristics?

5. Categorize the industry as one of the following market structuresa. Price Takers

- many firms- identical products

b. Monopoly- one firm- unique product

c. Oligopoly- a few firms- standard or differentiated product

d. Competitive Price Searchers- many firms- differentiated products



Many students will choose companies that produce consumer goods, where product differentiation is the most important characteristic. Most of these industries are either oligopolies or monopolistically competitive. A few students may have examples of monopoly, particularly utilities or patented medicines. Almost no one will give an example of pure competition.

Competition, while an economic ideal, does not accurately describe all sectors of the economy. Explaining that competition is a special case (and adding some examples of competitive industries) will help students understand why competitive firms face a horizontal demand curve and have no power over price.

Some students may have questions about the difference between oligopoly and competitive price searchers. Differentiating between a “few” and “many” is not always easy. Measures of market concentration can be introduced here.

2. A Profitable Opportunity?

Type : In-Class assignmentTopics: profit maximizationTextbook: Chapter 21 Price Takers and the Competitive ProcessMaterials Needed: noneTime: 15 minutesClass limitations: works in any size class

Purpose

This exercise reinforces the importance of marginal cost in decision-making. It shows average costs can be misleading.

Instructions

Tell the class, “As a recent graduate of this college you have landed a job in production management for Universal Clones, Inc. You are responsible for the entire company on weekends.”

“Your costs are shown below.”Quantity Average Total Cost

500 200501 201

Your current level of production is 500 units. All 500 units have been ordered by your regular customers.

“The phone rings. It’s a new customer who wants to buy one unit of your product. This means you would have to increase production to 501 units. Your new customer offers you $450 to produce the extra unit.”

a. Should you accept this offer?

b. What is the net change in the firm’s profit?



Most students will answer “yes.” Selling something for $450 when the average cost of production is $201 seems like good business. They are wrong.

The relevant comparison is marginal cost to marginal revenue. Marginal cost can be easily calculated as the change in total costs.

Quantity Average Total Cost Total Cost = Q * ATC500 200 100,000501 201 100,701

$100,701 – $100,000 = $701

Marginal cost in this example is $701. This is much higher than the marginal revenue of $450. The offer should not be accepted. It would result in a $251 loss in profits.

HINTS FOR ANSWERING CRITICAL ANALYSIS

1. In a highly competitive industry such as agriculture, lower resource prices might improve the rate of profit in the short run, but in the long run, competition will drive prices down until economic profit is eliminated. Thus, lower resource prices will do little to improve the long-run profitability in such industries.

3. False. They must not only produce efficiently, they must also identify those areas where current demand is strong enough to yield a market price greater than or equal to the minimum per unit cost of production.

4. The firms’ MC and AC curves will shift upward by the amount of the tax. The short-run market supply, reflecting the firm’s marginal cost, will also shift upward by the amount of the tax. In the short run, if the market demand is less than perfectly inelastic, the market price will rise by less than the amount of the tax. Therefore, producers will incur short-run losses, thereby assuming part of the tax burden. Total expenditures will rise if industry demand is relatively inelastic and fall if it is relatively elastic. However, in the long run, firms will leave the industry, supply will decline even further, the price will rise further, and the rate of profit will return to normal. If the factor prices remain constant, in the long run the entire burden of the sales tax will be passed on to consumers. However, since the total output of the industry will decline, the demand for the resources used by the industry may fall. This will cause their prices to decline and thereby place some of the long-run burden of the tax on the owners of resources used intensively by the industry.

5. a. Increase; b. Increase; c. Increase: firms will earn economic profit; d. Rise (compared with its initial level) if coffee is an increasing-cost industry, but return to initial price if it is a constant-cost industry; e. Increase even more than it did in the short run; f. Economic profit will return to zero.


7. The statement is false. A reduction in demand will cause the market price and short-run losses to occur. The losses will cause some but not all firms to go out of business. In the long run, the market supply will fall, causing the market price to rise. The supply will continue to decline and price will continue to rise until short-run losses have been eliminated.

Chapter 23 (10 Micro)Price-Searcher Markets with Low Entry Barriers

OUTLINE

I. Competitive Price-Searcher MarketsA. Firms in price-searcher markets with low entry barriers face a downward-sloping demand curve.

1. Firms are free to set price, but face strong competitive pressure.2. Competition exists from existing firms and potential rivals.

B. An alternative term for such markets is monopolistic competition.C. Product Differentiation

1. Price-searchers produce differentiated products-products that differ in design, dependability, location, ease of purchase, or etc.

a. Rival firms produce similar products (good substitutes) and so each firm confronts a highly elastic demand curve.

D. Price and Output in Competitive Price-Searcher Markets1. Price and Output

a. A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost.

(1). Its price will be lowered in the process and will continue until MR = MC.b. The price charged by a price searcher will be greater than its marginal

cost.E. Profits and the Long Run

1. If existing firms are making economic profits, then rival firms will be attracted to the market.

a. The entry of new firms will expand supply and lowering price.b. The demand curve faced by each will shift inward until the

economic profits are eliminated.F. Losses and Long Run

1. Economic losses will cause price searchers to exit from the market.a. The demand for remaining firms will rise until the losses have

been eliminated.(1) This will end the incentive to exit.

2. Price searchers can make either profits or losses in the short run, but only zero economic profits in the long run.

II. Contestable Market and the Competitive ProcessA. Contestable Markets

1. A contestable market is one in which entry and exit costs are low and there are no legal barriers to entry.

a. Example: Airline industry


2. Actual and potential competition from causes:a. Zero economic profits.b. Efficient production.

III. Evaluating Competitive Price-Searcher MarketsA. Allocative Efficiency

1. Allocative efficiency is achieved when most desired goods are produced at the lowest possible cost.2. Traditional economic theory criticized competitive price-searcher markets.

a. Price > marginal cost at profit maximizing output.b. LRAC not minimized.c. Excessive advertising is encouraged.

3. Recently economists have been more positive about competitive price-searcher markets.

a. Consumers may value wider variety of quality and styles.b. Advertising often reduces search time and provides valuable

information.c. Price searchers have incentives to operate efficiently and innovate

IV. A Special Case: Price DiscriminationA. Price Discrimination

1. Price discrimination is when a seller charges different consumers different prices for the same good or service.

2. Price discrimination can occur when a price searcher can:a. Identify groups of customers with different price elasticities of

demand.b. Prevent customers from retrading the product.

3. Sellers may gain from price discrimination charging:a. Higher prices to groups with more inelastic demand.b. Lower prices to groups with more elastic demand.

4. Price discrimination generally leads to more output and more gains from trade than otherwise would occur.

V. Entrepreneurship and Economic ProgressA. Entrepreneurs

1. Entrepreneurial judgment is necessary when no decision rules can be applied with available information.

a. Economic models cannot fully include the role of entrepreneurs.B. Economic Progress

1. Entrepreneurs who discover and introduce lower-cost production and new products promote economic progress.

2. Entrepreneurs also have a strong incentive to discover the type of business structure, size of firm, and scope of operation that can best keep the per-unit cost of products or services low.


Chapter 23 (10 Micro)/Price-Searcher Markets with Low Entry Barriers 231

C. Dynamic Competition, Innovation, and Business Failures1. Business failures are usually reported as bad news about the economy.

a. Though business failures are painful for those directly involved, they release resources so they can be employed more productively elsewhere.

b. The assets and workers of failed firms become available for use by others supplying goods that consumers value more relative to costs.

c. Without this release of resources, economic expansion would be slowed.

OBJECTIVES

This chapter focuses on the intermediate cases between price takers (pure competition) and price searchers with high barriers to entry (pure monopoly). Such price searchers face a downward-sloping demand curve. However, they also face the ever-present threat of competition in the rivalry sense. Price and output under these conditions are analyzed. Many economists believe that this (monopolistic competition) model is highly relevant to broad segments of our economy, including retail trade, housing construction, and small-scale manufacturing.


1. Although the term monopolistic implies a stranglehold, price searcher competition in the sense of rivalry is the dominant characteristic of monopolistically competitive markets (price searchers with low barriers to entry). Under price taking conditions, competition is solely on the basis of price. In contrast, competitive price searcher firms utilize a wide range of competitive weapons—product differentiation, location, service, and product quality—in order to lure customers away from rival sellers. Since barriers to entry are low, a seller will be under constant pressure from rival firms.

2. Note that there are many similarities between price taking and price searching with low barriers to entry. In neither case are there significant entry barriers to protect existing firms from new rivals. In both cases, profits and losses signal firms to enter into or exit from the market. In both cases, suppliers will expand (reduce) output in response to an increase (decrease) in demand. Despite the fact that competitive price-searcher firms face downward-sloping demand curves, market forces exert a similar impact on suppliers under both pure and monopolistic competition.

3. For several decades, economists have debated the implications of the competitive price searcher model for efficiency. Critics argue that they are inefficient because the firms fail to produce at the minimum cost long-run output level. Defenders argue that it is consistent with efficiency because the diversity of goods could not be produced at a lower cost. Discuss this issue with your students.

4. Although it does not appear in our models, the role of the entrepreneur is important in making the processes of the model work and in being the catalyst for change and improvement. Discuss the fundamentally important nature of entrepreneurship and why at the same time, it cannot be modeled.

232 Chapter 23 (10 Micro)/Price-Searcher Markets with Low Entry Barriers

5. The theory of contestable markets is a relatively recent development in economic theory and can help students understand the importance of entry and exit restraints. Make sure you cover this in your classroom discussion.

6. It is important to note that the competitive price searcher model does not require zero profits for all firms; it only must be true for the expectations (in present value terms) for marginal potential entrants (though to the extent that inter-firm differences become expected, the difference will be capitalized into the value of the asset or assets thought to be responsible). Typical competitive price searcher markets have both entry and exit going on at the same time (e.g., restaurants and gas stations), and potential entrants may not succeed in making close substitutes for the output of existing firms. The key to student understanding of competitive price searching is to think of it as a search for mutually beneficial characteristics of products in a world of uncertainty, not primarily as a comparative static model.

7. Go through the logic of why price searchers (whether with high or low barriers to entry) have incentives to price discriminate, if they can do so at a low enough cost. Once the conditions for price conditions are met, competitive price searchers may be forced to price discriminate to survive in competition with rivals.

8. Make sure that your classroom emphasis is on the competitive process, not on equilibrium conditions. Those equilibrium conditions are not realized for competitive price searchers; rather they indicate the direction the competitive process moves toward.

9. When the firm faces a downward-sloping demand curve, the relationship between product price and marginal revenue is difficult for students to understand. Point out that MR will be less than price because the firm must reduce its price of all units in order to increase sales. Go over a simple numeric example in order to illustrate the interrelationships among demand, price, and marginal revenue when the firm faces a downward-sloping demand curve.

10. Games 1 to 4 will help reinforce the material in Chapter 23.

GAMES

1. Price Discrimination and Time Travel

Type: In-Class demonstrationTopics: price discrimination, consumer surplusTextbook: Chapter 22 Price-Searcher Markets with Low Entry Barriers

Chapter 23 Price-Searcher Markets with High Entry Barriers Materials Needed: noneTime: 10 minutesClass limitations: works in any size class

Purpose

This example illustrates how a price discriminating price searcher can earn even higher profits than a price searcher charging a single price. The example uses an imaginary time machine to look at profits and consumer surplus. The cases of competition, monopoly, and price discriminating monopoly are examined.


Instructions

Use student names in the demand for time travel shown below.

Steve wants to travel back in time to see the dinosaurs; he is willing to pay as much as $200 to use the time machine


Joyce wants to relive this entire semester; she is willing to pay up to $150 to use the time machine.

Chip can’t wait for the semester to end; he is willing to pay as much as $125 to use the time machine

Dawn just wants to get through this class period; she is willing to pay up to $100 to use the time machine.

The demand curve for time travel is:

Price Quantity $200 1150 2125 3100 4

For simplicity, let the marginal cost of time travel be constant at $100.

If Time Travel was a competitive industry, price would equal marginal cost ($100) and four trips would be sold.

Consumer surplus would be $175.Consumer surplus = (200 – 100) + (150 – 100) + (125 – 100) + (100 – 100) = 175.

Profits are zero.Profits = 400 – 400.

Assume Time Travel is a patented product, giving the firm complete monopoly control. The monopolist will equate marginal cost and marginal revenue to find the profit-maximizing quantity. For a single-price monopolist, the total revenues is simply price times quantity.

Price Quantity Total Revenue Marginal Revenue $200 1 200 200150 2 300 100125 3 375 75100 4 400 25

The single price monopolist will operate where MC = MR. Marginal cost is constant at 100, so the monopolist will sell two trips at a price of $150. Consumer surplus drops to $50.

Consumer surplus = (200 – 150) + (150 – 150) = 50.Profits rise to $100. Profits = 300 – 200.

Now examine the case of price discrimination. The price discriminating monopolist will charge each consumer his or her maximum willingness to pay. Total revenue becomes the sum of the various prices charged to the different consumers. In this case, Steve pays $200; Joyce pays $150; Chip pays 125; Dawn pays $100.


Prices Quantity Total Revenue Marginal Revenue $200 1 200 200

200,150 2 350 150200,150,125 3 475 125

200,150,125,100 4 575 100

The price discriminating monopolist will also operate where MC = MR. Marginal cost is still constant at 100, but now the marginal revenue is the full amount of price paid by the additional consumer. The price discriminating monopolist will sell four trips. Each consumer will pay a different price. There will be no consumer surplus.

Consumer surplus = (200 – 200) + (150 – 150) + (125 – 125) + (100 – 100) = 0.Profits are even higher than the ordinary monopoly profits.

Profit = 575 – 400 = $175.


The price discriminating monopolist produces more than the ordinary monopolist and earns higher profit. This monopolist was able to perfectly price discriminate, eliminating all consumer surplus.

Price discrimination depends on three factors: monopoly power, the identification of consumers’ willingness-to-pay, and the ability to prevent resale. If Dawn could buy a trip from the firm for $100 and resell it to Steve for $200, the price discrimination would break down.

2. Market Structure Article

Type : Take-home assignmentTopics: market structureTextbook: Chapter 22 Price-Searcher Markets with Low Entry Barriers

Chapter 23 Price-Searcher Markets with High Entry BarriersClass limitations: works in any class

Purpose

This assignment integrates several concepts and relates them to a real world case. Students can easily find examples of oligopoly, monopoly or competitive price-searcher markets. Some have difficulty choosing the appropriate model to analyze their article, particularly for oligopolistic industries.

Instructions

Ask the students to complete the following assignment.



This assignment emphasizes the importance of product differentiation and oligopoly in the real world. Examples of imperfect competition are easier to find than examples of perfect competition.

Most firms face a downward-sloping demand curve for their product. This market power gives them some control over price. Many firms also need to consider the effect of their actions on rivals’ decisions.

Many firms can earn economic profits in the short run, but long-run profits depend on entry barriers.


Name ____________________ Course ______________________

Price Searchers

Find an article in a recent newspaper or magazine that illustrates a market structure other than pure competition.

Is it an example of monopoly, oligopoly, or a competitive price searcher market?

Do you think the firms in the industry are earning an economic profit? Are new firms likely to enter this market?

Use the analysis developed in class and the text to explain the situation. Use economic reasoning and show your analysis using a graph or other model, as appropriate.

Turn in a copy of the article along with your explanation

Article Source ____________________________ Date___________________


3. Brand Names

Type: In-Class assignmentTopics: product differentiationTextbook: Chapter 22 Price-Searcher Markets with Low Entry BarriersMaterials Needed: enough copies of the questions for each studentTime: 10 minutesClass limitations: works in any size class

Purpose

This activity illustrates the importance of product differentiation in consumer products.

Instructions

Give the students the following quiz. Ask them to make their best guess if they are not certain about a particular product. Assure them their grade will not be affected by their score on these questions. After they finish, go through the questions product by product, asking the class to raise their hands if they circled that product.


Student answers will be spread across the various brands for each company. All their answers are correct. In each case, the company makes every brand listed.

This illustrates the importance of product differentiation in consumer markets. These firms go to great expense to establish and maintain separate brand identities for products that essentially serve the same function.

This quiz can be a good way to introduce the effect of product differentiation on demand, or to introduce the impact of advertising.


Name _____________________ Course ______________________

Brand Names

Identify the brands made by each company

1. Margarine. Unilever makes:a. Imperial b. Promise c. Country Crock d. Shedd’se. Krona f. Mrs. Filbert’s g. I Can’t Believe It’s Not Butter

2. Bottled water. Nestle’ makes:a. Perrier b. Arrowhead c. Poland Springd. Ice Mountain e. Vittel f. Contrex

3. Pet Food. Quaker makes:a. Gravy Train b. Gaines Burgers c. Cycled. Kibbles ‘n Bits e. Top Choice f. Ken-L-Ration

4. Soap. Proctor and Gamble makes:a. Safeguard b. Zest c. Ivoryd. Camay e. Lava

5. Jeans. V.F. Corporation makes:a. Lee b. Wrangler c. Rustler d. Girbaud

6. Pasta. Borden makes:a. Creamette b. Prince c. Bravoc. Dutch Maid d. Gioia e. Anthony’s

7. Coffee. Phillip Morris makes:a. Brim b. Maxim c. Sankad. Maxwell House e. Yuban

8. Consumer Electronics. Matsushita makes:a. Panasonic b. Technics c. Quasar d. National

9. Vodka. Grand Metropolitan makes:a. Smirnoff b. Popov c. Finlandia


4. Equilibrium Price for Blue Jeans

Type : In-Class demonstrationTopics: product differentiationTextbook: Chapter 22 Price-Searcher Markets with Low Entry BarriersMaterials Needed: noneTime: 5 minutesClass limitations: works in any size class

Purpose

This assignment shows that market supply and demand graphs give an oversimplified picture of price when products are differentiated.

Instructions

Ask the students to draw a supply and demand graph illustrating the market for blue jeans. After they have drawn the graph, have them label the equilibrium price with a real dollar figure. This dollar amount should reflect the price of jeans as accurately as possible.

Draw a standard supply and demand graph on the board. Ask a student for the equilibrium price. Ask several more students for their prices.


The class will have a whole range of prices for blue jeans, reflecting the range of blue jeans in the real world. Recent prices at one shopping mall varied from $14 to over $100 for a pair of blue jeans.

The price differences reflect product differentiation. Quality, style, and reputation all effect the price of jeans. The same jeans sold by different retailers are likely to be priced differently.

The simple supply and demand graph can be useful for broad analysis of the market for jeans, but individual prices and quantities are determined by the demand and cost curves of the individual products.


5. Discovery is the primary function of the entrepreneur—the discovery of products valued more highly than costs and the discovery of lower cost methods of production. The models of economists generally assume that demand, costs of alternative methods of production, and profit-maximizing price (and output) for numerous goods and services are known. This is not the case, however, in the real world. These things must be discovered. This is precisely the role of the entrepreneur, and it is vitally important to dynamic economic progress.

6. These answers must be purely subjective!


7. No. A firm that maximizes total revenue would expand output as long as marginal revenue is positive. When marginal costs are positive, the revenue-maximizing price would be lower (and the output greater) than the price that would maximize the firm’s profits.

9. Our standard of living would fall if the government “bailed out” troubled businesses since resources are being used in inefficient firms. Firm failures are good for the economy. Business failures do not destroy either the assets owned by the firm or the talents of its workers. Instead, they release these resources for more productive use by other firms. The losses causing business failures indicate that consumers are unwilling to pay enough to cover the cost of the items supplied by these firms. A larger output could be achieved if the resources were released for use by profitable firms supplying goods and services that are more highly valued relative to their cost.

17.a. Total revenue: $0; $8,000; $14,000; $18,000; $20,000; $20,000; Total cost: $0; $5,000; $10,000; $15,000; $20,000; $25,000; Economic profit: $0; $3,000; $4,000; $3,000; $0; $5,000 (loss).

b. Marginal revenue: $8,000; $6,000; $4,000; $2,000; $0; Marginal cost: $5,000; $5,000; $5,000; $5,000; $5,000.

c. Profit-maximizing price: $7,000.

d. Rod will sell two boats at the profit-maximizing price of $7,000.

e. Rod’s economic profits will be $4,000 per week. Sales volume will be 2.

f. Yes, boats 1 and 2 are the only boats for which marginal revenue is higher than marginal cost.

g. Because of the existence of economic profit, more boat dealers will open up in the area. This will result in more competition and lower prices. The entry will continue until boat dealers’ economic profits fall to zero.

h. When demand is elastic, lowering price increases total revenue; thus, Rod’s demand is elastic between the prices of $9,000 and $5,000. When demand is unitary elastic, lowering price leaves revenue unchanged; thus, Rod’s demand is unitary elastic between the prices of $5,000 and $4,000. One could also assume that Rod’s demand would eventually become inelastic below a price of $4,000 because the elasticity of demand keeps falling as one moves down along a demand curve. When this happens, Rod’s total revenue will begin to fall as he continues to lower price. For example, at a price of $3,000, Rod may sell six boats per week, resulting in only $18,000 in revenue, which is less than the revenue Rod receives at a price of $4,000.

Chapter 24 (11 Micro)Price-Searcher Markets with High Entry Barriers

OUTLINE

I. Why Are Entry Barriers Sometimes High?A. Entry Barriers

1. Economies of Scale2. Government Licensing3. Patents4. Control Over an Essential Resource

II. Characteristics of MonopolyA. Monopoly

1. Monopoly is a market with:a. High entry barriers.b. Single seller of a well-defined product for which there are no

good substitutes.2. Only a few markets exist with only one seller but it is worth studying.

a. Help us understand markets with few sellers.B. Price and Output Under Monopoly

1. The market demand curve is the monopolist’s demand.2. Monopolists will expand output until marginal revenue equals marginal cost.

a. The monopolist will charge the price on the demand curve consistent with that output.

C. Profits Under Monopoly1. High entry barriers protect monopolists from competitive pressures.

a. Monopolists can earn long-run profits.2. Sometimes demand and costs conditions are such that monopolists can’t earn a profit.

III. The Characteristics of an OligopolyA. Characteristics of Oligopoly

1. Small number of rival firms.2. Interdependence among oligopolistic firms.3. Substantial economies of scale.4. Significant barriers to entry.5. Products may be either identical or differentiated.

IV. Price and Output in the Case of OligopolyA. Price and Output Under Oligopoly

1. No general theory exists for price and output under oligopoly.


a. If the firms operated independently, they would drive down the price to the per unit cost of production.


Chapter 24 (11 Micro)/Price-Searcher Markets with High Entry Barriers 245

b. If the firms colluded perfectly, the price would rise to the monopoly price level.

c. The outcome is usually between these two extreme outcomes.B. Incentive to Collude and Cheat1. Oligopolists have a strong incentive to collude and raise their prices.

2. Each firm has an incentive to cheat by lowering because the demand curve facing each firm is more elastic than the market demand curve.

3. This conflict makes collusive agreements difficult to maintain.C. Obstacles to Collusion

1. As the number of firms in an oligopolistic market increases, the likelihood of effective collusion declines.2. When it is difficult to detect and eliminate price cuts, collusion is less attractive.

3. Low entry barriers are an obstacle to collusion.4. Unstable demand conditions are an obstacle to collusion.5. Vigorous antitrust action increases the cost of collusion.

V. Market Power and Profit: The Early Bird Catches the WormA. Market Power and Profit

1. Just because a firm earns economic profit does not mean that buying stock in that firm will be more profitable.

a. This is because the value will be capitalized into the stock price.VI. Defects of Markets with High Entry Barriers

A. When entry barriers are high ad there are few, if any alternative suppliers, the discipline of market forces is weakened.B. Reduced competition results in allocative inefficiency.C. Government grants of monopoly encourage rent seeking.

1. Resources will be wasted by firms attempting to secure and maintain grants of market protection.

VII. Policy Alternatives When Entry Barriers Are HighA. Natural Monopoly

1. A natural monopoly exists when long-run average costs continue to decline as firm size increases, over the entire market demand.

a. A larger firm always has lower costs.b. Ex: Local phone service

B. Policy Alternatives1. Antitrust policy designed to maintain or increase the number of firms in an industry.

2. Relax regulations that limit entry and trade.3. Regulate the protected producer.4. Supply market with government production.

C. Problems with Government Intervention1. Problems with regulation:

246 Chapter 24 (11 Micro)/Price-Searcher Markets with High Entry Barriers

a. Lack of information.b. Cost shifting.


c. Special interest influence.2. Problem with government production:

a. Fewer incentives to minimize costs and satisfy consumers.D. Putting it all Together

1. Intervening into these markets with government policy may not create an attractive outcome.

a. When feasible, reduction of artificial entry barriers is the most attractive alternative.

VIII. The Competitive Process in the Real WorldA. Competitive forces are present even markets with high entry barriers.B. Quality competition is an important element of the competitive process.C. Profitability and high prices encourage technological change and the development of substitute products.

OBJECTIVES

This chapter covers the traditional monopoly (price searcher with high barriers to entry) model and policy issues that relate to it. Profit-maximizing decision making under monopoly is analyzed. A monopolist will restrict output and raise prices to the level consistent with profit maximization. This chapter should be used in conjunction with the earlier chapters on low barriers to entry. Most instructors will particularly want to compare and contrast expected outcomes under monopoly with those under price taking.

The theory of oligopoly is also developed and analyzed. To understand oligopoly, one must understand both the pressures toward and limits on collusive business behavior. Potential rivals can gain if they can collude, restrict output, and raise price. However, collusion has its costs. Collusion will not be successful when the number of rival firms is large, when secret price cuts by colluding partners are difficult to detect, and when potential competitors cannot be restricted from entering the industry. The last two factors serve to limit the payoffs from collusion even when only a few firms are colluding. The analysis of collusion is illustrated by a prisoner’s dilemma game theory example.

Analysis of the costs and benefits expected from collusive behavior yields clues as to the importance of competitive forces. However, in contrast to the earlier models that were discussed, no specific price and output level can generally be expected to persist in equilibrium under oligopoly.

The three major alternatives to monopoly are: (a) antitrust action, (b) regulation, and (c) government ownership. Antitrust action will be ineffective when economies of scale strictly limit the number of producers in an industry, that is, in the so-called natural monopoly case. Regulatory action also suffers from shortcomings. Economic theory suggests that regulatory commissions often lack both the ability and the incentive to impose price-quality standards consistent with allocative efficiency. Similarly, government-operated firms may fail to meet our conditions of ideal efficiency since the managers of such firms can often sacrifice efficiency for personal and political objectives. Thus, when monopoly power is based on the efficiency of large-scale production (relative to the total market), economics does not suggest a general solution fully consistent with standards of ideal efficiency.

While the static implications of monopoly are important, dynamic factors should not be ignored. Near the end of this chapter is a perspective that focuses on the economics of patents and the dynamics of product development.



1. Although the definition of a monopolist is not without ambiguity, the narrowness of product line and market area is a necessary characteristic. For example, the local power company probably has a monopoly on the sale of electricity in your city. However, nationally there are many producers of electric power. Similarly, several other sources of power (e.g., natural gas, petroleum, coal, hydropower) can sometimes be good substitutes for electricity. Point out these ambiguities while noting that monopoly power is seldom all-inclusive.

2. Students generally believe that a monopolist necessarily earns economic profit. This is not always true. Many goods are never produced because it would be unprofitable even for a monopolist to do so.

3. Students often believe that a monopolist will charge the highest possible price for his product. A price increase will not always increase the total revenue of the monopolist. Critical Analysis question 3 could be used as the focal point for a classroom discussion of the pricing policies of a monopolist.

4. Exhibits 1 and 2 illustrate the mechanics of profit maximization under monopoly. Of course, the monopolist will expand output until MR = MC. At this output rate, the monopolist will charge a price that exceeds marginal cost. Thus, under the model of monopoly, profit-maximizing firms will fail to meet our ideal conditions for static allocative efficiency. Be sure to go over a simple numeric example, illustrating the mechanics of profit maximization under monopoly.

5. From the standpoint of economic efficiency, monopoly (high barriers to entry) presents several problems. These problems are discussed in the text. Be sure to explain why economists are generally critical of monopoly (high barriers to entry).

6. The text discussion of the economics of regulation deals with both (a) what a regulatory agency should do and (b) what it is likely to do. Since a regulatory agency will lack information on costs as a function of output, approximating the ideal textbook solution is not easily accomplished. The managers of a regulated firm have a strong incentive both to (a) conceal their true costs and (b) follow actions that yield personal benefits even though cost inefficiency results. All these factors complicate the regulatory process. In addition, since regulation generally pits well-organized producers’ (and labor’s) special-interest groups against unorganized consumers, there is good reason to question whether a regulatory body will pursue the goal of ideal efficiency. Whereas most texts gloss over these issues, by applying economic tools to regulation we can gain valuable insights into the workings of the real world.

7. There is good reason to expect that a government-operated monopoly will be cost-inefficient, particularly in the long run. Competition from rivals is not present to force the firm to operate efficiently. Taxpayers, who are the major beneficiaries of greater efficiency, are generally both uninformed and unorganized. The political process fails to give taxpayers much incentive to police the actions of public sector managers. Thus, policies that provide managers with personal benefits at the expense of production efficiency are likely to be commonplace. No single, small group of individuals can capture the gains from improving


the operational efficiency of public sector firms. The incentives lead to the expectation of production inefficiency. (For additional information on how regulatory policy and public ownership affect operational efficiency, see A. A. Alchian and H. Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review, December 1972; Eirik Furubotn and Svetozar Pejovich, “Property Rights and Economic Theory: A Survey of Recent Literature,” Journal of Economic Literature, December 1972; and Louis DeAlessi, “The Economics of Property Rights: A Review of the Evidence,” in Research in Law an Economics, vol. 2, 1980.)

8. During the inflation-plagued 1970s, regulation based on historical cost sometimes imposed a very unfavorable profit ceiling on public utilities. In a few cases, public utilities had difficulty raising capital because their actual costs, reflecting the inflation, rose more rapidly than regulation (based on historical cost) permitted prices to rise. Many instructors will want to discuss this problem.

9. Locks are a good way of illustrating barriers to entry. You use locks as a barrier against others getting what is yours, but what if you could lock up other peoples’ things for yourself? Property rights are a form of such societal locks to keep others from stealing. One role for government is making sure legitimate locks work, but a risk of government police power is that it might allow government to create locks (legal barriers to entry) that allow some in society to take from others by creating monopoly power where it might not otherwise exist. This can then lead to discussion of licensing issues, etc., and their analysis.

10. In discussing market power in Chapters 23 and 24, it is important to note that the definition of the relevant market is often crucial in antitrust cases. The prosecution always argues for the narrowest market definition because that implies larger market shares and more market power; the defense argues for the broadest definition, because that implies less market power (e.g., the famous Cellophane case). Who wins in this dispute is often who wins the case.

11. It is important to note that it is possible for there to be fewer firms and, at the same time, more competitive results. For example, the advent of the railroad reduced transportation costs and lowered delivery prices, even though it resulted in fewer firms (which outcompeted smaller firms in terms of lower prices and better quality).

12. Be sure to emphasize the importance of economies of scale as a determinant of oligopoly (see text, Exhibit 4).

13. Exhibit 6 can be used to illustrate the conflict between (a) the interests of the firm and (b) the interests of the industry. When a firm lowers its price, it attracts both (a) new purchasers of the product and (b) old purchasers away from other firms. Therefore, since an oligopolistic competitor faces a more elastic demand than the demand for the product faced by the industry, each firm would like to reduce its price while having the others maintain the higher, collusively agreed-upon price. However, when several firms follow this policy (that is, cheat on an oligopolistic price agreement), the collusive agreement breaks down.

14. Review the conditions under which oligopolists are most (least) likely to collude successfully (from their viewpoint). This is the heart of oligopoly theory.


15. When property rights are established, a long-run rate of profit that reflects monopoly power will be capitalized into the value of an asset. For example, if licensing enabled a liquor store owner to earn economic profit, and if licenses were exchangeable, the price of licenses would be bid up until the economic profit was eliminated. Similarly, if a price-support acreage allotment program enabled tobacco farmers to earn economic profit, the price of land with acreage allotments would be bid up until the economic profit was eliminated. Note that, once unusually high profits become widely anticipated, new purchasers of monopoly rights will have to pay for them. This point is often overlooked.

16. Remind students that the same principles of monopoly and collusion now being talked about on the selling side of the market are also true of the buying side of the market (e.g., the NCAA) and will be talked about in the chapters on factor markets.

17. Go through the prisoner’s dilemma with your students. You might want to show its applicability by using it to discuss student incentives to try to collude on tests and other assignments, as well as their incentives to cheat on any such collusion.

18. Game 1 shows how widely prices can vary under different market structures.

GAMES

1. Four Markets for Widgets

Type: In-Class demonstrationTopics: market structure and priceTextbook: Chapter 23 Price-Searcher Markets with High Entry BarriersMaterials Needed: 7 volunteers, money ($2.50–$4.00)Time: 15 minutesClass limitations: works in any class with more than 15 students

Purpose

This illustrates how different market structures can result in wide differences in price for the consumer. It also shows how communication can increase oligopoly profits. The opportunity to win real money creates great student interest.

Instructions

Divide the class into four groups. Group A consists of one student (the first volunteer.) Group B consists of the next three volunteers. Group C consists of the other three volunteers. Group D is the rest of the class.

Each group manufactures a unique type of widget. The firms within a group compete, but there is no competition across groups. Widgets are produced by writing the word “widget” on a sheet of paper.

Group A represents a monopoly. The monopolist does not need to consider the actions of any other firms. The professor will buy one widget from Group A. The professor is willing to pay up to $1.00 for this widget.


Group B represents an oligopoly. This group can communicate with each other and can examine each others’ bids. (Have these students sit together.) They are allowed to make their decisions jointly, and may make agreements to share profits. The professor will buy one widget from Group B. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.

Group C also represents an oligopoly. This group cannot communicate with each other. (Move these students away from each other.) The professor will buy one widget from Group C. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.

Group D represents competition. The professor will buy one widget from Group D. The professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.Ask the students in each group to make a bid by writing their name and offer on a sheet of paper. Remind them they will need to consider the possible bids by rivals within their own group, since only the winning bid will be paid.

Collect the bids from each group in turn. Pay the low bid in each group.


The monopolist will bid $1, the maximum willingness to pay.

The colluding oligopolists usually each bid $1. They often will reach a profit-sharing agreement.

The oligopolists who do not communicate will have a lower winning bid. They also display large variation in the individual bids. Typically the bids range from a low of $0.25 to nearly a dollar.

The competitive group will also have a range of bids, but the lowest bid will be even lower than Group C’s low bid. Typically this widget will sell for $0.01.

The relation between market structure and price is displayed nicely. The monopolist charges 100 times the competitive price.

Communication among oligopolists allows price fixing. Collusion can lead to the joint-profit maximizing, or monopoly, price. Restricting communication greatly reduces the ability of oligopolists to coordinate pricing.

Large numbers of competitors lead to prices at the cost of production, since higher prices will be underbid.



1. The statement is true. Profits cannot exist in the long run without barriers to entry because without barriers new entrants seeking the profits would increase supply, drive down price, and eliminate the profits. But barriers to entry are no guarantee of profits. Sufficient demand is also a necessary condition.

2. Compared to competition, monopoly results in less production and exchange. At the lower output rate, potential gains from specialization and exchange are lost; the sum of the consumer and producer surplus is reduced. This loss of the potential gains from exchange is a “deadweight loss” of monopoly.

4. The formation of the monopoly will result in higher liquor prices and a smaller output. Illustrate this graphically. Current members of the retail liquor trade association will gain. However, if they sell their ownership rights to a newcomer, the expected monopoly profits will be capitalized into the value of a retail distributorship. Thus, future purchasers of these ownership rights will have to pay a higher price for them. Liquor consumers, who will now confront higher prices, will be the major losers from monopolization of the industry.

13. a. $15, profit = $110,000; b. $10.

14. a. The total revenue numbers are: $60, $110, $150, $180, $200, $210. The marginal revenue numbers are: $60, $50, $40, $30, $20, $10. The fixed costs are $40 for each output level. The total cost numbers are: $90, $110, $134, $163, $198, $243.

b. Decrease price.c. The profit-maximizing price is $45 with an output level of 4. The weekly profit level is

$17.

Chapter 25 (12 Micro)The Supply and Demand for Productive Resources

OUTLINE

1. IntroductionA. Productive assets are bought and sold in resource markets.B. These markets help determine what is produced, how it is produced, and the distribution of income.

II. Human and Nonhuman ResourcesA. Human and Nonhuman Resources

1. There are two classes of productive resources:a. Nonhuman resources.

(1) Physical capital.(2) Land.(3) Natural resources.

b. Human resources.(1) Composed of skills and knowledge of workers.

2. Investment in human capital refers to activities that increase the human capital and productivity of individuals.

a. Ex: education, training, experience.3. Human resources differ from nonhuman resources:

a. Human capital is embodied in the individual.b. Human resources can’t be bought or sold.

(1) Only their labor services can be sold.III. The Demand for Resources

A. Demand for Resources1. The demand for resources is derived from the demand for the products that the resources help produce.

a. Ex: A service station hires mechanics because customers demand repair service.

2. The quantity demanded of a resource is negatively related to its price for two reasons:

a. Substitution in production.(1) If one resource input becomes more expensive, producers will

shift to lower-cost substitute inputs.(2) The more substitute resources are available, the more elastic is

the demand for the resource.b. Substitution in consumption.

(1) A higher resource price will raise the product price and consumers will substitute towards other goods.


(2) The more elastic the demand for the product, the more elastic is the demand for the resource.

B. Time and the Demand for ResourcesC. Factors Shifting Resource Demand Curves

1. A change in the demand for a product will cause a similar change in resource demand.

2. Change in productivity of a resource will alter resource demand.a. If productivity of a resource rises, the demand for the resource

will rise.3. A price change of a related resource will affect demand for the original resource.

a. A rise in the price of a substitute resource will raise demand for the resource.

b. A rise in the price of a complement resource will lower demand for the resource.

IV. Marginal Productivity and the Firm’s Hiring DecisionA. Hiring Decision

1. Profit-maximizing firms will hire additional units of a resource up to the point where the marginal revenue product of the resource equals its price.

a. Marginal revenue product (MRP) is the change in total revenue that results from the employment of an additional unit of a resource.

(1) MRP = Marginal Product x Marginal Revenue.B. Multiple Inputs

1. With multiple inputs, firms will expand their usage of each until the marginal product divided by price is equal across units.

2. Wage differentials reflect skill differentials.a. If a high skill worker is twice as productive as a low skill

worker, the high skill worker will have twice the wage rate.3. When real world decision makers minimize per unit costs, the outcome will be as if they followed these mathematical procedures.

V. The Supply of ResourcesA. Supply of Resources

1. The amount of a resource supplied is directly related to its price.2. The supply of a resource will be more elastic in the long run than the short run.3. In the long run, investment can increase the supply of both physical and human resources.

B. Time and the Elasticity of Supply for ResourcesVI. Supply, Demand, and Resource Prices

A. Resource Prices1. The prices of resources are determined by supply and demand.

2. Changes in the market prices of resources will influence the decisions of both users and suppliers.a. Higher resource prices give users a greater incentive to use substitutes.


Chapter 25 (12 Micro)/The Supply and Demand for Productive Resources 255

b. Higher resource prices give suppliers a greater incentive to provide more of the resource.

256 Chapter 25 (12 Micro)/The Supply and Demand for Productive Resources

B. Equilibrium in a Resource MarketC. Changes in Resource Prices

1. Changes in resource prices in response to changing market conditions are essential for efficient allocation of resources.2. Profit is a reward for the entrepreneur who is able to see and act on opportunities to put resources to higher valued uses.

D. Adjusting to Dynamic ChangeVII. The Coordinating Function of Resource Prices

A. Resource prices coordinate the actions of the firms demanding factors of production and the households supplying them.

1. Resource prices provide users with both information about the scarcity of the resources they’re using and the incentive to conserve them in production.

2. Resource prices also provide suppliers with an incentive to learn skills and provide resources—particularly those that are intensely demanded by users.

OBJECTIVES

In this chapter, we outline the theory of price and input utilization for resource markets. Supply and demand form the core of the analysis. When the price of a resource declines, the amount of the input employed will increase for two reasons. First, at the lower price, firms will substitute the input (which is now relatively cheaper) for other resources. Second, the lower input price will also reduce the firms’ costs of production, encouraging them to expand output. This expansion in supply drives down the market price of the product and leads to an increase in the output of the product. The expansion in output will require an increase in the utilization of all inputs, including the one that declined in price.

Whereas the decisions of producers and marginal productivity underlie the demand curve for the input, the choices of resource suppliers are the foundation of the input supply curve. The number of competing firms supplying the input will rise, as resource prices increase; a reduction in input prices will have the opposite effect. The market price of resources acts as a balancing wheel, bringing supply and demand into harmony.


1. Students often have difficulty understanding the interrelationships among product and resource markets. While indicating that the demand for a resource is a derived demand, point out that an expansion (contraction) in the demand for the product will enhance (depress) the demand for resources needed to produce the product.

2. Be sure to emphasize the role of time as it affects resource markets. Exhibit 3 illustrates that the demand for a resource is typically more inelastic in the short run than in the long run. Exhibit 7 makes the same point with regard to the supply curve. One cannot fully understand the important role of resource prices without integrating time into the analysis.

3. Two conditions are necessary for long-run equilibrium in a resource market. First, supply and demand must be in balance. The second requirement for long-run equilibrium is sometimes overlooked. Resource owners must be earning the market rate of return (considering both pecuniary and non-pecuniary factors), and only the market rate, on their marginal investments

Chapter 25 (12 Micro)/The Supply and Demand for Productive Resources 257

in human and nonhuman capital. When the current rate of return on an investment in nonhuman or human capital needed to supply an input is above (below) the market rate, resources will flow toward (away from) the area. Thus, the short-run market supply of the resource will increase (decrease), disturbing the short-run market price. In long-run equilibrium, (a) supply and demand must be in balance and (b) resource suppliers must be earning precisely the normal rate of return on investment (at the margin).

4. Although economic thinking and the interrelationships among product and resource markets are emphasized in the text, certain abstract concepts cannot be avoided. Use Exhibit 4 to illustrate the marginal physical and marginal revenue products of an input. The problem presented in Critical Analysis question 3 emphasizes these concepts and their role in the firm’s hiring decision.

5. It is important to note that profit maximization requires the firm to produce a given output at the lowest possible cost. Explain why cost-minimizing firms employ each factor of production up to the point at which the marginal product per last dollar spent on the factor is equal for all inputs. Review this topic carefully with students. An interesting application would be to the issue of students allocating their study time based on their “marginal grade product.”

6. The impact of resource prices on the demand for substitute and complementary resources should be noted. How did the sharp increase in crude oil price during the 1970s affect the demand for substitute resources such as coal, insulation, and solar energy? What did it do to the demands for different size cars? How was the future supply of these resources influenced with the passage of time? Discussion of these and related questions will help students grasp the interrelationships among markets.

7. Be sure to point out that the theory of marginal productivity is a theory about the demand for resources. It does not imply that the price of a resource is “just” or “equitable.”

8. Critical Analysis questions 4, 5, 6, 8, 10, and 12 provide material suitable for a classroom discussion on the major points of this chapter.

9. Make a point of the fact that the resource thought to be responsible for superior performance will be bid up in price, but in a world of team production, it is not easy for even insiders to know which resources are in fact responsible. It is the principles we want students to understand, but they also need to know the principles are to be applied to a world that is far more complex than our models.


1. “Derived demand” means that the demand emanates from the consumer’s desire for the product or service that the resource helps produce rather than utility derived directly from the resource. There are two reasons why higher prices reduce resource employment: (1) substitution in production (the use of other resources rather than the one which increases in price), and (2) substitution in consumption (the use of other products rather than products that are now more expensive because the higher resource price pushes costs upward).

258 Chapter 25 (12 Micro)/The Supply and Demand for Productive Resources

5. Profit-maximizing firms will hire a resource only if they expect its MRP to be greater than (or equal to) its price (resource-hiring cost). However, they are not unique in this regard. Neither will resource suppliers sell their services unless they expect “to make money by doing so.” Trade, including sale of resource services, is not a zero-sum game. With regard to (b), resource productivity will be roughly proportional to resource prices; however, one should remember that both supply and demand (which is influenced by the productivity of the resource) operate to determine price. Answers (a) and (b) are not inconsistent with each other.

10. Other things being constant, a lengthy training requirement to perform in an occupation reduces supply and places upward pressure on the earnings level. However, resource prices, including those for labor services, are determined by both demand and supply. When demand is weak, earnings will be low, even though a considerable amount of education may be necessary to perform in the occupation. For example, the earnings of people with degrees in English literature and world history are generally low, even though most people in these fields have a great deal of education.

11. The highly elastic product demand will also enhance the elasticity of demand for the resources used to make the product.

Chapter 26 (13 Micro)Earnings, Productivity, and the Job Market

OUTLINE

1. Why Do Earnings Differ?A. Earnings would be equal if:

1. all individuals were identical.2. all jobs were equally attractive.3. workers were perfectly mobile among jobs.

B. Earnings Differentials Due to Non-identical Workers1. Worker Productivity and Specialized Skills.

a. More productive workers have greater earnings.2. Worker Preferences.

a. Workers motivated by monetary objectives are likely to pursue jobs with higher wages.3. Race and Gender.

a. Discrimination may lower earnings opportunities of women and minorities.

C. Earnings of Skilled and Unskilled WorkersD. Education Leads to Higher EarningsE. Earnings Differentials Due to Non-identical Jobs

1. Individuals with undesirable working conditions receive higher wages (compensating wage differential).2. Compensating wage differentials can be due to a variety of causes such as:

a Job risk.b Job location.c Working hours.

F. Earnings Differentials Due to Immobility of Labor1. Some wage differentials result from an incomplete adjustment to a labor demand change due to labor immobility.

2. Immobility can result from:a. Specialized labor.b. Institutional barriers.c. Minimum wage.d. Occupational licensing.e. Labor unions.

II. The Economics of Employment DiscriminationA. Wage Discrimination


1. Majority workers are preferred to minority workers (or men to women) and so demand is reduced for minority workers.


Chapter 26 (13 Micro)/Earnings, Productivity, and the Job Market 261

a. Minority workers receive lower wages.2. Impact of wage discrimination.

B. Employment Discrimination1. Minority and female workers are restricted in the types of jobs and occupations they are allowed to entry.

a. Supply in unrestricted jobs increases, causing wages to fall.b. Supply is restricted in jobs dominated by white males, causing

wages to rise.2. Discrimination is costly to employers.

a. If employers can hire equally productive minority workers at a lower wages than whites, the profit incentive gives them a strong incentive to do so.

(1) Nondiscriminatory employers will have lower costs than employers who discriminate.

C. Employment Discrimination and Earnings of Minorities1. Earnings may differ among groups for reasons other than employment discrimination.

2. To measure discrimination, we must:a. Adjust earnings for differences between groups in productivity-

related factors such as education.b. Then make comparisons between similarly qualified groups of

workers who differ only in race or gender.III. The Link Between Productivity and Earnings

A. Link Between Output and Earnings1. High productivity is the source of high wages.

2. Workers in the U.S. earn high wages because their output per hour is high as a result of:

a. Greater worker knowledge and skills (human capital).b. The use of modern machinery (physical capital).

B. Automation1. Automated methods of production will only be adopted if they reduce costs.

2. Automation may reduce employment in a specific industry.a. It also releases resources that can be employed in other areas.

3. Improved technology permits us to achieve larger output and income levels.C. Productivity, Wages, and the Computer Revolution1. Since 1996, the growth of productivity in the United States has increased well

above the growth rate achieved during the prior 20 years. The growth in real compensation has rebounded as well.2. Most economists believe that the recent acceleration in productivity growth is largely the result of the computer revolution and related technological innovations

262 Chapter 26 (13 Micro)/Earnings, Productivity, and the Job Market

OBJECTIVES

This chapter focuses on the role of prices (wages) in the allocation of labor services (human capital). The following chapter analyzes the role of prices in the allocation of capital resources.

There are three reasons why wage rates differ: (1) differences among workers with regard to skill level, preferences, and individual characteristics; (2) differences among jobs (working conditions); and (3) imperfect information and resource mobility. The text discusses why each of these factors leads to wage differences. It also provides extensive discussions of employment discrimination, and the link between productivity and earnings. Lastly, it discusses the link between productivity and earnings.


1. Differences in: (a) individual skills and experience, (b) jobs, and (c) the mobility of resources explain why earnings vary among workers. Some people have greater productivity (for example, cognitive and non-cognitive skills, specialized talents, native abilities) than others. Some persons are more willing to give up leisure in order to enhance both their earnings and their human capital. Still others confront employment discrimination as the result of their race or sex. All these factors generate earnings differentials.

Differences in jobs—location, convenience of working hours, and non-pecuniary working conditions—also contribute to the variation in earnings among workers. In addition, worker immobility stemming from such factors as occupational licensing, unionization, and obsolescence of skills contributes to the variations in individual earnings. Clearly, when earnings are determined by market forces, substantial variation is inevitable. The Thumbnail Sketch summarizes the sources of individual earnings differentials.

2. Students have difficulty grasping the impact of employment discrimination on earnings. Be sure to point out that earnings differences according to race or sex may be the result of factors other than employment discrimination. When seeking to isolate the impact of current employment discrimination, comparisons should be made between majority and minority (or male and female) workers of similar productivity and job preferences. Exhibit 4 provides estimates for the minority/majority wage ratios in 2003–2006 corrected for differences in productivity.

3. Typically, students perceive that employers benefit from discrimination. Economic theory suggests that this view is incorrect. If an employer could hire minority employees at a wage rate lower than that paid equally productive non-minority workers, he could reduce his costs (and increase his profits) by substituting minority for non-minority workers. For a firm to minimize its unit costs, the change in output (marginal product) from the expenditure of an additional dollar must be equal for all inputs. This would not be true for employers who discriminate. An additional dollar spent on minority employees would expand output more than an additional dollar on non-minority workers. Thus, when an employer pays non-minority workers wages higher than those paid to equally productive minority employees (both actual and potential), his costs will increase relative to those of the non-discriminating employer.

Chapter 26 (13 Micro)/Earnings, Productivity, and the Job Market 263

4. Students seldom see the link between real income and output. Output and real income are simply opposite ways of viewing the same thing. When output expands, resource suppliers gain increased control of their products—that is, the real purchasing power of their earnings increases. Without an expansion in real output, it would be impossible for the income of resource suppliers to expand in real terms. Expansion in production, broadly defined to include, for example, leisure time and an attractive environment, is the only way in which a nation’s real income can expand. Exhibit 5 illustrates the close relationship between output and real earnings.

5. Both employee compensation and self-employment earnings are primarily returns on human capital. On the other hand, interest, rents and corporate profits are primarily returns on physical capital. Approximately four-fifths of the U.S. domestic income is allocated to human capital.

6. The myth on automation should stimulate student discussion. Do not forget to emphasize the secondary effects when analyzing the total impact of automation on the availability of jobs.

7. Students are often troubled by wage differentials, which nonetheless have a significant economic function. Discuss how wage differentials mediate between the following groups:

a. college graduates compared to high-school graduates;

b. skilled versus unskilled laborers;

c. lawyers, accountants, and engineers compared to historians;

d. skilled, professional baseball players compared to minor leaguers;

e. airplane pilots versus taxi drivers;

f. computer specialists compared to specialists in home economics.

8. Critical Analysis questions 2, 6, and 16 should help to stimulate classroom discussions of automation, jobs, and the sources of economic progress. Questions 3, 7, 8, 10, 12, and 11 focus on sources of wage differences. We believe that you will find students are quite interested in the questions at the end of this chapter.

9. As an illustration of how fringe benefits are included in the calculations of workers, you can use the consumption benefits a university provides in addition to human capital production. Going to school provides both investment in human capital and current consumption components. While these two might be substitutes from the point of view of how a university allocates its resources, they are complements when it comes to attracting the best students. Other things equal, the better the consumption benefits of a particular school, the more valuable attendance is to a student, and better students can be attracted. This, in turn, may lead to higher quality graduates, not because they learned more at the school, but because they entered as better students.

264 Chapter 26 (13 Micro)/Earnings, Productivity, and the Job Market


7. a. Not unless it leads to production of a service that is valued highly others.

b. Production of goods and services that others value highly and are therefore willing to pay a lot for leads to high income. In contrast, people who fail to produce things valued highly by others will earn only low incomes.

8. The opportunity cost of leisure (nonwork) for higher wage workers is greater than it is for lower wage workers.

10. Scenarios (a), (b), (e), and (f) will generally increase hourly earnings; (c) and (d) will generally reduce hourly earnings.

Chapter 27 (14 Micro)Investment, the Capital Market, and the Wealth of Nations

OUTLINE

I. Why People InvestA. Capital and Investment

1. Types of capital:a. Physical capital.b. Human capital.

2. Investment: purchase, consumption, or development of a capital resource.3. Saving is income not spent on current consumption.

B. Savings and Investment1. Investment and saving are closely linked:

a. Saving is the non-consumption of income.b. Investment is the use of unconsumed income to produce a

capital resource.c. Savings is required for investment.

C. Investment and Consumption1. Can often produce more consumption goods in future by:

a. Using resources now to produce more physical and human capital.b. Then use capital to produce more consumption goods in future.

2. Delaying consumption is less desirable since people have a positive rate of time preference—prefer goods sooner rather than later.

II. Interest RatesA. Interest Rate

1. The interest rate is the price of earlier availability.2. It is the premium that borrowers must pay to lenders to acquire goods now rather than later.

B. Determination of Interest Rates1. Interest rates are determined by the supply and demand for loanable funds.

2. The demand for loanable funds comes from two sources:a. Investors from the productivity of capital resources.b. Consumers from the positive rate of time preference.

3. Interest rewards lenders who curtail current consumption and provide loanable funds.4. The market interest rate will bring the quantity of funds demanded by borrowers into balance with the quantity supplied by lenders.

C. The Money Rate vs. Real Rate of Interest1. During inflation, the nominal interest rate, or money rate of interest is misleading of the true cost of borrowing.


a. The money interest rate will include an inflationary premium reflecting the expected change in the price level.

b. The real rate of interest or money rate minus the inflationary premium is a better measure of the true cost of borrowing.

D. Interest Rates and Risk1. More than one interest exists in loanable funds market.

a. Ex: mortgage rate, credit card rate.b. Riskier loans will have higher money interest rates.

E. Components of Money Interest Rate1. Pure rate of interest.

a. Price for earlier availability.2. Inflationary premium.

a. Reflects expectation that the loan will be paid with dollars of less purchasing power.3. Risk premium.

a. Reflects probability of default.III. The Present Value of Future Income and Costs

A. Present Value1 The interest rate connects the value of dollars today with the value of dollars in the future.

2. The present value (PV) of a payment received one year from now is:a. PV = receipts one year from now/(1 + interest rate)

(1) Ex: PV = $100/1.06 = $94.343. The present value of a future dollar payment is inversely related to:

a. The interest rate.b. How far in the future the payment will be received.

IV. Present Value, Profitability, and InvestmentA. Discounted Present ValueB. Expected Future Earnings and Asset Value

1. The present value of expected future net earnings will determine the value of existing assets.2. An increase (decline) in expected future earnings derived from asset will increase (reduce) the market value of the asset.

V. Investing in Human CapitalVI. Uncertainty, Entrepreneurship, and Profit

A. Economic Profit1. Economic profit plays a central role in the allocation of capital and the determination of which investment projects will be undertaken.

2. In a competitive environment, profit reflects:a. Uncertainty.b. Entrepreneurship.


Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations 267

(1) The ability to recognize and undertake profitable projects that gone unnoticed by others.

B. Returns to Physical and Human Capital1. Employee compensation and self-employment income represent primarily returns to human capital. These two components have comprised about 80 percent of national income in the United States for the last several decades.

VII. Why is the Capital Market so Important?A. If the potential gains from innovative ideas and human ingenuity are going to be fully realized, it must be relatively easy for individuals to try their innovative and potentially ingenious ideas, but difficult to continue if the idea is a bad oneB. To grow and prosper, a nation must have a mechanism that will attract savings and channel into investment projects that create wealth.

1. The capital market performs this function in a market economy.2. When property rights are defined and securely enforced, productive investments will also be profitable.

C. Political Allocation and the Structure of Incentives1. When investment funds are allocated by the government, rather than by the market, an entirely different set of incentives comes into play. 2. Political influence rather than market returns will decide which projects will be undertaken. 3. Businesses will use contributions, lobbying, and other resources to attract favors from government. In turn, politicians will use subsidies, tax breaks, and “bail outs” to help those most willing to provide them with political support. 4. Profits and losses direct investors toward productive projects and away from those that are counterproductive. 5. The political process does not have anything similar to profit and loss that can be counted on to direct funds toward wealth creation. 6. As a result, the political process will lead to the inefficient allocation of capital

OBJECTIVES

Many goods are durable—that is, they provide a stream of future services (or revenues). The focus of this chapter is the decision making with regard to assets and costs that have a time dimension.

The interest rate enables a present value to be assigned to a flow of future revenues (or costs). Stock data can thus be transformed into flow, and vice versa. In this chapter, we discuss the meaning of interest and explain why the interest rate is generally positive. The concept of net present value is introduced and used to explain how the value of a stream of future revenues or costs is determined. The investment decisions of firms are analyzed in this framework.

Ownership of capital assets involves risk as well as the sacrifice of interest income. Persons who seek to avoid risk will require compensation for this cost before they will undertake capital ownership. The pure profit return on capital and entrepreneurship is analyzed within this framework.

We emphasize the crucial importance of a private capital market to a society and the destructiveness of interest rate controls.

268 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations


1. Discuss the meaning of investment in terms of roundabout methods of production, and indicate the circumstances under which such production techniques are advantageous. Note that the construction of tools demands that current consumption be foregone.

2. Explain why an implicit interest rate would exist even in a non-monetary economy.

3. Discuss how each of the following serves to determine the interest rates:

a. the time preference of consumers for goodsb. the potential productiveness of capital goodsc. the expected rate of inflationd. the risk of lending fundse. the duration of the loanf. the cost of processing the loan

4. Even though money interest rates in the 1970s were quite high, it could be argued that real interest rates were often low. At various points during the 1970s, the real interest rate may actually have been negative. Distinguish clearly between money and real interest rates, while discussing the relationship between inflation and high money rates of interest. Extend this to discuss the consequences of interest rate ceilings in such an environment.

5. After defining net present value, work several calculations with the formula. Without the use of discounting procedures, it would be impossible to compare the value of a stock figure (for example, the price of a capital asset) with flow data (for example, the expected income derived from the asset). Note that discounting is a procedure enabling investors to estimate precisely an expected flow of future expenses and to assess an expected flow of future revenues.

6. Discuss how each of the following contribute to the yield derived from the ownership of capital assets:a. the pure interest yieldb. the risks of ownershipc. entrepreneurshipd. monopoly power

7. While non-pecuniary factors are generally more important for investment decisions involving human capital, there are many similarities between business investment decisions and the student’s decision to invest in human capital (schooling). Both involve giving up income now and the expectation of earning a larger income in the future. Both investment decisions must be made with less-than-perfect information about the future. Both involve risk. Profit or loss (unexpected outcomes stemming from imperfect knowledge and uncertainty) will generally be associated with both physical and human capital investment decision. Point out these similarities. Instructors may want to discuss earnings differences between people with different amount of education as an illustration.

8. We recommend Critical Analysis questions 2, 5, 7, and 11 as “discussions starters” in the classroom.


9. A good present value illustration is the explanation of why more expensive cars are generally maintained better (adding to their longevity, which is often touted in their ads). Answer: the costs of not maintaining a more expensive car in terms of added depreciation are far higher. It is also important to stress that even if a car lasts longer, it is not clear that the owner is better off because the costs of providing a more durable asset will be included in the purchase price today but only captured in the increasingly distant future (this optimal degree of durability issue itself is an interesting present value illustration), and the costs of that maintenance may exceed the value of the added services. Another present value illustration in this area is why most companies leasing automobiles include free maintenance for the term of the lease. Answer: the person leasing the car will not be as concerned about its value at the end of the lease as is the company that owns the car.

10. Looking ahead to the special topic about natural resources, now is a good time to introduce the idea that conservation decisions are present value decisions where the same principles as in this chapter apply (conserve as long as the present value of the future expected price to the decision maker is greater the current price he can capture).

11. An interesting sidelight to the present value discussion of this chapter is to ask students whether self-financing might sometimes be cheaper than borrowing. It might be in cases where you have substantially better knowledge than an outside lender of the risks accompanying the loan and your susceptibility to moral hazard problems.

12. Games 1 to 2 will help reinforce the material in chapter 27.

GAMES

1. The Universal Replicator

Type: In-Class AssignmentTopics: technological changeTextbook: Chapter 26 Investment, the Capital Market, and the Wealth of NationsMaterials Needed: noneTime: 20 minutesClass limitations: works in any size class

Purpose

This assignment explores the economic implications of an imaginary new technology, called the Universal Replicator. Many issues about growth and change are raised.

Instructions

The Universal Replicator is a machine that can replicate any physical good. If a car is put into the Universal Replicator, the machine will create an exact working duplicate, at the touch of a button. It will work on any non-living object.

Assume this technology becomes widely adopted throughout the country, by manufacturers of all types.




1. What impact would the Universal Replicator have on the economy?Most students focus on the negative aspects of this technology: job loss, disruption of institutions, chaos.

Some will also see the positive side: the elimination of poverty, the ability to meet all material needs, the elimination of tedious and unsafe jobs.


2. What jobs would not be needed?manufacturing, mining, agriculture, any assembly line job.

3. What would happen to the price of goods?The price of goods would drop dramatically.

4. What kinds of problems would you expect?Structural unemployment, recession, waste disposal, idleness, income distribution may become less equitable, skills become obsolete, arms build-up, new legal structures needed.

5. What benefits do you see?More material goods, more leisure time, the ability to devote resources to social problems.

6. What kinds of jobs would still be necessary?Designers, inventors, doctors, teachers, lawyers, police, barbers, . . .Most service jobs will still be needed.

Of course, the Universal Replicator doesn’t really exist but technological change has had very similar effects. For example, look at the long-term advances in agriculture. Two hundred years ago 80 percent of the U.S. labor force worked in farming. Today, farming accounts for 2 percent of U.S. jobs. Agricultural production has increased tremendously and food prices have decreased substantially.

Manufacturing has followed a similar, but less extreme, path. Fewer workers are able to produce more goods, at lower costs. The “Deindustrialization of America” has been accompanied by increased industrial output.

As agricultural and manufacturing employment decline, we find more workers in the service sector. Lower prices for agricultural and manufactured goods mean services become relatively expensive. Many public issues, such as concerns about health care, education, and police protection, are affected by this increase in the relative cost of services.

Like the Universal Replicator, technological progress increases material well-being. And the same questions remain: What happens to displaced workers? What happens to the distribution of income? How are by-products, wastes, and pollution handled?


NAME _______________ Course __________________

Universal Replicator Assignment

1. What impact would the Universal Replicator have on the economy?

2. What jobs would not be needed?

3. What would happen to the price of goods?

4. What kinds of problems would you expect?

5. What benefits do you see?

6. What kinds of jobs would still be necessary?


2. Create a Portfolio

Type: Take-home AssignmentTopics: financial marketsTextbook: Chapter 26 Investment, the Capital Market, and the Wealth of NationsClass limitations: works in any size class

Purpose

This assignment requires students to use the financial pages of the newspaper to create their own portfolio. Many students are unfamiliar with the basic elements of stock and bond tables. This assignment then asks students to analyze elements that would affect their portfolio.

Instructions

Ask the students to do the following assignment. Many possible variations exist. It can be worthwhile to have students reevaluate their portfolio at the end of the semester.


Most students pick a mix of common stocks, mutual funds, and bonds. Some choose familiar, low-risk, but low-yielding, bank accounts and certificates of deposit. A few may choose more sophisticated financial instruments.

This can be used to introduce the trade-off between risk and return and the concept of the risk premium.

The impact of macroeconomic events on financial markets usually interests students. Portfolios heavily invested in cyclical stocks will give low returns in the event of recession. Bonds and cash perform poorly with unanticipated inflation. Foreign-denominated assets may give high returns if the dollar depreciates. Interest rate changes can cause large swings in the value of bond-heavy portfolios.


Name____________________ Course ______________

Financial Portfolio

1. Assume you have $100,000 in savings. Create a portfolio of securities worth $100,000. Decide what financial instruments you would like to use, then find their current prices in the newspaper. Calculate your holdings of each security, based on current prices.

2. What objectives do you have for this portfolio? Was it chosen to maximize short-term gains, long-term stability, or some other objective?

3. Explain how each of the following economic events would affect the value of your portfolio.a. an increase in interest ratesb. a decrease in interest ratesc. a recessiond. rapid inflatione. a depreciation of the U.S. dollar


HINTS FOR ANSWERING CRITICAL THINKING QUESTIONS

3. Human and physical capital investment principles are the same, but non-pecuniary characteristics and preferences play an important role because human capital is embodied in the individual. Profits and losses arise from the same sources in both types of investment.

7. Interest rate controls can be explained in the same terms as any price ceilings.

Chapter 28 (15 Micro)Income Inequality and Poverty

OUTLINE

I. How Much Income Inequality Exists in the United StatesA. Inequality in Money Income in the United StatesB. A Closer Look at Factors Influencing Income Distribution

1. A high portion of annual income inequality is due to differences in age, education, family size, marital status, number of earners in the family, and time worked.2. Young, inexperienced workers, students, single-parent families, and retirees are over-represented among those with low incomes.

C. Why Has Income Inequality Increased?1. An increasing proportion of both single-parent and dual-earner families.2. An increase in earnings differentials on the basis of skill and education.

3. More “winner-take-all” markets.4. Increases in the reported income of those in the top tax bracket due to lower marginal tax rates.

II. Income Mobility and Income Inequality in Economic StatusA. Income Mobility

1. Annual income data hide the movement of persons up and down the distribution over time.2. Tracking of household income over time shows there is considerable movement both up and down the income spectrum.

III. Poverty in the United StatesA. Changing Composition of PoorB. Transfer Payments and the Poverty Rate

1. Income transfers expanded rapidly over the past several decades.2. These transfers have been largely ineffective.

a. Though per capita income has increased substantially over time, the poverty rate of working-age Americans has stayed about the same.

C. Income Transfer Effects1. Income supplements large enough to significantly increase the economic status of poor people will:

a. Encourage behavior that increases the risk of poverty.b. Create high implicit marginal tax rates that reduce the

recipient’s incentive to earn.IV. Income Inequality: Some Concluding Thoughts

A. Positive economics cannot determine how much inequality should be present.


B. Income inequality reflects differences between individuals and influences their incentive to develop resources and engaging productive activities.


Chapter 28 (15 Micro)/Income Inequality and Poverty 279

C. The nature of the process as well as the pattern of income distribution is relevant to the issue of fairness.

OBJECTIVES

In this chapter, we present empirical evidence on economic inequality and poverty. Statistics in this area are often misleading and often misused. Static data on the distribution of income often conceal important information. They do not reveal why (for example, differences in age, education, and family status) incomes vary. Neither do they reveal the extent that people exchange economic positions over time. This chapter discusses these factors and presents data on income mobility as well as “snapshot” data on the distribution of income at a point in time.

The chapter also focuses on poverty in the United States—who are the poor and what might be done to improve their economic status? Analysis of the socioeconomic characteristics of the poor in the United States reveals that they are a heterogeneous group—some from a permanent underclass whereas others are temporarily poor. Sometimes, poverty is rooted in the depreciation of skills, unforeseeable market changes, and just plain bad luck. In other cases, personal limitations, shortsightedness, and the failure to take advantage of existing opportunities are important contributors to poverty status. As the experience of the War on Poverty illustrates, this diversity complicates the ability of government transfers to uplift the poor. Transfer programs often exert unintended side effects that retard their effectiveness. This chapter considers each of these issues.


1. Exhibit 1 presents a breakdown of annual money income data by quintile. As the table shows, the distribution of annual money income during the last 50 years has been relatively stable. Money income inequality has probably increased somewhat since 1970. However, money income data ignore: (a) non-cash benefits, (b) taxes, and (c) changes in the composition of families. In recent years, non-cash transfers, particularly those directed toward the poor, have expanded and the number of single-parent families has increased substantially as a share of the total. Changes such as these may distort the “snapshot” annual income data. Thus, data like that of Exhibit 1 should be interpreted with caution.

2. Exhibit 2 presents data on the differences in the characteristics of high- and low-income recipients. In most families with high incomes, more than one family member works, the level of education is high, the household is headed by a prime-age worker, and the family consists of three or more persons. In contrast, low-income families typically include a large proportion of single-parent families with few workers (often none). Often low-income families are headed by a poorly educated person who is either quite young or quite old.

3. The panel income data have substantially improved our knowledge of income mobility. As Exhibit 3 shows, these data indicate there is significant mobility up and down the income ladder in the United States.

4. It is difficult to overemphasize the heterogeneity of the poor. The poor are a diverse group with respect to number of children, employment experience of the household head, age, health, and marital status. The distinction between the temporarily poor and the permanently poor is highly important. Many college students with long-run income prospects far above the poverty level are often temporarily poor. Similarly, many elderly persons whose lifetime

280 Chapter 28 (15 Micro)/Income Inequality and Poverty

incomes have been far above the poverty level will be considered poor in old age, having left the labor force. Recognition of the diversity is highly important from the standpoint of economic policy.

5. Students are generally interested in how the poverty rate is calculated. The boxed feature “Determining the Poverty Rate” focuses on this topic.

6. During the last 50 years there has been a substantial change in the composition of the poor. Today, families headed by a female of prime-working age who is not in the labor force are the dominant category. The representation of the elderly among the poor has dropped sharply since 1959. See Exhibit 4 for additional details on the changing composition of the poor.

7. As Exhibit 5 illustrates, the poverty rate of families declined sharply during the 1950s and 1960s and bottomed out in 1968. It has remained near 10 percent since 1968. This pattern is present for both the official poverty rate and the poverty rate adjusted for non-cash transfers.

8. Like other changes in economics, transfer payments generate secondary effects. Means-tested transfers generally increase the marginal (implicit) tax rate of the poor. When transfers provide an attractive alternative to personal earnings, they retard the workforce participation and skill development of the poor. Transfers may also encourage individuals to engage in behavior that leads to poverty. Thus, the relative ineffectiveness, compared to the expectations, of the War on Poverty transfer programs is not really surprising. See the text for analysis of this issue.

9. A negative income tax is often discussed as a means of bridging the gap between income inequality and the removal of productive incentives. Carefully explain how the negative income tax would work. Be sure to emphasize the significance of the marginal tax rate as a determinant of productive incentive. An analysis of the merits and limitations of the negative income tax would make an excellent topic for a student paper assignment.

10. The Critical Analysis questions provide material suitable for a stimulating classroom discussion. Questions 1, 5, 9, and 12 are favorites of the authors.

11. It is important to get students to see that attempts to redistribute income may result in more measured inequality. For example, an increase in non-measured in-kind transfers may lead some low-income people to earn even less to qualify, making them look even poorer. Similarly, highly progressive taxes on high earners will depress the number of people in those fields, raise their pretax wages, and thereby increase the degree of pretax income inequality.

12. A good way to talk about income distribution issues and incentives is to talk about how reductions in the top marginal tax rates affected the incentives of secondary workers to enter the labor force and hence the number of two earner families.


GAMES

1. What Do You Need to Get By?

Type: In-Class AssignmentTopics: earning power, poverty lineTextbook: Chapter 27 Income Inequality and PovertyMaterials Needed: noneTime: 20 minutesClass limitations: works in any size class

Purpose

This assignment illustrates that for most people, the value of their labor is their biggest asset. It then explores income levels needed to achieve particular comfort levels, and compares those to official measures of poverty.

Instructions


1. What income do you expect to earn the year after you graduate?

2. What do you expect your highest annual income to be?

3. Estimate your average annual income, over your career. (You may use a simple average of your answers to questions 1 and 2.)

4. Estimate the total value of your lifetime earnings. (One method is to multiply your average income by 40.)

5. In your opinion, what is the minimum income needed to support a family of four at each of these comfort levels:a. enough money to “fulfill their dreams”b. enough money to “be reasonably comfortable”c. enough money to “just get by”

6. Calculate the pretax earnings of a worker employed full-time for a year at the minimum wage. (This can be approximated by multiplying the minimum wage by 2000.)


The estimates of lifetime earnings will range widely, but typically are in the range of a few million dollars. The main point is that earning power is the most valuable asset for nearly everyone.

282 Chapter 28 (15 Micro)/Income Inequality and Poverty

The answers for question 5 will also vary widely. To some extent the figures will be correlated with the individual student’s family income. The answers to part c are the most relevant to the discussion of poverty. If those figures are truly the minimum needed to “just get by,” then families earning less than that amount are poor.

Essentially this figure is a personal judgment of the poverty line. The typical dollar figures are substantially higher than the official poverty line. Often, the lowest estimate is twice the official poverty line. Many students will give figures higher than the median income for all households.

This helps put poverty figures in perspective. Living below the poverty line is substantially worse than “just getting by.” The derivation of the official poverty figures from the “budget food plan” can be discussed here.

The final question ties together earnings and poverty. Working full time at minimum wage will not provide a high enough income to raise a family above the poverty line. Poverty in the United States is substantially a problem of the inability to earn a sufficient wage.

2. Picture a Poor Person

Type: In-Class demonstrationTopics: povertyTextbook: Chapter 27 Income Inequality and IncomeMaterials Needed: noneTime: 2 minutesClass limitations: works in any size class

Purpose

This exercise attempts to broaden the view of the poor beyond common stereotypes.

Instructions

Ask the class to visualize a poor person. Not someone they know personally, but a representative individual. Ask them to picture a particular individual, and to answer the following questions:

What gender is this person?How old is this person?Where do they live?What race is this person?


The most common face of poverty is:femalea childliving in a rural areawhite

The actual picture does not fit the typical stereotypes.


Many students think of poverty as an urban problem. They may associate poverty with older males or with minorities. Most poor people are not visible in our society.

This can introduce a discussion of the difference in poverty rates by race, the declining poverty rate for the elderly, or reforms of the welfare system.

HINTS FOR ANSWERING CRITICAL THINKING QUESTIONS

1. The appropriate distribution of income is a subjective issue. There are two general criteria for judging fairness: (1) the pattern of income shares relative to some desired pattern and (2) the fairness of the process. In considering this issue, ask students to consider questions like the following: Is an athletic contest fair if some are given a head start? Does the pattern of the outcome determine the fairness of an athletic contest? Are income differences fair if they reflect hard work, merit, luck, or superior opportunity?

5. Of course there is not a right answer to these questions. We suggest the following points for discussion: (1) Is the property right of individuals to personal income meaningful if there are no limitations on the “taking” of income through the political process? (2) Does income generated by individuals belong to them or the government? (3) The U.S. Constitution provides Congress with the power to tax to provide for “the common defense and general welfare” (Article I, Section 8)—do transfer payments meet this criteria? and (4) The Constitution also states “nor shall private property be taken for the public use without just compensation” (Amendment V)—do transfer payments meet this criteria?

Special Topic 1Government Spending and Taxation

OUTLINE

I. Government ExpendituresA. Government spending includes both purchases of goods and services and income transfers.

1. About three-fifths of government spending takes place at the federal level. Four categories—income transfers (including Social Security), health care, national defense, and interest on the debt—account for 85 percent of federal spending.2. At the state and local level, the largest categories of spending are education and public welfare.

B. Government Spending Per Person 1. During the first 125 years of U.S. history, federal expenditures per person were small and they grew at a relatively slow rate.

2. Federal spending soared throughout most of the 20th century. In 2008, federal spending per person was over 70 times the level of 1916.

C. How has the Composition of Federal Spending Changed? 1. During the last five decades, the composition of federal spending has shifted away from national defense and toward spending on income transfers and health care.

II. Taxes and the Finance of GovernmentA. Types of Taxes

1. The federal government derives approximately half of its revenue from the personal income tax and another third from the payroll tax.2. State and local revenues are derived primarily from sales taxes, income taxes, user charges, and grants from the federal government.

B. Taxes and the Cost of Government1. A tax dollar extracted from an individual or a business ends up costing the private economy much more than just one dollar. This is the case for two main reasons.

a. The collection of taxes is costly.b. Taxes impose an additional burden on the economy because they

will eliminate some productive exchanges (and cause people to undertake some counterproductive activities)..

C. How Has the Structure of the Personal Income Tax Changed? 1. Even though marginal tax rates have been reduced substantially during the last four decades, upper-income Americans pay a much larger share of the federal income tax today than was previously the case.

D. Income Levels and Overall Tax Payments 1. The U.S. income tax system is highly progressive—the percentage of income taken from high earners is greater than for those with less income.


III. How Does the Size of Government Affect Economic Growth?A. The size of the U.S. government is smaller than that of Japan and major Western

European countries, but larger than for a number of high-growth Asian economies.B. When governments focus on the core activities of providing (1) a legal and

enforcement structure that protects people and their property from aggression by others and (2) a limited set of public goods, they promote economic growth. However, when governments grow beyond this size, expanding into activities for which they are ill suited, they deter growth.

IV. Expenditures, Taxes, Debt Finance, and DemocracyA. More than half of American families derive benefits from various transfer programs,

while the share of the population paying federal income tax has declined substantially during the past decade.

B. Moreover, large budget deficits have pushed the debt to GDP ratio to levels not seen since the aftermath of World War II.

C. These factors, along with upward pressure on expenditures for Social Security and Medicare as the baby-boomers retire, will make it very difficult to control federal finances.

D. Thus, the United States confronts a troublesome fiscal future in the years immediately ahead.

OBJECTIVES

In this special topic, we take a closer look at government in the United States. We focus on the taxing and spending activities of government. The feature documents the major categories of government spending and sources of tax revenue. We show that the size of the federal government grew dramatically in the 20th century and early 21st century. Over the past 50 years, federal government spending has moved away from national defense and toward spending on income transfers and health care. With regards to government revenue, the U.S. tax system is highly progressive and the tax burden has increased over time.

Lastly, we show the size of the U.S. government is smaller than that of Japan and major Western European countries, but larger than for a number of high-growth Asian economies. When governments focus on productive activities they promote economic growth. However, when governments expand into activities for which they are ill-suited, they deter growth. The empirical evidence indicates that the governments of most, if not all, industrial countries are larger than the growth-maximizing size.


1. Exhibit 1 demonstrates that real federal spending per person (measured in 2012 dollars) was generally less than $50 prior to the Civil War and it ranged from $125 to $200 throughout the 1870–1916 period. However, beginning with the spending build-up for World War I in 1917, real federal spending per person soared, reaching $11,051 in 2012. The 2012 figure is almost 80 times that of 1916.


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2. To provide some information regarding changes in the composition of government spending, review with students Exhibit 2. This exhibit shows that federal government spending, over the past four decades, has shifted away from defense and toward income transfers and health care.

3. Exhibit 3 shows that almost half of federal revenues are derived from the personal income tax. The payroll tax and corporate income tax are also major sources of federal revenue. The major revenue sources of state and local governments are sales and excise taxes, personal income taxes, user charges, and grants from the federal government.

4. Students are often surprised at how large a share of the personal income tax burden is borne by those with high incomes. Exhibit 4 shows that about one-third of all federal personal income tax payments are paid by those with the highest 1 percent of income. It also shows that though marginal tax rates have been reduced substantially since 1980, upper-income Americans still pay a much larger share of the federal income tax today than was true during the earlier year.

5. Review with students the data in Exhibit 5. It shows that the federal income tax structure is highly progressive. Federal taxes take 25.1 percent of the income generated by the top quintile (20 percent) of earners, compared to 14.3 percent from the middle-income quintile and 4.0 percent from the lowest quintile of earners.

6. Emphasize to students that a tax dollar extracted from the private sector is more costly than one dollar. This is due to two reasons. First, a cost is incurred to collect taxes. Second, taxes will cause some productive exchanges not to be conducted.

7. Exhibit 7 will help students understand the relationship between the size of government and economic growth. Increases in the size of government, if it focuses on productive activities, will increase economic growth. However, when governments undertake activities for which they are ill-suited, they decrease economic growth.

8. The main point of Exhibit 8 is that the governments of most, if not all, industrial countries are larger than the growth-maximizing size. The empirical evidence indicates that a 10 percent rise in government expenditures as a share of GDP lowers the annual growth rate by about 1 percent.

9. Critical Analysis questions 3 and 5 are good classroom discussion starters.


2. The shift away from national defense and toward income transfers and health care is unlikely to improve the operation of the economy. National defense is a public good, while income transfers and health care are not. Public goods will not be provided at an efficient level by the private sector and so the public provision of such goods will improve economic efficiency. The shift away from public goods will likely decrease economic efficiency.

Special Topic 2The Economics of Social Security

OUTLINE

I. Introduction to the U.S. Social Security Program A. Offers protection against the loss of income that usually accompanies old age or the death of a breadwinner.

B. It is a pay-you-go system. It is not based on saving-and-investment model.C. Primarily an intergenerational income-transfer program: Most taxes collected from the present generation of workers are used to finance current benefits.D. Because of the pay-as-you-go nature of the program, it is influenced by changing demographics.

II. Why Is Social Security Headed for Problems?A. Baby boomers moving into the retirement phase of their life will place strong pressure on the Medicare program as well as the Social Security retirement system.

B. The current deficit of revenues from the payroll tax relative to retirement benefits will accelerate around 2016.

III.Will the Trust Fund Make It Easier to Deal With the Retirement of the Baby Boomers?

A. Current revenues exceed expenditures on benefits by about $100 billion per year.B. This surplus is put in a trust fund “invested” in government bonds.C. Because the federal government both pays and receives the interest on these bonds, they are not like the bonds, stocks, and physical assets held by a private insurance company.D. The SSTF bonds are an IOU from the Treasury to the Social Security Administration, so their net asset value to the federal government is zero.

IV. The Real Problem Created by the Current SystemA. A crisis faced by the pay-as-you-go system will arise around 2017 when the revenues from the payroll tax will begin to fall short of the benefits promised to retirees.B. Four possible ways of dealing with the future shortfall of revenues relative to promised benefits:

1. reduce benefits;2. raise taxes and/or cut other government expenditures in order to inject additional funds into the system;

3. borrow from the general public;4. reform the system in a manner that will increase the rate of return earned by (or for) workers and future retirees.

C. The presence of SSTF bonds does not change these alternatives or make it easier to deal with future Social Security deficits


D. The problem is not depletion of the trust funds, but the burden of soaring Social Security deficits on the economy beginning in about 13 years


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V. Does Social Security Help the Poor?A. Does Social Security Help the Poor?1. While the Social Security benefit formula favors those with lower lifetime

earnings, low-wage workers have a lower life expectancy, begin work at a younger age, and gain less from the spousal benefit provisions of the current system.2. These latter factors largely, if not entirely, offset the egalitarian effects of the benefit formula.

VI. Social Security and the Treatment of Blacks and Working Women.A. Adversely Affects Blacks and Other Groups with Below-Average Life

Expectancy1. Because of their shorter life expectancy, blacks derive a lower rate of return from Social Security than whites, and a substantially lower return than Hispanics.

B. Discrimination Against Working Women1. Social Security discriminates against married women in the workforce.

VII. Is Social Security Suitable for the Twenty-First Century?A. The demographics of the twenty-first century reduce the attractiveness of pay-as-you-go Social Security.

1. Various plans that would place more emphasis on saving and investment are likely to be considered in the future.

OBJECTIVES

This special topic examines one of the most widely discussed and debated public policy issues—Social Security. The problem facing Social Security is explained as well as its treatment of various demographic groups. The special topic concludes with a discussion of possible reforms.


1. Review Exhibit 1, which shows the workers per Social Security beneficiary. As the worker/beneficiary ratio falls under a pay-as-you-go system, either taxes must be increased or benefits reduced (or both).

2. It is important to contrast the pay-as-you-go approach of Social Security with the approach of private saving for retirement. Comparison to Ponzi schemes is also instructive.

3. Remind students that any pay-as-you-go policy that gives early retirees an unsustainably good deal faces the same sort of problem as Social Security.

4. There is a huge amount of literature on the effects of Social Security. Interested instructors will find this topic really “grabs” students, who are major losers from the system.

5. To provide students a perspective of the magnitude of the problem with Social Security, go over Exhibit 3. Point out that beginning around 2016, the system’s current surplus changes to a deficit, which will persist for several decades.

6. Make sure students understand that the surplus building up in the Social Security trust fund will not lighten the future tax burden. The current surplus of the Social Security system is used

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to purchase U.S. Treasury bonds. Because the federal government is both the payee and recipient of these bonds, their net asset value to the federal government is zero. They will not reduce the level of future taxes needed to cover the Social Security deficit when the baby boomers begin to retire.

7. Review the four possible solutions to the Social Security crisis: reduce benefits, raise taxes, borrow from the general public, or reform the system.

8. Discuss one of the options for reform of the Social Security system (i.e., moving toward privatization through personal retirement accounts). Be sure to discuss the issues surrounding this solution.

9. An interesting topic for class discussion is who is helped and who is hurt by Social Security. The three issues the text analyzes are whether:a. Social Security helps the poor;b. Social Security adversely affects groups with a lower life expectancy;c. Social Security discriminates against married women in the workforce.

10. Class discussion of Critical Analysis questions 1, 3, and 5 will help students integrate the major concepts of this chapter.


3. No. It would make no difference whether the tax was imposed on employers or employees. The incidence of a tax is determined by the elasticity of labor supply and labor demand, rather than who physically pays the tax.

Special Topic 3The Stock Market: Its Function, Performance, and

Potential as an Investment Opportunity

OUTLINE

I. The Economic Functions of the Stock MarketA. The stock market provides investors, including those who are not interested in participating directly in the operation of the firm, with an opportunity to own a fractional share of the firm’s future profits.B. New stock issues are often an excellent way for firms to obtain funds for growth and product development. C. Stock prices provide information about the quality of business decisions.

II. Stock Market Performance: The Historical RecordA. The stock market allows nearly anyone to participate in the risks and opportunities of corporate America. Real returns for the past two centuries have averaged 7 percent per year.

III. The Interest Rate, the Value of Future Income, and Stock PricesA. Underlying the price of a firm’s stock is the present value of the firm’s expected future net earnings, or profit.B. The value of a share depends on

1. the expected size of future net earnings, 2. when these earnings will be achieved, and 3. the interest rate by which the investor discounts the future income.

C. If D represents dividends (and gains from a higher stock price) earned during various future years (indicated by the subscripts) and i represents the discount or interest rate, the present value of the future income stream is:

D. A higher interest rate reduces the present value of future returns from holding shares of a stock.

IV. The Random Walk Theory of the Stock MarketA. When considering the future of stock prices, many economists stress the implications of the random walk theory.1. Investor expectations about an uncertain future determine current prices, and no

one can forecast future stock prices with precision or certainty.V. How the Ordinary Investor Can Beat the Experts

A. Buying and selling individual stocks without specialized knowledge for quick profit is very risky.1. Holding a diverse portfolio of unrelated stocks and holding them for long periods

of time greatly reduces the risk of investing in the stock market.


B. An equity mutual fund that is tied to a broad stock market index like the S&P 500 provides an attractive method for long-term investors to obtain relatively high yields with minimal risk.1. Indexed mutual funds have substantially lower operating costs than managed funds

because they engage in less trading and have no need for either a market expert or research staff.

C. Should you invest in a fund because of its past performance? 1. No, past performance is a not a reliable indicator of future performance.

OBJECTIVES

This special topic considers several issues regarding the stock market. First, it discusses the economic functions of the stock market and historical performance. Second, the relationship between stock prices and the interest rate is analyzed. Third, a discussion of the random walk theory of stock prices is provided. Lastly, the special topic discusses how the individual investor can profit from stock market investments.


1. Review Exhibit 4. It indicates that the risk of a poor return from a holding a diverse portfolio of stocks declines as the length of the holding period increases. Small investors can obtain a diverse portfolio by purchasing stock in an equity mutual fund, a corporation that buys and holds shares of stock in many firms. Be sure to stress the advantages of indexed mutual funds (e.g. lower operating costs).

2. Be sure to explain the determinants of stock prices. Underlying the price of a firm’s stock is the present value of the firm’s expected future net earnings, or profit. The value of a share depends on (1) the expected size of future net earnings, (2) when these earnings will be achieved, and (3) the interest rate by which the investor discounts the future income. Since, a higher interest rate reduces the present value of future returns from holding shares, the stock price will fall.

3. Discuss the relationship between the stock market and corporations. The decisions of a firm’s executives influence the firm’s stock price. When investors (and their advisors and fund managers) believe that the decisions of corporate managers will increase the firm’s future income, they will buy more of the stock, driving its price up. When investors believe that bad decisions are being made, the reverse happens and the stock’s price fall. Also note that corporate board members are usually stockholders, and top managers are often given stock options. The value of the stock options will rise sharply as the firm’s stock price increases. This helps bring the interest of corporate decision makers into harmony with other stockholders

4. It is important to discuss the random walk theory of stock prices. That is, future stock prices are unpredictable based on current information. Stock prices change only in response to surprises. As result, stock recommendations appearing in financial magazines such as Money and Smart Money are not worth pursuing. This is the point addressed in Critical Analysis question 4. Other good discussion starters are Critical Analysis questions 2, 3, 5, and 6.


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HINTS FOR ANWERING CRITICAL ANALYSIS QUESTIONS

2. It will lower the value of stocks. Higher nominal interest rates will reduce the discounted value of future income derived from stock ownership. Though higher inflation will raise the nominal value of future income, it will have two other adverse effects on stock prices. First, a higher rate of inflation will raise the tax burden accompanying capital gains. Second, high and variable rates of inflation increase the uncertainty of investment and other long-term contracts. This will hurt both the economy and the stock markets.

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Special Topic 4Great Debates in Economics: Keynes Versus Hayek

OUTLINE

I. Keynes and HayekA. Keynes and Hayek

1. John Maynard Keynes and Friedrich Hayek are giants in the economics profession. Their theories and ideas represent contrasting alternative views on several of the central issues of economics.

B. Keynes1. Keynes believed that market economies were inherently unstable and government

intervention in the form of fiscal and monetary stimulus could be used effectively to promote economic stability.

2. Keynes believed that government central planning could improve on market outcomes.

3. Keynesians believe that the job of the economist is to develop policies that will reduce economic instability and correct market failures. Keynesian analysis largely ignores how economic incentives influence the operation of the political process.

C. Hayek1. Hayek believed that economic instability was primarily the result of malinvestment

generated by monetary and credit expansion and that government stimulus would slow market adjustments and the recovery process.

2. Hayek believed that policy-makers simply do not have the information or incentives to plan the economy effectively and that their efforts to do so would be far less efficient than allocation through markets.

3. Hayekians recognize that the political incentive structure often caters to well-organized interest groups and results in the adoption of shortsighted policies. Thus, they stress the importance of legal and political institutions that will provide both market participants and political decision-makers with incentives to engage in productive rather than counterproductive actions.

II. Keynes Hayek, and Great Debates in EconomicsA. What is the cause and cure for the business cycle?

B. Should an economy be directed by government central planning or decentralizes individual planning and the invisible hand of market prices?C. Can democratic decision-making be counted on to allocate resources efficiently?

OBJECTIVES

In this feature, we focus on the views of John Maynard Keynes and Friedrich Hayek with regards to the business cycle, in the context of two videos.


2. Keynes argues that increased saving will decrease aggregate demand and thus lead to economic downturns. Furthermore, he argued that government spending was necessary to increase aggregate demand in recessions. Hayek argues that booms and busts were caused by activist policies that push interest rates to too low levels and businesses thus undertake poor investments. He argued that savings should be used to finance investments.


Special Topic 5The Crisis of 2008: Causes and Lessons for the Future

OUTLINE

I. The Crisis of 2008A. The headlines of 2008 were about falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Fed and the Treasury.B. The crisis reduced the wealth of most Americans and generated widespread concern about the future of the economy.C. This crisis and the response to it may be the most important macroeconomic event of our lives.

II. Key Events Leading Up to the Crisis A. Boom and bust in housing pricesB. Rising default and foreclosure ratesC. Sharp downturn in the stock marketD. Soaring prices of crude oil and other energy sources

III. What Caused the Crisis of 2008? A. Change in Mortgage Lending Standards

1. The role of Fannie Mae and Freddie Maca. These two Government Sponsored Enterprises (GSEs) were set

up as “for profit” firms by the federal government.b. Because of their GSE status and the perceived government

backing of their bonds, they could borrow funds at 50 to 75 basis points cheaper than other lenders.

c. The GSE structure meant they were asked to serve two masters: (1) their stockholders and (2) Congress and federal regulators.

d. The GSEs were highly political: their top management provided key congressional leaders with large contributions and often hired away congressional staffers into high paying jobs lobbying former bosses.

e. Fannie and Freddie did not originate mortgages, instead they operated in the secondary market where they purchased the mortgages originated by banks and other lenders.

f. They dominated the secondary mortgage market.2. Regulations imposed by the Department of Housing and Urban Development (HUD) in the mid-1990s, forced Fannie and Freddie to extend more loans to low and moderate income households.3. The HUD mandates required Fannie and Freddie to extend 40% of their new loans to borrowers with incomes below the median in 1996. This mandated share was increased to 50% in 2000 and 56% in 2008.

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4. In 1999, HUD guidelines required Fannie and Freddie to accept smaller down payments and extend larger loans relative to income.5. In order to meet HUD mandates, the GSEs accepted more subprime loans.6. Mortgage originators were willing to make subprime and other high risk loans because they could be passed on to the GSEs.7. Beginning in 1995, modified regulations imposed by the Community Reinvestment Act (CRA) also lowered mortgage lending standards.8. The CRA pushed banks to extend more loans to high risk borrowers9. Mortgage loans to subprime borrowers soared as a result of these regulations10. The intent was to promote affordable housing, but the regulations eroded lending standards, fueled the housing price boom and bust, and the defaults and foreclosures that followed.

B. Low-Interest Rate Policy of the Fed During 2002-20041. During 2002-2004 the Fed supplied additional reserves to the banking system and kept short-term interest rates low.2. This policy supplied additional bank credit, increased the attractiveness of adjustable rate mortgages (ARMs), and fueled the housing price boom.3. But, as inflation increased during 2005-2006, the Fed increased interest rates and this helped turn the housing boom to a bust.

C. Increased Debt to Capital Ratio of Investment Banks1. A regulation adopted by the SEC in April 2004, permitted investment banks to leverage their capital by a larger amount and thereby extend more loans.2. Banks were required to maintain 8% capital against commercial loans, but only 4% against residential housing loans, and only 1.6% against low-risk (AAA rated) securities.3. Thus, if mortgage-backed securities had a AAA rating they could be leveraged up to 60 to 1 against bank capital.4. Major investment banks and many commercial banks bundled mortgages together and received AAA ratings for the securities backing the mortgages.5. These highly leveraged securities generated large profits for investment and commercial banks and the GSEs (Fannie and Freddie) during the housing boom.6. Based on prior history of default rates, lending institutions thought the mortgage-backed securities were quite safe.7. But they failed to recognize that the erosion of the lending standards would lead to higher default and foreclosure rates.8. As housing prices leveled off in the latter half of 2006, default rates increased and the value of the highly leveraged mortgage-backed securities plummeted.9. This led to the collapse of investment banks like Bear Stearns and Lehman Brothers, and serious problems for other financial institutions.

D. High Debt to Income Ratio of Households1. The debt to income ratio of households has risen sharply since the early 1980s2. Because mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated against housing assets.3. As a result, housing is hit hard when economic conditions weaken.

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IV. Housing, Mortgage Defaults, and the Crisis of 2008A. Regulations that eroded lending standards, the Fed’s interest rate policy, imprudent leverage lending by banks with the help of security rating firms, and the growth of household debt combined to create the financial crisis of 2008.B. The mortgage-backed securities were marketed throughout the world, and as default rates rose, the value of the securities plummeted and the crisis spread around the world.C. The default and foreclosure rates rose well before the recession started in December 2007, indicating that it was the housing crisis that caused the recession, not the other way around.

V. Lessons From the Crisis A. Regulation is a two-edged sword – it can generate adverse as well as positive resultsB. Monetary policy should focus on monetary and price stability, rather than trying to

control real output and employment.1. If it creates a stable monetary price environment, this will help promote strong

growth and a high level of employment.C. Institutional reforms that restore sound lending practices, strengthen the property rights of shareholders, and provide corporate managers with a stronger incentive to pursue long-term success would help promote recovery and future prosperity.D. To a large degree, the 2008 crisis reflects what happens when policies confront people with perverse incentives.

E. Constructive reforms need to focus on getting the incentives right.

OBJECTIVES

The headlines of 2008 were dominated by falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Federal Reserve and the U.S. Treasury. The Crisis of 2008 substantially reduced the wealth of most Americans and generated widespread concern about the future of the U.S. economy. This crisis and the response to it will probably be the most important macroeconomic event of our lives. Thus, it is vitally important to understand what happened, why things went wrong, and the lessons that need to be learned from the experience.

This special topic examines at the key events leading up to the crisis and the underlying factors that generated the collapse.


1. The housing boom and bust during the first seven years of this century are central to understanding the economic events of 2008. Exhibit 1 shows that housing prices increased slowly during the 1990s, but they began rising more rapidly toward the end of the decade. Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. But the boom turned to a bust during the second half of 2006, and the housing price decline continued throughout 2007–2008. Exhibit 2 shows that the mortgage default and foreclosure rates rate fluctuated within a narrow range for more than two decades prior to 2006. Both soared starting 2006.

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2. Be sure to discuss the four factors that caused the Crisis of 2008: (1) Change in Mortgage Lending Standards; (2) Low-Interest Rate Policy of the Fed During 2002-2004; (3) Increased Debt to Capital Ratio of Investment Banks; and (4) High Debt to Income Ratio of Households.

3. Emphasize the three lessons to be drawn from the Crisis of 2008: (1) Regulation is a two-edged sword – it can generate adverse as well as positive results; (2) Monetary policy should focus on monetary and price stability, rather than trying to control real output and employment; and (3) Institutional reforms that restore sound lending practices, strengthen the property rights of shareholders, and provide corporate managers with a stronger incentive to pursue long-term success would help promote recovery and future prosperity. To a large degree, the 2008 crisis reflects what happens when policies confront people with perverse incentives. Constructive reforms need to focus on getting the incentives right.

4. Critical Analysis Questions 2 and 6 are good discussion starters.


4. The mortgage default and housing foreclosures started to rise in 2006. The economy entered recession in December 2007. The end of housing bubble, as evidenced by the rising default and housing foreclosure rates, helped to cause the Crisis of 2008.

Special Topic 6Lessons from the Great Depression

OUTLINE

I. The Economic Record of the Great DepressionA. Large reductions in output

1. Real GDP plunged during 1929-19332. After a modest recovery during 1934-1936, real GDP fell again in 1938

B. Soaring unemployment1. The rate of unemployment rose from 3.2% in 1929 to 8.7% in 1930 and 15.9% in 1931.2. In 1932-1933, the unemployment rate soared to nearly one-quarter of the labor force.3. After declining to 14.3% in 1937, the rate of unemployment rose to 19% in 1938 and it stood at 17% in 1939, a decade after the catastrophic decline began.

C. Farm and home foreclosuresD. Bank FailuresE. Human suffering

II. Was the Great Depression Caused by the 1929 Stock Market Crash?A. The 1929 decline in stock prices reduced wealth, aggregate demand, and real output.B. Stock prices have fallen by 50% or more during other recessions, but the economy still moved toward a recovery within a year or two.C. While the decline in stock prices may have triggered the initial economic decline, the length and severity of the Great Depression were the result of other factors.

III. Why Was the Great Depression So Lengthy and Severe?A. Contraction of the Money Supply

1. The supply of money expanded slowly but steadily throughout the 1920s.2. Even though prices were relatively stable in the 1920s, the Fed increased the discount rate, four times between January 1928 and August 1929, pushing it from 3.5% to 6%.3. After the October stock market crash, the Fed aggressively sold government bonds, which drained reserves from the banking system and reduced the money supply.4. Sound monetary policy is about monetary and price stability5. The Fed failed during the 1930s: The initial monetary contraction during 1929-1933 plunged the economy into recession and the second monetary contraction during 1937-1938 stifled the prospects for recovery.6. The monetary instability of the 1930s generated uncertainty and undermined the exchange process.

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B. Smoot-Hawley Tariff Increases of 19301. Legislation passed in June 1930, increased tariffs by more than 50% on approximately 3,200 imported products.2. Like proponents of trade restrictions today, the Smoot-Hawley supporters argued the bill would “save jobs”.3. Recognizing the restrictions would reduce both trade and output, more than 1,000 economists pleaded with President Hoover to veto the bill; he rejected their advice.4. Sound monetary policy is about monetary and price stability5. The stock market, which had rebounded to levels prior to the October 1929 crash, moved steadily downward as Congress debated and passed the Smoot-Hawley bill.6. Sixty countries responded with higher tariffs on American exports and the volume of trade fell by more than 50%.7. Smoot-Hawley reduced the gains from specialization and trade, generated less tariff revenue even though the rates were higher, and plunged the economy further into recession.8. The unemployment rate was 7.8% when Smoot-Hawley was passed, but it ballooned to 23.6% just two years later.

C. Tax Increases in the Midst of a Severe Downturn1. As the Federal budget fell into deficit in 1931, Congress and the Hoover Administration instituted a huge tax increase in order to balance the budget.2. This tax increase reduced aggregate demand and the incentive to earn and invest, plunging the economy still deeper into recession.3. Recognizing the restrictions would reduce both trade and output, more than 1,000 economists pleaded with President Hoover to veto the bill; he rejected their advice.

D. Price Controls, Regulations, and Constant Policy Changes1. Many history books credit New Deal policies with the eventual end of the Great Depression.2. Some New Deal policies were helpful:

a. The Federal Deposit Insurance programb. Re-evaluation of gold and the expansion in the money supply

during 1934-1936.3. But other policies were harmful, and increased the length and severity of the Great Depression.

a. The Agricultural Adjustment Act (AAA)(1) Under the AAA, adopted in 1933, the Roosevelt

Administration tried to push prices up by restricting supply.(2) Farmers were paid to plow under portions of cotton,

corn, wheat, and other crops(3) Potato Farmers were paid to spray their potatoes with

dye so they would be unfit for human consumption(4) Cattle, sheep, and pigs were slaughtered

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(5) AAA was declared unconstitutional in 1936b. The National Industrial Recovery Act (NIRA)

(1) More than 500 industries ranging from automobiles and steel to dog food and dry cleaners were organized into cartels.

(2) Government and business leaders set production quotas, prices, wages, working hours, and distribution methods for each industry.

(3) Once approved by a majority of the firms, the regulations were legally binding on all of the firms in the industry.

(4) Government and business leaders set production quotas, prices, wages, working hours, and distribution methods for each industry.

(5) Businesses that did not comply were fined and subject to jail sentences.

(6) Prior to this legislation, price fixing of this type would have been a violation of anti-trust legislation.

(7) All of this reduced competition, promoted monopoly pricing, and undermined the market process.

IV. Fiscal Policy During the Great DepressionA. Prior to the Keynesian Revolution, the view that the Federal Budget should be

balanced was widely accepted.B. Both the Hoover and Roosevelt Administrations raised taxes in an effort to reduce the

size of the budget deficitC. Many Keynesian economists argued that prior to World War II the budget deficits

were too small to provide sufficient demand stimulus.V. Lessons from the Great Depression

A. Monetary contraction will undermine economic activity such as investment and thereby retard output and employment.

B. Trade restrictions will reduce the gains from specialization and exchange.1. They will not save domestic jobs2. Instead they will lead to inefficient use of resources and reductions in output

C. Raising taxes during a recession will reduce output and make matters worseD. Constant policy changes will generate uncertainty, retard private investment, reduce

business activity, and thereby prolong the depressed conditionsE. Good intentions are no substitute for sound policies

1. Key decision-makers such as Presidents Hoover and Roosevelt, Sen. Smoot, Rep. Hawley, other members of congress, and the monetary policy-makers of the 1930s had good intentions, but their actions tragically turned what would have been a recession into the Great Depression.

OBJECTIVES

This special topic is designed to give students an overview of the Great Depression. The first section describes the economic conditions in the Great Depression. The second section points out that while the Great Depression may have been started by the Stock Market Crash of 1929, it was

306 Special Topic 6/Lessons from the Great Depression

not the cause of it being so lengthy and severe. The third section discusses the major reasons for the Great Depression being so long and deep. The fourth section notes that the budget deficits and increases in government spending were too small to exert much impact on total demand and the level of economic activity during the 1930s. The last section highlights the lessons to be learned from the Great Depression.


1. Review Exhibit 1. It shows the Great Depression was a severe economic plunge that resulted in unemployment rates of nearly 25 percent during 1932–1933 and rates of more than 14 percent for an entire decade. It was the longest, most severe period of depressed economicconditions in American history.

2. Point out that Contrary to a popular view, the Great Depression was not caused by the 1929 stock market crash. We have had similar reductions in stock prices to those of 1929, both before and after the Great Depression, without experiencing prolonged depressed conditions like those of the 1930s.

3. Be sure to discuss the four factors that caused the Great Depression to be so severe and lengthy: (1) Monetary instability; (2) Smoot-Hawley trade bill; (3) 1932 tax increase; and (4) structural policy changes.

4. Use Exhibit 6 to demonstrate that The budget deficits and increases in governmentspending were too small to exert much impact on total demand and the level of economic activity during the 1930s.

5. Emphasize the lessons to be drawn from the Great Depression. It highlights the importance of monetary stability; free trade; avoidance of high tax rates; and avoidance of price controls, entry restraints, and persistent policy changes that generate uncertainty and undermine the security of property rights. Perhaps most important, the Great Depression vividly illustrates that good intentions are not a substitute for sound economic policy.

6. Critical Analysis Questions 3 and 4 are good discussion starters.


6. The Great Depression highlights the importance of monetary stability; free trade; avoidance of high tax rates; and avoidance of price controls, entry restraints, and persistent policy changes that generate uncertainty and undermine the security of property rights. Perhaps most important, the Great Depression vividly illustrates that good intentions are not a substitute for sound economic policy. It is clear that not all of these lessons have been learned.

Special Topic 6/Lessons from the Great Depression 307

Special Topic 7The Federal Budget and National Debt

OUTLINE

I. Deficits, Surpluses, and the National DebtA. The national debt (the sum of the outstanding bonds of the U.S. Treasury) is increased by budget deficits and reduced by budget surpluses.B. The national debt reflects the cumulative effect of all prior budget deficits and surpluses.

II. Who Owns the National Debt?A. The national debt is held by U.S. government trust funds, the Federal Reserve, private domestic investors, and foreign investors.B. It is important to distinguish between (a) the total national debt and (b) privately held government debt.

1. Only the privately held debt imposes a net interest obligation on the federal government.

III. How Does Debt Financing Influence Future Generations?A. Overview

1. For domestically held debt (about two-fifths of total privately held debt), the future generations that pay the tax liability accompanying the debt will also receive the interest income.2. Debt financing of a government activity cannot push the opportunity cost of the resources used by the government into the future. 3. Debt financing will influence future generations primarily through capital formation.

B. How Does Debt Financing Influence Capital Formation?1. The new classical view: people will increase their savings in anticipation of the higher future taxes implied by additional debt, leaving interest rates, consumption, and capital formation unaffected. 2. The traditional view: government budget deficits reduce future capital stock by increasing current consumption, pushing up real interest rates, and retarding private investment.

C. Borrowing from Foreigners1. Borrowing from foreigners accounts for approximately three-fifths of the federal debt.2. If the foreign borrowing is used to finance productive projects, future generations will inherit more productive assets that will make it possible for them to service the debt.3. Alternatively, if the borrowing from foreigners is used to finance current consumption or unproductive investment projects, the earnings from the additional capital formation will be insufficient to cover the interest payments. In this case, future generations of Americans are harmed by the debt financing.

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D. Deficits 2001-20131. As the U.S. experienced large budget deficits from 2001 to 2013, consumption increased as a share of GDP, private investment was weak, and trade deficits were large.2. This pattern indicates that the current generation was the primary beneficiary of the deficits.

IV. Government Debt: A Cross-Country ComparisonA. A large national debt relative to the size of an economy leads to a large tax burden just to pay the interest on the debt.B. Several countries have larger government debt to GDP ratios than the United States.

V. Social Security, Budget Deficits, and the National DebtA. Including Social Security in the unified budget of the federal government makes the deficit appear smaller or the surplus appear larger than would otherwise be the case.B. Social Security surpluses are intended to increase the national saving rate and stimulate additional investment, and thereby help to finance the retirement benefits of the baby boomers paying the surpluses.

1. Using these funds to finance current government expenditures completely undermines this strategy.2. Many economists argue that the federal government should balance its operating budget—that is, its budget exclusive of the Social Security system—implying a surplus at least equal to the annual surplus of the Social Security system.

VI. The Political Economy of Debt FinancingA. Spending makes it possible for politicians to provide voters with benefits now, but if financed by taxes, current costs are also highly visible.

B. Debt financing (borrowing) can push the need for higher taxes into the future, reducing the visibility of the current cost.

C. Debt financing is attractive to politicians because it makes it possible for them to spend in the current period without having to impose visible costs in the form of current taxes.

VII. Politics, Demographics, Federal Debt, and the Dangers AheadA. During 2009-2010, 40% of federal expenditures were financed by borrowing.B. The large deficits have pushed the federal debt as a share of the economy to levels not seen since WWII.C. The retirement of the baby boomer generation will push spending on Social Security and Medicare upward making it more difficult to control the growth of the federal debt.D. What will happen if the federal government does not control the growth of its debt?E. Lending to countries with a large debt to GDP ratio is risky and as this ratio increases the governments will have to pay higher interest rates. This will make it still more difficult to control the budget deficit.

1. This happened in Ireland in 1986, Belgium in 1994, and Greece 2011.

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Special Topic 7/ The Federal Budget and National Debt 311

F. A country such as the U.S. with a central bank, is highly unlikely to directly default on its debt. G. Instead, it is far more likely to use money creation to meet its debt obligations.

1. In turn this will lead to inflation.OBJECTIVES

This special topic is designed to enhance student understanding of budget deficits and the national debt. Several alternative views are presented. The recent teaching experience of the authors indicates that there is a strong student interest in the topics of this application.


1. Be sure to point out that the budget deficit is a “flow” concept (like water flowing into a bath tub), while the national debt is a “stock” concept (like amount of water in the tub).

2. Go over Exhibit 1, which presents data for the 1960–2012 period for both the federal budget deficit and the national debt as a percent of GDP. Note that when the budget deficit as a percent of GDP is less than the growth of real output, the federal debt will decline relative to the size of the economy and vice versa.

3. Review Exhibit 2, which shows that over two-fifths of the national debt is owned by U.S. government agencies and Federal Reserve banks. For this portion of the debt, the government both pays and receives the interest (except for the expenses of the Fed). Only the privately held federal debt, the portion of the national debt owned by domestic and foreign investors, generates a net interest obligation for the government.

4. Would a tax increase reduce the size of a budget deficit? Or would Congress and the president simply spend all or most of the additional revenue? Discuss these questions with your students. The public choice perspective on the deficit at the close of this application provides a framework for thinking about this issue.

5. Critical Analysis questions 1, 3, 4, and 8 provide the basis for a stimulating class discussion of the major topics of this chapter.

6. In talking about the size of the “real” budget deficit, be sure to include a discussion of the sizable off-budget commitments that are being made, but not yet funded, and that therefore do not appear in the current budget.

7. Be sure to discuss the impact of the Social Security surplus on the deficit. That is, inclusion of Social Security in the budget calculations makes the deficit appear smaller or the surplus larger than would be true if these funds were omitted.

8. To help students remember that the crucial issue whenever borrowing is being used to fund expenditures is whether the assets being acquired are worth more than the debt that will go with it; use an analogy to the fact that most students are running substantial current deficits and are becoming better off at the same time. This also can be used to discuss the human capital formation versus entertainment consumption trade-offs involved in students’ time and effort at college.

312 Special Topic 7/ The Federal Budget and National Debt

9. Many will find it worthwhile to conduct a short discussion of why it is so much harder to devise simple yet workable fiscal policy rules than it is to do the same for monetary policy. Compare fiscal and monetary policy with regard to the number of decision makers and policy variables involved and the ability of policy makers to use “smoke and mirrors” to disguise the budgetary effects of their actions.


4. The Social Security system ran a surplus until 2010 a surplus, which reduced the size of the deficit. If the Social Security system is not reformed, the size of the deficit will be greater a decade from now as the surplus has disappeared. The size of the deficit does matter because a larger debt (and accompanying interest liability) will require higher tax rates. The deadweight losses and disincentive effects of taxes will be directly related to the magnitude of the tax rates.

Special Topic 8The Economics of Health Care

OUTLINE

I. Structure of the Health Care IndustryA. Spending on health care has soared in recent decades.

1. Measured as a share of the economy, total health care spending has risen from 5.2 percent in 1960 to 9.2 percent in 1980, and 17.9 percent in 2011.2. Expenditures on both Medicare and Medicaid have soared during the last three decades.

B. Discrimination Against the Direct Purchase of Health Insurance1. The tax system encourages employees to demand and employers to provide low-deductible, small co-payment health insurance policies.

a. As a result of this distortion, more health care bills are paid for by third-party insurers and fewer are covered directly by the health care consumer or through high-deductible insurance plans.

b. The linking of health insurance to employment also reduces employee mobility and increases the number of people without any health insurance coverage.

II. Third-Party Payments and Health Care InflationA. Since the mid-1960s, the direct expenditures of health care consumers gradually declined and those of third-party payees expanded.

1. The out-of-pocket spending of consumers accounted for only 14 percent of health care spending in 2011, down from 55 percent in 1960.

B. The growth of subsidies to health care consumers and greater reliance on third-party payments of recent decades

1. increased the demand for medical services and 2. reduced the incentive of both health care consumers and providers to

economize.3. Both of these factors contributed to the health care inflation and soaring expenditures of recent decades.

III. The Growth of the Elderly Population and Health CareA. In the next two decades, the elderly population will grow more rapidly than in recent decades.

1. Under the current Medicare program, this will increase the demand for health care services and the share of medical payments financed by a third party.2. It can also be expected to result in higher health care prices and increased taxes for the finance of Medicare.

IV. American Health Care at a CrossroadsA. Perverse Incentives and the Provision of Health Care

1. The structure of government programs relies on third-party payments that erode the incentive to economize.

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2. The huge tax advantage provided for the purchase of health insurance throughone’s employer undermines competition and makes it very costly for

individuals or families to purchase a health insurance policy that fits their preferences.3. State regulations that force insurers operating in the state to cover numerous items such as in vitro fertilization, drug rehabilitation, marriage counseling, acupuncture, and massage therapy also drive up costs and make it still more difficult for consumers to purchase a policy that fits their preferences.4. Regulations prevent consumers from purchasing a health insurance plan offered in another state.

B. Controlling Health Care Spending1. The Patient Protection and Affordable Care Act sought to control the future growth of health care spending.

a. The act will set more than 7,000 reimbursement rates for medical procedures.

b. All doctors will be required to keep patient records in electronic form. c. The breadth of mandated coverage and number of people insured will

increase. d. The share of medical bills covered by third-party payments will expand.

e. The legislation focuses on the demand side of the market and does nothing to promote additional supply.

f. Economic analysis indicates that the results of the act are likely to be disappointing

V. How to Improve the Performance of the Health Care IndustryA. Several reforms would help avert the crisis that will occur when baby boomers retire.

1. Equalize the tax treatment of out-of-pocket medical expenses and the direct purchase of health insurance with that of health insurance purchased through an employer. 2. Allow the residents of each state to purchase health care from out of state providers.3. Encourage health savings accounts and the direct payment of medical bills from the accounts.4. Encourage the purchase of catastrophic health insurance and discourage the purchase of policies with first-dollar coverage and small co-payments.5. Shift Medicare at least partly from a reimbursement service to a defined-benefit plan.6. Place more emphasis on the supply side of the health care market.

OBJECTIVES

This special topic analyzes why spending on health care has soared in recent decades. We focus on the impact of subsidies to health care consumers and the greater reliance on third-party payments. We then discuss why health care spending and inflation will likely rise over the next

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Special Topic 8/The Economics of Health Care 315

two decades as baby boomers begin to retire. The special topic concludes with five reforms that would make health care more efficient and cost effective.


1. Review with students the data of Exhibits 1 and 2. Exhibit 1 documents that health care spending has soared over the past four decades. Measured as a share of the economy, total health care spending has risen from 5.2 percent in 1960 to 9.2 percent in 1980, and 17.9 percent in 20111. Exhibit 2 shows that, adjusted for inflation, the 2011 expenditures on Medicare were three times the level of 1990 and 12 times the figure for 1970. The real Medicaid expenditures have risen even more rapidly.

2. Exhibit 3 shows that direct expenditures of health care consumers has fallen dramatically and those of third-party payees expanded. The out-of-pocket spending of consumers accounted for only 14 percent of health care spending in 2011, down from 55 percent in 1960.

3. Be sure to explain that the growth of subsidies to health care consumers and greater reliance on third-party payments of recent decades (a) increased the demand for medical services and (b) reduced the incentive of both health-care consumers and providers to economize. Both of these factors contributed to the healthcare inflation and soaring expenditures of recent decades.

4. Discuss the impact of the retirement of baby boomers will have on the health care system. Under the current Medicare program, this will increase the demand for health care services and the share of medical payments financed by a third party. It can also be expected to result in higher healthcare prices and increased taxes for the finance of Medicare.

5. An interesting topic for class discussion is how to reform the heath care system. The text suggests six reforms:a. Equalize the tax treatment of out-of-pocket medical expenses and the direct purchase of

health insurance with that of health insurance purchased through an employer.b. Allow the residents of each state to purchase health care from out of state providers.c. Encourage health savings accounts and the direct payment of medical bills from the

accounts.d. Encourage the purchase of catastrophic health insurance and discourage the purchase of

policies with first-dollar coverage and small co-payments.e. Shift Medicare at least partly from a reimbursement service to a defined-benefit plan.f. Place more emphasis on the supply side of the health care market.

6. Class discussion of Critical Analysis questions 1, 3, and 5 will help students integrate the major concepts of this chapter.


1. The growth of government subsidies to health care consumers and the accompanying expansion in third-party payments pushed prices of medical services upward. There are two reasons for this outcome. First, subsidies like those provided by Medicare and Medicaid, will increase the demand for medical care. In turn, the stronger demand will lead to higher prices.

316 Special Topic 8/The Economics of Health Care

Second, the growth of third party payments reduced the incentive of consumers to economize and shop for low-cost services, and for producers to provide the goods at a low price.

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Special Topic 9Earnings Differences Between Men and Women

OUTLINE

I. Employment Discrimination and Earnings of WomenA. Besides employment discrimination, differences in specialization within the family, educational choices, and career goals contribute to the gender earnings gap.

II. Marital Status and the Earnings of WomenA. Besides employment discrimination, differences in specialization within the family, educational choices, and career goals contribute to the gender earnings gap.

III. The Changing Workforce Objectives of WomenA. As career and educational choices of women have become more like men during the last 20 years, the earnings gap has fallen.1. This trend is likely to continue in the future as more and more women prepare and

acquire experience in high-paying professional and business areas that have been traditionally dominated by men.

OBJECTIVES

This feature analyzes the earnings differences between men and women and the changing economic role of women. It documents that women earn less than men. We then discuss possible reasons for the gender earnings gap. Besides employment discrimination, differences in specialization within the family, educational choices, and career goals contribute to the gender earnings gap. We also show that as career and educational choices of women have become more like men during the last 30 years, the earnings gap has fallen.


1. Students have difficulty grasping the impact of employment discrimination on earnings. Be sure to point out that earnings differences according to race or sex may be the result of factors other than employment discrimination. When seeking to isolate the impact of current employment discrimination, comparisons should be made between male and female workers of similar productivity and job preferences.

2. Exhibits 1 and 2 provide data on the female-male earnings ratio, which is useful for stimulating class discussion. The following questions should help get the discussion going. How much of the male-female earnings gap is the result of employment discrimination? If employment discrimination is the major cause of earnings differences according to sex, how does one account for the 91 percent female/male earnings ratio of full-time/full-year never married persons in 2008-2009? Is the situation improving or deteriorating? Are the employment preferences of females changing? What can we expect in the future?

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1. False. On average, men and women differ with regard to other factors that influence earnings, including career objectives, commitment to the labor force, physical strength, and location mobility. As long as these differences remain, earnings differences between men and women will continue even in the absence of employment discrimination.

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Special Topic 10Do Labor Unions Increase the Wages of Workers?

OUTLINE

I. Union Membership as a Share of the WorkforceA. Union Membership Trend

1. Since the mid-1950s, union membership has declined.2. It declined slowly as a share of the labor force during 1955–1970.3. It has fallen more rapidly during the last couple of decades.

a. In 2012, union members comprised only 11 percent of non-farm employment.

B. Causes of Union Decline1. Employment growth has been in sectors where unions have been weak.

a. Small firms.b. Sunbelt.c. Services.

2. Competition has eroded union strength in several important industries.a. Foreign competition has risen.b. Deregulation of transportation and communication industries.

C. Unionization by SectorD. Unionization by State

II. How Do Unions Influence Wages?A. Restrict the supply of competitive inputs, including nonunion workers.B. Apply bargaining power enforced by a strike or threat of one.C. Increase the demand for the labor service of union members.

III. What Gives a Union Strength?A. If a union is to be strong, the demand for union labor must be inelastic.

1. This will enable the union to obtain large wage increases while suffering only modest reductions in employment

B. Determinants of Elasticity1. Demand for union labor will be more inelastic when:

a. There is an absence of good substitutes for the services of union employees.

b. The demand for the product produced by the union labor is highly inelastic.

c. The union labor input is a small share of the total cost of production.d. The supply of available substitutes is highly inelastic.

IV. Wages of Union and Nonunion EmployeesA. Unions and Wages

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1. Studies suggest that the wage premium of union members relative to similar non-union workers increased during the 1970s.

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Special Topic 12/Do Labor Unions Increase the Wages of Workers? 323

2. Since the late 1970s, union-nonunion private-sector wage differential has been in the 20 percent and 28 percent range.

B. Profits and Employment1. If unions increase the wages of unionized firms above the competitive market level, then profits will fall unless productivity rises.

a. Evidence shows that unions reduce profits.2. The growth of both productivity and employment tend to lag in the unionized sector.

a. Resources shift away from unionized operations and toward nonunion firms.

V. Impact of Unions on the Wages of All WorkersA. Unions and Labor’s Share

1. Unions increase the wages of their members but not for all workers.a. They have not increased the share of national income going to

labor (human capital rather than physical capital).2. The real wages of workers are a reflection of their productivity rather than the share of the work force that is unionized.

OBJECTIVES

In this application, we analyze the way in which unions affect wages, employment, and working conditions. Unions can increase the earnings of their members in three basic ways: (a) by restricting the supply of competitive resources, including nonunion labor; (b) by increasing the demand for union labor, most notably by applying political pressure; and (c) through bargaining power and the threat of a strike. Each of these three methods is reviewed in the text.

Not all unions are able to have a positive influence on the wages of their members. A union is strong when: (a) there are not good substitutes for union labor; (b) the demand for the product produced by the union labor is highly inelastic; (c) the union labor comprises a small share of the total production costs; and (d) the supply of substitute inputs is highly inelastic. Absence of these conditions will weaken the economic power of a union.

The impact of labor unions on the share of income going to human capital (labor) is also analyzed.


1. Note that union membership increased between 1930 and 1950. However, measured as a share of the labor force, union membership peaked out in the mid-1950s. As a proportion of non-farm employment, union membership declined from 33 percent in 1955 to 11 percent in 2012 (see Exhibit 1).

2. Point out that work stoppages are usually costly to both striking employees and to employers. Thus, a strike (or the threat of one) does give both management and labor an incentive to reach an agreement.

3. Exhibit 4 illustrates two general strategies utilized by unions to increase the wages of their members. As Exhibit 4 illustrates, while supply restrictions and bargaining power may be

324 Special Topic 10/Do Labor Unions Increase the Wages of Workers?

utilized to increase the wages of union members, both will also lead to a decline in the employment of labor.

Special Topic 12/Do Labor Unions Increase the Wages of Workers? 325

4. Policies that increase the demand for union labor will lead to an increase in both wages and employment. Tariff restrictions and the Davis–Bacon Act provide examples of policies that have been utilized to expand the demand for union labor.

5. Competition from products supplied by nonunion labor often limits the market power of a labor union. The recent experience of the United Auto Workers and the Teamsters illustrates this point.

6. Be sure to distinguish clearly between the ability of unions to (a) increase the earnings of union members, and (b) increase the share of income allocated to labor. Although ample evidence indicates that they have accomplished (a), neither economic theory nor empirical evidence suggests that they can achieve (b).

7. The Critical Analysis questions of this chapter will stimulate classroom discussion. Our experience indicates that students will have a particularly strong interest in questions 3, 4, 5, and 7.

8. An interesting connection between this application and public choice analysis is to ask students why unionization efforts in recent years have been far more successful in the public sector than the private sector.

9. To connect the issues of unionization and international trade, ask students whether union members in exporting industries would agree or disagree with those in import-substitute industries on whether protectionism is a good idea. This can be used to illustrate that we all want free trade for what we buy because it is then cheaper for us to buy it, but we want restrictions on our competitors, which means we can then get a higher price for what we sell. This helps explain why there are so few people who support free trade for all goods.


2. Unions will be able to increase the wages of its members when the demand for union labor must be inelastic. This will enable the union to obtain large wage increases while suffering only modest reductions in employment. Demand for union labor will be more inelastic when: (a) there is an absence of good substitutes for the services of union employees; (b) the demand for the product produced by the union labor is highly inelastic; (c) the union labor input is a small share of the total cost of production; and (d) the supply of available substitutes is highly inelastic. A union is unlikely to have much impact on wages if the demand for unionized labor is highly elastic.

Special Topic 11The Question of Resource Exhaustion

OUTLINE

I. Doomsday ForecastsA. Forecasts that the world will soon run out of various key resources have been made for centuries.

1. These forecasts have consistently been wrong.II. Why Have the Doomsday Forecasts Been Wrong?

A. When resources are allocated by markets, increased scarcity leads to higher prices.

1. The higher prices will strengthen the incentive for (a) users to reduce their consumption, (b) suppliers to search for ways to expand future supply, and (c) both producers and users to search for substitutes.

a. All of these adjustments will increase future supply relative to demand and make it highly unlikely that the resource will be depleted.

III. Proved Reserves and Running Out of ResourcesA. Proved reserves are the verifiable quantity of a resource available at current prices and technology.

B. They are not the total supply of the resource that will be available in the future.1. Proved reserves can be expanded with improvements in technology and increases

in prices.IV. Are Resources Becoming Scarcer?

A. The trend in the price of resources has been downward for at least a century, indicating that the relative scarcity of most resources has been declining.

V. Renewable Resources A. Renewable resources are those that are renewed in nature, like water flows, or grown, like timber.B. Are Forests Disappearing?

1. Where strong market economies exist the forces of supply and demand are keeping forests from declining severely.

C. Technology and Land Management.1. By raising productivity per acre, technology reduces the amount of land required to

produce food and fiber.D. Those resources, too, can become scarcer and more expensive in a market depending on (1) the ability of users to find substitutes and reduce the quantity demanded and, over time, the demand; and (2) producers’ ability to produce more output at the higher price and to find substitute products to bring to market for buyers.

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VI. Natural Resources When Markets are not Allowed to Function Fully? A. When property rights are poorly defined or when regulations make a resource non-tradable, waste will result because the resource will often be directed toward less valuable uses.

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Special Topic 13/Are We Running Out of Resources? 329

1. Water Marketsa. Water supply problems reflect the fact that in most situations, water

markets are missing or are incomplete.

OBJECTIVES

This application analyzes whether we are running out of resources. The chapter starts with a discussion of doomsday forecasts and whey they have been wrong. The special then analyzes whether resources are becoming scarcer and discusses proved reserves. The special topic also some of the difficulties that arise in resource markets when they are not allowed to fully function.


1. Be sure to discuss the doomsday forecasts that have been made for centuries that the world will soon run out of various key resources. These forecasts have consistently been wrong. , When resources are allocated by market increased scarcity of resources leads to higher prices. The higher prices will strengthen the incentive for (a) users to reduce their consumption, (b) suppliers to search for ways to expand future supply, and (c) both producers and users to search for substitutes. All of these adjustments will increase future supply relative to demand and make it highly unlikely that the resource will be depleted. Be sure to discuss doomsday forecasts and why they have been wrong.

2. Point out proved reserves are the verifiable quantity of a resource available at current prices and technology. They are not the total supply of the resource that will be available in the future. Proved reserves can be expanded with improvements in technology and increases in prices.

3. The trend in the price of resources has been downward for at least a century, indicating that the relative scarcity of most resources has been declining. To help make this point, review Exhibit 1. It shows that for most mineral resources, existing proved reserves are constantly being used up but are being amply replaced by the “proving” of new reserves from existing resources in the ground.

4. Use Exhibit 2 to point out that virtually there was no increase in oil price between and 1949 and the 1970s. Exhibit 2 shows that since then, however, the real price of crude oil has risen sharply, fallen back, and then risen sharply again since 2000.

5. Renewable resources are those that are renewed in nature, like water flows, or grown, like timber. Those resources, too, can become scarcer and more expensive in a market depending on (1) the ability of users to find substitutes and reduce the quantity demanded and, over time, the demand; and (2) producers’ ability to produce more output at the higher price and to find substitute products to bring to market for buyers.

6. It is important to discuss the consequences of not letting markets not fully function in natural resources markets. When property rights are poorly defined or when regulations make a resource non-tradable, waste will result because the resource will often be directed toward less valuable uses. Water supply problems reflect the fact that in most situations, water markets are missing or are incomplete.

330 Special Topic 11/Are We Running Out of Resources?

7. Critical Analysis questions 1, 3, and 5 focus on the major topics of this chapter and are suitable for use as classroom discussion starters.


1. When resources are allocated by markets, increased scarcity leads to higher prices. The higher prices will strengthen the incentive for (a) users to reduce their consumption, (b) suppliers to search for ways to expand future supply, and (c) both producers and users to search for substitutes. All of these adjustments will increase future supply relative to demand and make it highly unlikely that the resource will be depleted.

Special Topic 12Difficult Environmental Cases and the Role of

Government

OUTLINE

I. Government Regulation and the EnvironmentA. When it is difficult to assign and enforce private property rights, markets often results in outcomes that are inefficient. 1. This is often the case when large numbers of persons engage in actions that impose

harm on others.2. Government regulation has some promise, but also poses problems of its own.

II. The Economics of Global WarmingA. There is much uncertainty regarding global warming. Scientists agree on some facts, but disagree on many others.B. Mitigation versus Adaptation Strategy1. Making changes as actual problems as they occur may be a better way of dealing

with the uncertainty regarding global warming.III. Market-Like Schemes: Reducing the Cost of Specific Regulations

A. Market-like schemes for reducing pollution 1. Pollution charges or taxes.

2. Emission standards and tradable permitsB. Market-like schemes can reduce the costs of reaching a chosen environmental goal, but the programs do not help in choosing the right goal.

IV. Property Rights as a Tool for Government PolicyA. Ocean Fisheries: A Lack of Property Rights Causes Overfishing

1 Overfishing in the oceans is a classic example of overexploitation of a resource that is not privately owned. To reduce the harvest so that a sufficient breeding stock is left, regulators typically mandate a shorter fishing season.2. A strategy increasingly used around the world is to replace limits on season length with property rights strategies for the control of fishing. A prominent example is the adoption of ITQs, or individual transferable quotas, which give fishers ownership of a portion of the annual allowed catch.3. In the past, fishers were part of a wasteful and dangerous “race to fish.” ITQs allow either individual fishers, or groups of fishers acting together, to keep for themselves the gains from slower and more careful fishing.

V. Government Ownership of Resources and Provision of ServicesA. Federal ownership of national parks, as with other lands, has brought troublesome results along with benefits, but there seems to be progress in moving closer to market solutions that provide better information and incentives for federal managers.

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OBJECTIVES

This special topic examines the possibilities for achieving environmental goals though governmental control of pollution and of natural resources, as well as the problems that arise from government action in these areas. The special topic discusses the issue of global warming. It also discusses the use of market-like schemes to achieve environmental goals. Lastly, it outlines the advantages and disadvantages of government ownership of resources and services.


1. Point out that even though environmental decisions are often made outside a market context, the basic principles of economics still apply. That is:a. Purposeful choices, influenced by prices (or their absence) and other incentives, are made

without full knowledge.b. Values are subjective.c. The secondary effects of decisions are often important.

2. When enforceable property rights cannot be put into place, government regulation is an alternative mechanism that can promote wise use of resources and the environment. However, regulatory choices are not based on information and incentives from market prices. Thus, regulation has the same potential for inefficiency and ineffectiveness faced by the socialist governments whose citizens have suffered many environmental harms.

3. Critical Analysis questions 1, 3, and 4 should serve to stimulate a lively class discussion on the major topics of this chapter.


2. Without prices, the vital flow of information and incentives is missing. Without positive prices, park managers would neither know nor have the incentive to provide the things visitors most want in their visits to the park.

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1 THE ECONOMIC APPROACH - Find the cheapest test …testbankeasy.eu/sample/Solution Manual for Economics... · Web viewPart 2 Text Overview This section, which is organized by chapter,