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The following chapter summaries are mostly based on the McConnell & Brue text “Economics- 16th Ed.” Details available at http://highered.mcgraw-hill.com/sites/0072819359/information_center_view0/ note arrow means “leads to,” “results in,” “causes”

Chapter 1 – The Nature and Method of Economics Economics is the study of scarcity and choice Key concept- opportunity cost: for a person to get more of one thing... he/she must forego getting something else

e.g. to get food must pay (give up) money In economics rational behavior is assumed, e.g. people want more goods for less money Assumption: we all want to increase utility = happiness, satisfaction Rational self-interest not same as selfishness, e.g. one reason for donating to charity is because of derived satisfaction Key concept- marginal analysis- comparisons of marginal benefits and marginal costs, e.g.: keep eating until full, that is... until marginal benefit = marginal cost...

i.e. not worth it to pay for more food when already full Why study economics? As John Maynard Keynes said “indeed, the world is ruled by little else.” Most practical ideology is found in economics Economics for citizenship- intelligent participation in a democracy requires a knowledge of fundamental economics However, from the 2004 “A Fifty College Study” by the American Council of Trustees and Alumni: “One of this study’s most extraordinary findings was that not one college or university among those studied requires a general course in economics” http://liberalorder.typepad.com/the_liberal_order/files/HollowCoreWeb.pdf Understanding of concept of marginal benefits / marginal costs are required for business management Ultimately economics is a social science seeking society’s overall fullest advantages and best interests Article 1.1 – “The Opportunity Cost of Economics Education” – see end of this chapter

Figure 1.1 – Economic Methodology

Figure 1.1 - economics methodology Scientific method: observe real-world activity, then...

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formulate hypothesis statement, e.g. “seems A happens because of B,” then... test hypothesis by gathering facts, then... modify and strengthen hypothesis to become a theory Theoretical economics- the process of deriving economic theories and principles from observation Role of economic theorizing is to arrange facts, interpret them, and generalize from them Economic theories and principles- are statements about behavior of the economy that enable prediction of the probable effects of certain actions Principle (also called “law”) - a strong, established theory, Model - made from a combination of theories and/or principles, often graphic in form Generalizations - economic theories, principles and models are generalizations, e.g. when personal income goes up people tend to consume more, but some individuals will not Other-things-equal assumption often used - e.g.: when price of product A goes down people will buy more of A, assuming quality of A has not also gone down Abstractions - simplifications that omit irrelevant facts Policy economics - economic theory and data formulation of government policies and courses of action solve economic problems and achieve economic goals Economic policy is most often applied by governments after problems arise, but with economic analysis we can predict problems and apply policy in advance, e.g.: Federal Reserve Bank (central bank of the U.S.) anticipation of recession reduce interest rates increase business investment avoid recession Note throughout this summary the terms “firms” and “businesses” have the same meaning - private (as opposed to government) profit-seeking organizations The four steps of economic policy: 1- statement of goal, e.g. maintain full employment 2- determine policy options, e.g. lower taxes or raise amount of government spending 3- implement the policy 4- evaluate the result and effectiveness the implemented policy Some of the economic issues and goals government policymakers must consider: economic growth full employment increase personal income higher living standards price-level stability, i.e. avoid inflation economic freedom and efficiency through minimization of regulations taxation and government spending equitable income and wealth redistribution reduction of poverty economic security, e.g. social security payments for retirees expansion of free trade with other countries Economic goals often involve tradeoffs e.g.: redistribution of income/wealth transfers to the poor increased taxation of the rich reduced opportunities for the rich to invest including starting new businesses, and...

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reduced incentives for the poor to retrain, relocate, work hard slowed economic growth, slowed job growth

The two main categories of economics study: macroeconomics and microeconomics Macroeconomics - examines the economy as a whole and its main sectors: government sector, household sector, business sector An “aggregate” is a collection of specific economic units treated as one unit, e.g. the millions of consumers lumped together and called “consumers” Macroeconomics seeks to obtain an overview or outline of the economy, i.e. examines the beach, not the grains of sand Microeconomics - examines details of specific economic units... such as one household (typically a nuclear family), company, or unit of government... i.e. examines the sand grains not the beach Positive and normative economics Positive economics - focuses on facts and cause-and-effect relationships includes theory development and testing avoids right-wrong value judgments central question- “what is?” example positive economic statement- “unemployment is high” Normative economics - involve value judgments such as what the economy should be like what goals are desirable and what policy actions can achieve those goals central question- “what ought to be?” example normative economic statement- “better to have overall lower standards of living than a high unemployment rate” most disagreements among economists are regarding normative economics, e.g.: economists agree on the principle of supply-demand curves, but... do not agree on what is the best level of taxation

Pitfalls to sound reasoning Discussions about economics can become personal and emotional, but one must think objectively and accurately, must avoid non-logical thinking Biases cloud thinking and interfere with objective analysis, must avoid preconceptions e.g. “large corporations are evil” Loaded terminology, must avoid language such as “all taxes are bad” Definitions and terms used in economics sometimes differ from common usage, e.g. “investment” used by economists strictly means purchase of new capital assets used for production/ output such as machinery Fallacy of composition - assumption that what is true for one individual is necessarily true for a group e.g. if you stand you will get a better view, but...

if everyone stands the view for everyone is not improved e.g. if one farmer’s crop is larger than normal he will get sharply higher income, but... not if all farmers’ crops are larger- because prices will be down due to increased supply

Causation fallacies - mistakes in identifying which is cause and which is effect Post ad hoc fallacy (also called “after this, therefore because of this” fallacy) - just because event A precedes event B, A does not necessarily B e.g. rain dance does not rain

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Correlation versus causation fallacy - correlation between event X and event Y does not mean one causes the other, perhaps they are both caused by event Z e.g. rising river X does not greener grass Y, rather recent rain Z causes both e.g. country A does not get richer because country B is getting richer, but rather because both have increased trade with country C End of chapter 1, next - The Economizing Problem Go to the following link for background information for concepts in this chapter: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter1/origin_of_the_idea.html Article 1.1 – “The Opportunity Cost of Economics Education” The following is a selection from the article: The Opportunity Cost of Economics Education By ROBERT H. FRANK The New York Times September 1, 2005 SHORTLY after I began teaching, more than 30 years ago, three friends in different cities independently sent me the same New Yorker cartoon depicting a woman introducing a man to a friend at a party. "Mary, I'd like you to meet Marty Thorndecker," she began. "He's an economist, but he's really very nice." Cartoons are data. That people find them amusing usually tells us something about reality. Curious about what drove responses to the economist cartoon, I began asking about the disappointed looks that appeared on people's faces when they first discovered I was an economist. Invariably they mentioned unpleasant memories of an introductory economics course. "There were all those incomprehensible graphs," was a common refrain. Needless to say, a course can be valuable even if unpleasant. Unfortunately, however, most students seem to emerge from introductory economics courses without having learned even the most important basic principles. According to one recent study, their ability to answer simple economic questions several months after leaving the course is not measurably different from that of people who never took a principles course. What explains such abysmal performance? One problem is the encyclopedic range typical of introductory courses. As the Nobel laureate George J. Stigler wrote more than 40 years ago, "The brief exposure to each of a vast array of techniques and problems leaves the student no basic economic logic with which to analyze the economic questions he will face as a citizen." Another problem is that the introductory course is increasingly tailored not for the majority of students for whom it will be their only economics course, but for the negligible fraction who will go on to become professional economists. Such courses focus on the mathematical models that have become the cornerstone of modern economic theory. These models prove daunting for many students and leave them little time and energy to focus on how basic economic principles help explain everyday behavior. But there is an even more troubling explanation for students' failure to learn fundamental economic concepts. It is that many of their professors may have only a tenuous grasp of these concepts, since they, too, took encyclopedic introductory courses, followed by advanced courses that were even more technical. Consider, for example, the cost-benefit principle, which says that an action should be taken only if its benefit is at least as great as its cost. Although this principle sounds disarmingly simple, many people fail to apply it correctly because they do not understand what constitutes a relevant cost. For instance, the true economic cost of attending a concert - its "opportunity cost" - includes not just the explicit cost of the ticket but also the implicit value of other opportunities that must be forgone to attend the concert... http://www.ssc.wisc.edu/~gwallace/ECON_101/Resources/NYT_09_01_05.pdf

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Chapter 2 - The Economizing Problem

Fundamental elements of economics are scarcity, choices, and costs Economizing problem- wants are unlimited and insatiable, but resources are limited Objective of all economic activity is to fulfill needs and wants Economic goals: individuals- obtain goods and services for needs, satisfaction, pleasure, and fulfillment businesses- growth and profit governments- provide stable and prosperous economic environment

Two categories of goods/services: Consumer goods- that directly satisfy consumer needs/wants Capital goods (or simply “capital”) - equipment, machinery, tools, supplies used to create other goods Economic resources- all natural, human and manufactured resources used for production of goods and services Two types of economic resources: 1- property resources – land, raw materials, capital 2- human resources – labor and entrepreneurial ability Note that ecomomists estimate labor costs are about 75% of all costs for U.S. firms Resource categories as follows are collectively called “the factors of production” 1a- land- including all natural resources, such as water, minerals 1b- capital- equipment, machinery, tools used to create goods and services in economics the term “investment” means the acquisition of capital goods (in finance it means buying any asset) 2a- labor- physical and mental talents of individuals used in producing goods and services 2b- entrepreneurial ability- owners/managers activities, featuring: risking personal wealth innovating, inventing, setting goals, motivating bringing the other resources (1a, 1b, 2a above) together and managing them making main, strategic business decisions Resource income types income to entrepreneurs is called “profits” income to those who supply labor is called “wages” income to owners of property and assets is called “rent” and “interest” The four factors of production (1a, 1b, 2a, and 2b above) are limited in quantity, therefore productive output and wealth generation is limited labor unemployment results when labor is plentiful relative to the other three factors in year 2002 U.S. output was $36,000 per person; in the poorest nations it was as low as $300 Economics is concerned with efficient use of resources, getting the most from the available four factors of production maximizing business output/profits, and... consumer satisfaction Full employment- current full use of all available 1a, 1b, 2a, and 2b resources Full production- efficient current use of all available 1a, 1b, 2a, and 2b resources to achieve maximum possible output Therefore, without efficiency it is possible to have full employment, but not full production

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Two types of efficiency- productive efficiency and allocative efficiency Productive efficiency- least costly production of any mix of goods and services if have only $100 in resources... and can make a radio for $10... then have $90 remaining to make other things... but if could make radio more efficiently for $5... would have $95 remaining to make other things So, productive efficiency is a micro, narrow view of and approach to efficiency – make products efficiently regardless of what consumers want Allocative efficiency- production of the particular mix of goods and services most wanted by society, i.e. mix that maximizes people’s well-being do not have allocative efficiency if make radios for $5 each, but making more than consumers want allocative efficiency means produce desired mix of goods/services, each item at lowest cost allocative efficiency means apportion limited resources among industries so we obtain the mix of goods/services consumers want So, allocative efficiency is a macro, wide view of and approach to efficiency, produce efficiently and produce what consumers want The production possibilities model (PPM) Because resources are limited, amount of produced goods/ services is limited, therefore choices must be made Four assumptions while creating PPM: 1- full employment and productive efficiency- the four factors of production are fully used and used most efficiently at least cost 2- fixed resources- available supplies of the four factors of production are fixed in quantity and quality 3- fixed level of technology 4- two goods produced and consumed in the model economy The following PPM will show only two goods- pizzas and robots pizzas to represent consumer goods that directly satisfy consumer wants robots to represent capital goods, i.e. equipment and tools needed to make pizzas In this model: limited and fixed resources, and... the economy output is at full capacity making two goods, pizzas and robots to get more of one good must give up some of the other

Table 2.1 - Production Possibilities Table, production possibilities of pizzas and robots with full employment and productive efficiency

Production Alternatives Type of product A B C D E Pizzas (in hundred thousands) 0 1 2 3 4 Robots (in thousands) 10 9 7 4 0

Production possibilities table 2.1 above, shows what combinations of products can be made with current resources and at full output; for example at alternative A can make 10,000 robots and no pizzas

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Figure 2.1 – Production Possibilities Curve

Figure 2.1 production possibilities curve (PPC) includes table 2.1 data All possible combinations of maximum production are along the curve For the economy to operate at points on the PPC must have full employment and productive efficiency Inside the line, yellow area, e.g. point I, combinations are possible but economy is not achieving maximum possible production, i.e. not achieving full employment and/ or productive efficiency Combinations outside the curve, e.g. point U, are not attainable with current resources and technology Law of increasing opportunity cost- the higher quantity of a product being produced, the greater its opportunity cost Opportunity cost here- amount of one product (e.g. robots) that must be given up to obtain one unit of the other product (e.g. pizzas) For example in figure 2.1 and table 2.1 above: On figure 2.1 when moving from point A to B, looking at table 2.1 we see opportunity cost of one unit additional pizza is one less unit of robots when moving from point B to C, cost of one additional pizza is two less units of robots when moving from point C to D, cost of one additional pizza is three less units of robots when moving from point D to E cost of one additional pizza is four less units of robots Slope of the curve is bowed, rather than straight, because of increasing opportunity costs Economic rationale for law of increasing opportunity costs- resources cannot be used equally efficiently for any quantity of productive use e.g.: once all bricklayers are employed, a carpenter forced into bricklaying will not be as productive as a trained bricklayer e.g.: with a factory of set size and equipment and 100 workers, cannot add more and more workers and continue to get a proportional increase in production for each added worker, and eventually it would be so crowded production would go down The PPC illustrates four concepts: 1- scarcity, shown by the area outside the curve representing unattainable combinations of output 2- choice, can have combinations of goods along the curve 3- opportunity cost, the curve shows if you want more of one product, you must give up some of the other product

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4- law of increasing opportunity costs- the concave shape of the curve shows you have to give up more and more of one product to get less and less of the other product Allocative efficiency If we have full employment of human and property economic resources, and... Have productive efficiency, i.e. make things in the most efficient way... We will be maximizing output, i.e. be on a point on the PPC However, maximum output does not mean we are making the mix of products most desired by society, e.g. maybe we are making 4 units of pizzas and no robots, but society wants some robots If we have allocative efficiency it means we are making the desired mix point of robots and pizzas Finding the desired mix point involves comparison of marginal benefits and marginal cost Any economic activity should expanded if marginal benefit is greater than marginal cost, i.e. until: Marginal Benefit = Marginal Cost (MB = MC) Two main MB and MC concepts: 1- the current unit of a good a person consumes yields more satisfaction than the next unit of the same good 2- the current unit of a good a person produces is less costly to produce than the next unit of the same good

Figure 2.2 – Allocative Efficiency: MB = MC

Looking at figure 2.2, we see intersection point MB=MC optimum quantity of pizzas is 2 units of pizzas, or 200,000 pizzas If we are making only 100,000 pizzas, marginal benefit for the next pizza is $15, but marginal cost is only $5, therefore we make more pizzas By making the next pizza at quantity 1, in effect we are giving up one unit of something else we value at $5 for that next pizza we value at $15, so we make the trade since $15 > $5 This is how the free market sets prices and quantities produced unit price MB customers pay for a product decreases... until unit cost MC for producers rise to equal that unit price

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It can be said all actions in life involve MB and MC decisions E.g. you sit down and play guitar for fun... until the MC, the time given up to play guitar when you could be doing something else... is no longer worth the MB... i.e. eventually you reach the point of satisfaction, where MC = MB... and move on to spend your time or other scarce resource on something else

Figure 2.3 – Unemployment, Productive Inefficiency, and the Production Possibilities Curve

In figure 2.3: Any point inside the PPC, e.g. point I, represents unemployment and/or productive inefficiency The arrows indicate that, by achieving full employment and productive efficiency the economy could operate on the PPC, meaning the economy could produce more of one or both products than at point I Over time, a growing free market economy allows two things: 1- increases in resource supplies growing population and better training/ education allows more and better labor and entrepreneurial abilities increasing amount of capital (machinery and tools) discovery and utilization of new natural resources 2- advances in technology, new and better products and new and better ways to make them; more efficient use of natural resources to minimize depletion

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Figure 2.4 – Economic Growth and the Production Possibilities Curve

Economic growth means more production capacity, the ability to produce a larger total output, e.g. in figure 2.4 movement of PP curve outward Here is a table showing the information in figure 2.4:

Table 2.2 - Production Possibilities Table, Increased Production Resulting From a Growing Economy

Production Alternatives Type of product A B C D E Pizzas (in hundred thousands) 0 2 4 6 8 Robots (in thousands) 14 12 9 5 0

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Figure 2.5 – Economic growth affected by choice of present and future goods, countries Alta and Zorn

Viewing figure 2.5, an economy’s present choice of positions on its production possibilities curve helps determine the curve’s future location Country Alta’s current choice favoring present goods, (pizzas) will cause some outward shift of the curve in the future Country Zorn’s current choice favoring “future goods,” (robots) as made by Zorn, will result in a greater outward shift of the curve in the future Future goods include capital goods e.g. robots, tools, and education and are ingredients of economic growth Present goods are consumer goods that provide immediate satisfaction such as food e.g. pizza and clothing This is one argument for need of a large “rich” segment of people in a country, they will invest most of their excess income in future goods (e.g. shares of stock in public corporations), not having to spend it on present goods In this example countries Alta and Zorn at first are the same, except Alta favors present goods and Zorn favors future goods Zorn will achieve greater economic growth, shown by the farther right position of future production possibilities curve Production possibilities curve, interactive graph at: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter2/interactive_graphs.html International trade enriches the local economy, moving the production possibilities curve to the right Specialization and trade enables a country to get more of a desired good “A” at less sacrifice of other good “B,” e.g. sacrifice 2 units of robots rather than 3 to get an extra unit of pizza Output gains from greater international specialization and trade are the equivalent of economic growth, i.e. pushing to right the PPC Economic systems types There are two general types of economic system- the market system, and the command system

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All economies have features of both, countries must decide where on the market-command spectrum they want to be, most political conflicts result from elements of making this decision, i.e. how much government involvement in the economy is best The market system (capitalism, free enterprise) Private ownership of factors of production including property Each person seeks to maximize one’s own satisfaction or profit through their own decisions regarding consumption or investment Product and resource allocation and prices are determined through free and open markets Competition between many firms in the marketplace The U.S. is an example of market system: government role in economics is minimized government is involved in many ways as providing goods and services not provided by the private sector such as monetary and judicial systems, and pre-college schooling some redistribution of income, such as welfare and social security transfer payments Extreme case is laissez-faire, government role limited to law enforcement including protecting private property, and maintaining optimum environment for operation of market system; e.g. schools not provided by government; the U.S. was close to this prior to the Great Depression of the 1930s The command system (socialism, government control) Government ownership and control of most factors of production and most property Government decides what is satisfactory, and how satisfaction can be gained Government allocates goods and production factors, and sets prices Government controls marketplace with many regulations and restrictions Government owns most large industries including oil and steel Extreme case is communism, the state owns and controls everything including all housing North Korea and Cuba are examples of command system, almost total government role in economics; some small street vendor businesses are allowed

Figure 2.6 – The Circular Flow Model

Figure 2.6 circular flow model shows how a market system works, Red counterclockwise arrows show “real flow” of resources and finished goods and inputs Black clockwise arrows show “money flow” of income and consumption

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A market economy has two main groups of decision makers- households and businesses (government will be added in a more detailed model in chapter 5) Public = households + businesses (but not including government) A market economy has two markets, resource market and product market Resource market This is where productive resources needed by businesses are bought and sold Viewing the top red counter-clockwise arrows, households sell their resource inputs - labor, land, capital, entrepreneurial ability - via the resource market to businesses needed to create products Viewing the top black clockwise arrows, businesses then pay for those resources Product market This is where goods and services produced by businesses are bought and sold Viewing the bottom red counter-clockwise arrows, businesses sell their products to households Viewing the bottom black clockwise arrows, households pay for the products End of Chapter 2, chapter - Individual Markets, Demand and Supply Go to the following link for background information for concepts in this chapter: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter2/origin_of_the_idea.html

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Chapter 3 – Individual Markets: Demand and Supply Market – institution or mechanism that brings together buyers (“demanders”) and sellers (“suppliers”) of goods, services and resources Market examples- local retail store, websites such as Amazon and EBay, New York Stock Exchange, newspaper containing a want ad for a company desiring to hire a new employee Demand schedule – table or curve showing amounts of a product consumers are willing and able to buy at various prices during a given time period

Table 3.1 – An individual buyer’s demand schedule for corn

Price per bushel Bushels demanded per week $5 10 4 20 3 35 2 55 1 80

Table 3.1 is a hypothetical demand schedule for a single consumer purchasing bushels of corn As expected, the lower the price, the more quantity is demanded “Willing and able” is key, must want to buy and be able to buy, in this case at price $5 the buyer is willing and able to buy 10 bushels per week Time period also key, stating a buyer will buy 10 bushels at $5 has no meaning because it could be over a lifetime; assumption of a limited time period is made when no time period is specified Law of demand- all else equal, as price falls the quantity demanded rises, and as price rises the quantity demanded falls “All else equal” is key, e.g. buyers’ perception of quality stays the same as price goes up For example in the 1980s Gibson raised the prices of their guitars, buyers perceived better quality and bought a higher number of Gibson guitars, although actual quality did not improve proportionally Why the inverse relationship between price and quantity demanded? - common sense, people naturally buy higher quantities when prices are lower - diminishing marginal utility - in any time period a buyer of a product will derive less satisfaction (benefit, utility) from each successive unit of the product bought/ consumed - income effect- lower prices increase purchasing power of consumer, i.e. when a person buys at a lower price more income remains enabling person to make more purchases - substitution effect- when product A (corn) price falls and similar product B (soybeans) stays same, buyers substitute product A for product B, e.g. consume more corn products and less soybean products

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Figure 3.1 – An Individual Buyer’s Demand Curve For Corn

Demand curve (D) - curve on a graph showing quantities demanded at various prices Figure 3.1 demand curve is a graph of the relationship between price and quantity demanded, this plots the information in table 3.1 The above example assumes one buyer for corn, but in a competitive market there is more than one buyer By adding up quantities demanded by all buyers we move from individual demand to market demand

Table 3.2 – Market demand for corn, three buyers Quantity demanded, bushels, per buyer

Total bushels

Price per First Second Third demanded bushel buyer buyer buyer per week

$5 10 + 12 + 8 = 30 4 20 + 23 + 17 = 60 3 35 + 39 + 26 = 100 2 55 + 60 + 39 = 154 1 80 + 87 + 54 = 221

Table 3.2 shows an example of three buyers, with their resulting totals demanded

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Figure 3.2 – Market Demand For Corn, Three Buyers

Figure 3.2 shows the resulting move to the right of the demand curve from D1 to D2 when market demand of three buyers is totaled You can visualize the D2 curve as continuing downward and to the right for quantities at prices $2 and $1 A demand curve can be a representation of an entire market with thousands or more buyers, the quantities of corn are multiplied, but the downward slope of the demand curve is similar reflecting higher quantities demanded at lower prices Determinants of demand- factors other than price affecting purchase quantity, including: Consumers’ tastes- if one loses interest in guitars, will not buy more if guitar prices go down Number of buyers in market, e.g. trade agreements have reduced foreign trade barriers resulting in more buyers overseas and higher sales of U.S. farm products there Income- rising income results in more purchases of “normal goods” (but not for “inferior goods” e.g. used clothing) Prices of related goods: if price of a substitute good goes down, such as soybean products, consumers buy less corn products if a price of a complementary good such as gasoline goes up consumers buy less motor oil, because they are driving their cars less Future expectations- people bought more gasoline ahead of Y2K (January 1, 2000) because they were worried about possible disruptions of supply of gasoline Change in demand results if any of the determinants of demand change (conditions other than price) The demand curve will move left for any decrease in demand (less quantity demanded at all prices) The demand curve will move right for any increase in demand (more quantity demanded at all prices) For example, if number of buyers (a condition other than price) increase the demand curve will shift right When drawing a demand curve, since only quantity and price is shown, the determinants of demand are assumed to remain constant for the time period In figure 3.2, the demand curve shifts right from D1 to D2 because of increased number of buyers, even though price remains the same, this is a change in demand Change in quantity demanded is a movement along a current demand curve This is a straightforward change in quantity demanded because of change of price

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In figure 3.2 this is shown by movement along D1 curve from one red dot to another Supply schedule - table or curve showing amounts of a product suppliers are willing and able to supply at various prices during a given time period

Table 3.3 – An individual supplier’s supply of corn

Quantity Price per Supplied bushel per week $5 60 4 50 3 35 2 20 1 5

Law of supply- all else equal, as price rises the quantity supplied rises, and as price falls the quantity demanded falls Prices serve as an incentive for a supplier, the higher the price the more of a product is made Amount supplied depends on cost of production, if revenue from additional products made will be more than costs of making those additional products, a company will supply more of those products Supply amount increases until: marginal cost = marginal benefit - or - cost of one more item = benefit gained from one more item E.g. if it costs $70 a barrel to pump out oil from an old deep well in Texas, the oil company will not pump it out until demand has driven the price of a barrel over $70

Figure 3.3 – Supply Curve, Individual Supplier’s Supply of Corn

Supply curve (S) - curve on a graph showing quantities supplied at various prices Figure 3.3 shows one supplier’s supply curve, to get the full market supply curve all the individual suppliers’ curves would be added together, similar to demand table 3.2 and figure 3.2 above

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Figure 3.4 – Change In a Determinant of Supply Means a Change In Quantity Supplied

Determinants of supply- factors other than price that affect quantity supplied of a product, including: Resource prices- e.g. decreased cost of supplies used for production more of a product will be offered to the market E.g. in figure 3.4, assume a beginning market selling price of $3 and quantity demanded of 35 bushels, then: sudden decrease of fertilizer costs occur production cost per bushel decreases quantity supplied at price $3 increases from 35 to 60 Technology- as technology advances, costs of production go down and higher quantities are produced, e.g. modern farmers using tractors produce more than previous farmers growing by hand Taxes and subsidies- these raise or reduce supplier costs, shifting the supply curve left or right Prices of other goods- “substitution of production” can occur when a supplier can make more than one product e.g. if price of soybeans is higher than corn, a farmer will supply soybeans, resulting in a left shift of supply curve for corn

Price expectations- farmers anticipating a higher wheat price in the future might withhold some of their current wheat harvest from the market, causing a decrease in the current supply of wheat (shift to left of supply curve) Number of sellers- as more suppliers enter the market the farther to the right the supply curve shifts Change in supply results if any conditions change other than price, as we can see from the above Supply change caused by change of determinants of supply, causing a shift to a new supply curve e.g. from S to S1 in figure 3.4 The supply curve will move left for any decrease in supply The supply curve will move right for any increase in supply When drawing a supply curve, since only quantity and price is shown, the determinants of supply are assumed to remain constant for the time period

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Change in quantity supplied is a movement along a current supply curve This is a straightforward change in quantity supplied because of change of price In figure 3.3 this is shown by movement along S curve from one red dot to another Supply and Demand – Market Equilibrium We can now bring supply and demand curves together to find the point where market price and quantity is determined

Figure 3.5 – Market supply of and demand for corn

Figure 3.5 above combines the previous demand and supply tables for corn, demand on left and supply on right Surplus- is excess supply, shown on right side in blue print above the 7,000 quantity E.g. at price of $4 per bushel farmers are willing to supply 10,000 bushels, but at that price buyers are only willing to buy 4,000 bushels, the resulting surplus production of corn is 6,000 bushels This could happen if the government set an artificially high price of $4 rather than letting the market decide price, which would be $3 Shortage- is too little supply, shown in blue below the 7,000 quantity E.g. at price of $2 a bushel farmers are willing to supply 4,000 bushels, but at that price buyers want to buy 11,000 bushels; again this could happen if the government set an artificially low price of $2 Equilibrium price- price where there is no excess supply nor excess demand, also called “market clearing price;” in the table 3.5 example this is $3 Equilibrium quantity- results from equilibrium price, no fewer nor more quantities are demanded nor supplied in the market In summary: At a too high price suppliers want to sell more than consumers want to buy resulting in surplus At a too low price consumers want to buy more than suppliers want to sell resulting in shortage

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Figure 3.6 – Equilibrium Price and Quantity

Above demand and supply curves are combined in figure 3.6 Point E1 is market-clearing equilibrium point E.g. distance between points A and B shows the surplus of 6000 bushels if price is set by government at $4 Supply and demand, interactive graph at: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter3/interactive_graphs.html Rationing function of prices- ability of competing forces of supply and demand to establish a price at which selling and buying decisions clear the market Any change in determinants of supply or determinants of demand would move either S or D curve left or right resulting in a new supply-demand equilibrium point E.g. in figure 3.6 an increase in quantity demanded, caused by increased number of buyers determinant, would shift the demand curve to the right, e.g. intersecting the supply curve at point B What would the new equilibrium quantity supplied and price be?- 10,000 bushels and $4 However, if there is a subsequent increase in quantity supplied, e.g. caused by increased number of suppliers determinant, the supply curve would shift to the right, e.g. causing intersection at point E2 What would the quantity supplied and price be?- 14,000 bushels and $3 In a free market a product’s price tends to stabilize or even go down when its supply determinants are not scarce E.g. abundant cheap overseas labor S curve shift to right decrease in price of DVD players... despite growing demand for DVD players, which moves D curve to right but more slowly

A product’s price tends go up when its supply determinants are scarce, such as the increasing price of gasoline because of dwindling/ controlled supply of crude oil

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Figure 3.7 – Price Ceiling Results In Shortage

Price ceiling- maximum legal price a seller may charge for a good or service Government-set price ceiling resulting in shortage example is shown in figure 3.7 Substituting gasoline for corn if the US government mandated a gasoline pump price of $2 a gallon 11 units would be demanded... but only 4 units would be supplied to the market (e.g. only easiest-to-pump-lowest-cost Saudi oil) shortage of 7 units, and... long lines at gas stations, and... lack of incentives to conserve energy and develop new sources of energy Another result of government-set low price ceiling would be development of a black market some people would wait in line for many hours and... then buy as much gasoline as they could, then.... turn around and sell it at a price higher than $2 to those who don’t want to wait in line One real-world example of government-set low price ceiling is the rent price controls for apartments in New York City: the lower-than-market set rent prices long wait lists for those wanting to rent, and... lack of interest in renting by building owners, building owners thinking “why rent apartments when I can

convert the units to condos and sell at higher market prices?”)

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Figure 3.8 – Price Floor Resulting In Unemployment

Price floor- a minimum price fixed by the government, often used when society feels the free market system does not provide a sufficient income for a certain group of resource suppliers An example is minimum wage laws Looking at figure 3.8: if the government mandates artificially high minimum wage price (floor) of $4... supply of unskilled labor becomes point B 10 units... but demand for unskilled labor is only point A 4 units... with resulting unemployment of 7 – 4 = 3 units Note overall unskilled laborers are better off at wage of $3: $3 x 7 = $21 total income, but... $4 x 4 = $16 total income Artificially high minimum wage price floor results fewer unskilled laborers employed smaller companies that cannot bear the artificially high costs go out of business cost/ price of products increase companies decide to manufacture overseas rather than in the U.S. Note the use of the term “artificially high” here; if the market price for unskilled labor is $3.00 and a law is passed mandating a minimum wage of $3.00, there will be no unemployment caused Article 3.1 – “Why the minimum wage doesn't matter” – see end of this chapter Price ceilings and price floors, interactive graph at: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter3/interactive_graphs.html End of chapter 3, next : Chapter 3w – Applications and Extensions of Supply and Demand Analysis Article 3.1 – “Why the minimum wage doesn't matter” Why the minimum wage doesn't matter The once-reliable bugbear has lost much of its political bite. And there are better ways to help the working poor. By Elaine S. Povich, FSB Magazine August 21 2006: 9:53 AM EDT

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WASHINGTON, D.C. (FSB Magazine) -- If you were looking for an opponent of minimum-wage increases, you might turn to someone such as Mazyar Rahimzadeh, 25. He's got a half-million dollars in debt hanging over him, employs 35 workers, and just opened his second restaurant, Bijan, in Walnut Creek, Calif. Yet when he's asked about the California legislature's proposed bill to raise the state's minimum wage by 50 cents an hour, he just shrugs. "It wouldn't make that much of a difference," he says, pointing out that he already pays his workers more than the state's current minimum of $6.75 an hour. This election season, the minimum wage has once again become a political rallying point. The Chicago City Council's recent decision to require big-box retailers to pay all employees at least $10 an hour, plus $3 an hour in benefits, is just the beginning. Democrats in Congress are renewing their efforts to raise the federal minimum wage - stuck at $5.15 since 1997 - as a way to paint themselves as the party of the little guy. Most Republicans, while wary of polls that show public support for a higher wage, oppose it on free-market grounds, especially when addressing small-business audiences. (The Republican-controlled House approved a minimum-wage hike only after it was attached to a cut in the estate tax in late July, a move that doomed the bill in the Senate.) But as Rahimzadeh's shrugging response indicates, the issue may no longer hold the power it once did to provoke heated passions among most business owners or even many low-income workers. "I don't see the minimum wage as something that can drive a Democratic message or become a political flash point," says Amy Walter, an analyst for the Cook Political Report, who closely follows congressional races. To be sure, the half-million Americans who earn the minimum would welcome a raise. And the major small-business lobbying groups have rallied against further increases. Employers of entry-level workers in businesses such as restaurants, landscaping firms, and retail shops, especially outside the major cities, are the most adamant opponents. But since that last minimum-wage hike in 1997, inflation has pushed up most wages to the point that only 0.3% of full-time workers are paid the minimum. (One percent make less than that, either illegally or because they receive tips.) In a poll of small-business owners released in March by Wells Fargo and the Gallup Organization, 86% of those surveyed said the minimum wage had no effect on them or their hiring practices. And even if the wage went up by 10%, some 75% said there would be no effect on their business. Only 14% of small-business owners who said they were thinking about hiring a new employee told the pollsters they would hire at the minimum wage. Dennis Jacobe, Gallup's chief economist, who conducted the survey, says that its results could be partially explained by the growing number of states and localities that have set their minimum wages higher than the federal level. Even more important, Jacobe says, the typical small business hires fewer unskilled workers and more specialists than in years past. And in a tight labor market, businesses are finding that they need to pay higher wages, even to entry-level employees, to find good workers and retain them. Between 1997 and 2004, the most recent year for which the U.S. Bureau of Labor Statistics has figures, the average hourly wage rose 8.3%. The minimum wage has become irrelevant to a growing majority of business owners and workers. But if a minimum-wage hike won't raise many hackles, that doesn't mean that it will be without victims - specifically, those businesses that do pay the minimum to many of their workers and operate in competitive industries. "We cannot raise prices," says Jack Wolcott, the owner of a bookstore in Corvallis, Ore. "So we have to consider discontinuing slower-moving items to compensate [for higher wages]." It gets more difficult to justify the burden on small employers of a mandated wage hike when you consider that the Bureau of Labor Statistics estimates that fewer than 30% of minimum wage earners are considered "heads of household," according to Richard Burkhauser, professor of policy analysis and management at Cornell University. The other 70%? Mostly relatively well-off part-timers, such as suburban teenagers working summer jobs. Boosting the minimum wage, then, would benefit many workers who aren't poor, and punish many businesses owners who can't afford it. There are more targeted ways to help the working poor. Burkhauser proposes an increase in the earned income tax credit, which would essentially rebate some of the 15.3% federal payroll tax that is paid even by workers too poor to owe income taxes. Stuart Butler, vice president for domestic and economic policy at the conservative Heritage Foundation, suggests giving further tax incentives to the working poor, including offering refundable health-care tax credits and repealing the federal unemployment tax.

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Why haven't these options gotten as much attention from lawmakers as has the minimum wage? Just a guess, but maybe it's because they don't offer as many juicy election-year opportunities to pit workers and employers against each other. http://money.cnn.com/2006/08/18/magazines/fsb/whos_afraid_minimumwage.fsb/index.htm?postversion=2006082109 other minimum wage articles: http://money.cnn.com/2006/11/08/news/economy/minimum_wage/index.htm?postversion=2006110915 http://money.cnn.com/2006/08/18/magazines/fsb/whos_afraid_minimumwage.fsb/index.htm?postversion=2006082109

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Chapter 3w – Applications and Extensions of Supply and Demand Analysis

Note – this chapter was later added by the authors. This chapter is available for download the following link: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/web_chapter3/origin_of_the_idea.html

Figure 3w.1 – Example- Change In Supply: Market for Lettuce After Crop Freeze Results In Decreased Supply

Original supply curve for lettuce is S1, original demand curve for lettuce is D1, original price is P1, original quantity supplied is Q1 a weather freeze occurs smaller quantity of lettuce produced shift of the supply curve to S2... weather does not affect demand for lettuce, so demand curve remains D1 price becomes P2 and quantity supplied becomes Q2 This is an example of change in supply (shift to a new supply curve), and... change in quantity demanded (movement along an existing demand curve)

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Figure 3w.2 – Example- Change In Demand: Market For American Flag Sales After National Tragedy Results In Increased Demand

Original supply curve for American flags is S1 original demand curve for American flags is D1 original price is P1, original quantity supplied is Q1 The 9/11 terrorist attacks result in larger quantity of American flags demanded, shifting the demand curve to D2 The attack does not enable suppliers to make more flags... and potential new suppliers know the demand will soon return to normal... so new suppliers do not enter the market Result is price becomes P2 and quantity supplied becomes Q2 This is an example of change in demand (shift to a new demand curve)... and change in quantity supplied (movement along an existing supply curve) Note that raised prices are not from “price gouging,” but rather from the normal workings of the economy if the government did not allow temporary higher prices for flags... the suppliers would refuse to supply more than Q1... because they would be selling at a loss, e.g.... paying workers overtime but not able to include overtime costs in selling price If the government did not allow temporary higher prices for flags... the resulting shortage of Q2-Q1... would bid up prices of flags already available to a price well above P2... a black market for flags would arise... profits going to black marketers rather than legal producers/suppliers government tax collections are also hurt because black marketers do not collect sales taxes This government interference would create great profits for criminal black markets.. these criminals would have plenty of money to bribe police/ government officials... to look the other way and to keep the price restrictions in place

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Figure 3w.3 – Example- Change In Both Supply and Demand: The Market For Pink Salmon After Change In Technology and

Change In Consumer Tastes Results In Increased supply and Decreased Demand

Original supply curve for pink salmon is S1 original demand curve is D1 original price is P1 original quantity supplied is Q1 Improved fishing technology including larger and better-equipped boats increased supply of pink salmon, shifting the supply curve right to S2 quantity supplied becomes Q2 and price becomes P2 But then consumer tastes change away from lower quality pink salmon... to higher quality Chinook salmon shift of demand curve for pink salmon left to D2 quantity of pink salmon supplied becomes Q3 and price becomes P3 this is an example of change in supply = shift to a new supply curve... and change in demand = shift to a new demand curve

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Figure 3w.4 – Example- Change In Both Supply and Demand: The Market For Gasoline Decreased Supply and Increased Demand

Original supply curve for gasoline is S1 original demand curve is D1 original price is $1.00 original quantity supplied is Q1 Supply interruptions such as resulting from damage caused by hurricanes reduced supply shift of supply curve left to S2 quantity supplied becomes Q2 and price becomes $1.50 Then, more use of SUV’s in the U.S... and more people starting to use autos in China increase of consumer demand for gasoline demand curve shifts right to D2 quantity supplied becomes Q3 and price becomes $3.00 Oil companies are large by nature... so in the above model even if their net profit margin is and remains a normal 6%... during move from D1 to D2 (price move from $1 to $3)... their total amount of profits will increase... and it will seem to many that oil companies are unfairly benefiting... from the higher prices created in the marketplace Note that along supply curve S2... the gasoline supplied at quantity/price Q3/$3... is more costly for the producers than Q1/$1 remember, price = cost, since cost includes a normal profit As always, the assumption is: no illegal artificial monopolistic shortages have been created by companies or governments there is free, open, transparent competition between suppliers Note, it is always in the best interest of an individual supplier to have a gain economic profits... and the way to maximize economic profits is to establish a monopoly it is always in the best interest of the economy as a whole and for consumers to have free markets so, a vital role of government is to enforce and assure free markets Legal ways for individual suppliers of goods to gain economic profits include... differentiate their products from those of other companies obtain patents, copyrights, and trademarks

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Normal profit and economic profit will be discussed in the next chapter 4

Figure 3w.5 – Example- Change In Both Supply and Demand: The Market For Sushi Results In Increased Demand And increased Supply

Original supply curve for sushi is S1... original demand curve is D1... original price is P1... original quantity supplied is Q1 Then changing tastes increase of demand for sushi... shifting demand curve right to D2... quantity supplied becomes Q2... and price becomes P2 Then more sushi restaurants open shifting supply curve right to S2... quantity supplied becomes Q3... and price returns to P1 Note that... it is easy for new producers to enter the sushi market... low capital investment required to open a restaurant... than for new producers to enter the gasoline supply market... high capital investment required Preset Prices Examples As discussed previously: a) when prices are fixed below market prices – producer shortages result b) when prices are fixed above market prices – producer surpluses result These cases mostly occur when government gets involved in pricing decisions... but also can occur in the free market, as the two following examples show

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Figure 3w.6 – Example: Market for Olympics Women’s Figure Skating Finals Tickets, Price Fixed Below Market Price

Ticket price fixed in advance at $75, based on predicted D demand curve This arena seats 20,000 people which is the fixed quantity supplied... indicated by vertical supply line S... no matter what quantity is demanded... the supplied amount of seats cannot change However, unexpectedly a low-ranked skater from the host country... is near the top going into the finals... resulting in shift right of demand curve for seats to D1 What are the results from the change in demand? they could have filled a (unavailable) 37,000 seat arena at price $75, or... they could have charged $180 per seat and still filled the existing 20,000 seat arena However, since arena size nor ticket price can be changed... a shortage of 17,000 tickets results, and under-pricing of tickets by $105 This results in a market for “ticket scalping”... some people who have bought tickets on the “primary market” for $75... sell them on the street “secondary market” for $180 Secondary markets may be illegal “black markets”... such as when local laws prohibit ticket scalping... or legal- such as trade of collectables, or stocks in the stock market Note that in some cases ticket prices are purposely under-priced, for example... superstar rock bands may sell tickets for their performances at lower than market price... to create buying frenzies and long lines... in an attempt to create an image of super-popularity and good-will “concern for our fans” but the result? - ticket scalpers make the profits that should go to the rock bands

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Figure 3w.7 – Example Market For Olympics Curling Finals Tickets Price Fixed Above Market Price

Ticket price fixed in advance is $75, based on predicted D demand curve This arena seats 10,000 people which is the fixed quantity supplied indicated by vertical supply line S no matter what quantity is demanded... the supplied amount of seats cannot change However, unexpectedly a high-ranked curling team from the host country... has lost and will not be in the finals... resulting in shift left of demand curve for seats to D1 What are the results from the change in demand? they could fill a 3,000 seat arena at price $75... but, since 10,000 seats are available, demanded price for tickets has fallen to $25 What are the results from the change in demand from D to D1? they would have to lower ticket price to $25 to fill this 10,000 seat arena, but... at ticket price $75 only 3,000 people plan to show up Since arena size nor ticket price can be changed... a surplus of 7,000 tickets results Would the Olympics have been better off if they had charged $25 from the beginning? – yes $25 x 10,000 attendance = $250,000 but $75 x 3,000 attendance = $225,000 In these situations in many instances ticket prices are reduced... for example performance-day half-price tickets for theatre plays sold at kiosks in New York City Situation of nonpriced goods - “problem of the commons,” e.g., historical plight of the buffalo goods that are owned in common by society and available for no-cost, unrestricted taking One example is the buffalo of the American western plains... at one time there were hundreds of thousands of buffalo... but then were nearly wiped out by “white” hunters... and now just a relative few remain In the 1800s buffalo were a nonpriced good owned in common by everyone... and could be freely taken

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Figure 3w.8a – Example- Nonpriced Good – Buffalo Before Arrival of White Hunters

Supply curve S is vertical... representing the stable, renewable, sustainable population of buffalo... on the plains before the white hunters came The supply of buffalo in nature (as opposed to raised on farms) is independent of any price on buffalo In actuality, there is no price on buffalo nor on any nonpriced goods... the hunters did not have to pay anything for the taking of buffalo, the price was zero The demand curve D above shows the weak demand for buffalo before the hunters came... only a relative few, Q1, were taken by Native Americans Since here there is only one real price, zero... the demand curve is hypothetical- what the curve might be if there was a price In figure 3W.8a we really only have to look at Q1 and Q2 along the bottom zero price line... what does it show?... there was small demand for buffalo... compared to the quantity available (supplied)... resulting in a large surplus (Q2-Q1) of buffalo on the plains Q2 could have been taken without affecting the Q2 supply of buffalo Because of the surplus... Q1 was taken by Native Americans rather than Q2... and the supply curve S was moving to the right over the years... meaning there became a population of millions of buffalo on the plains

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Figure 3w.8b – Example- Nonpriced Good – Buffalo After Arrival of White Hunters

Then the railroad came west and with it white hunters... who shot buffalo for food, hides, and for the sport of it As shown in figure 3w.8b, the increased demand shifted the demand curve for buffalo to the right again we only have to look at Q3 and Q1 along the bottom zero price line... and we can see the surplus became a shortage The sustainable supply of buffalo decreased and the supply curve S shifted left... in this example to Q3... but eventually to near zero quantity In the end zero price, excess demand, and declining supply... meant near extinction of the buffalo Nonpriced goods such as fish... tend to get over-consumed and exhausted lacking governmental controls Nonpriced goods is one case where government intervention in the marketplace is justified... using bans or number limits on taking certain species, set seasons, and costly licenses... all of which reduce demand and stabilize supply In the ideal situation demand is adjusted by these government controls... so the demand curve intersects the supply curve at an optimum supply quantity... In above figure 3w.8b , because of government intervention... the demand curve D would be moved to the left... so it intersects the desired S supply curve... and supply stabilizes at desired quantity Q3 along the bottom zero price line note that the zero price line would become $50 or whatever the hunting license fee was Today hunting buffalo is outlawed on public lands and their population has stabilized at about 350,000 Consumer and Producer Surplus Everyone has bought something thinking... “I just bought this at $10, but I would have paid up to $15 for it”... the $5 difference is consumer surplus Consumer surplus- the difference between the maximum price... a consumer is willing to pay for a product... and the actual price that consumer pays for that product Consumer surplus is realized on most purchases... only in those cases when you buy something...

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only after spending time agonizing over whether or not to buy it... are you not getting consumer surplus You would spend hours in a supermarket... if you did not get a consumer surplus for almost every item you buy... everything that you do not buy... e.g. that expensive snack you looked at but put back on the shelf... has no consumer surplus However you might want to load up on every item at the supermarket... if they were all discounted 90% E.g., you have your eye on a handbag priced at $80 but don’t buy it... then it goes on sale for $70 and you buy it... therefore your consumer surplus is somewhere between $0 and $10

Figure 3w.9 – Example- Consumer Surplus – HB Handbags

In figure 3w9, blue triangle consumer surplus area... shows the difference between... the maximum prices a certain individual consumers are willing to pay for this type HB handbag... and the lower market equilibrium price these handbags sell for in stores... selling price here shown to be $80 At quantity of 10,000 handbags supplied/bought... consumers are willing to pay for this HB handbag... the total dollar sum of the amounts represented... by the blue triangle area and brown rectangle area But because all consumers only pay the amount in the brown rectangle area... it means the blue triangle represents consumer surplus What is the total market dollar amount paid in this case?- brown rectangle 10,000 x $80 = $800,000 What is the total market consumer surplus in this case?- blue triangle (10,000 x $80) /2 = $400,000

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Table 3w.1 – Consumer Surplus, HB Handbag

Maximum Actual Price Price Willing (Equilibrium Consumer

Person To Pay for HB Price) Surplus

Julia $130 $80 = $50 Angelina $120 $80 = $40

Kate $110 $80 = $30 Jennifer $100 $80 = $20

Betty $90 $80 = $10 Heather $80 $80 = $0

Table 3w.1 shows the resulting consumer surplus for six of the consumers in this HB handbag market Julia values these handbags the most... she may or may not be the richest of these six people... and when she buys at the store price of $80... she gains a consumer surplus of $50... and is delighted as she leaves the store... if it would have been priced $130 she still would have bought Heather values these handbags the least... and when she buys at the store price of $80... she gains a consumer surplus of $0... she leaves the store wondering whether or not she should have bought the handbag... if it had been priced $81 she would not have bought What of consumers who value these handbags at, say $70, point a on the demand curve?... they will buy later if/when they go on sale for $70 or less In the case of a price lowered to $70, along the demand curve on figure 3w.9... you can approximate handbag quantity sold of about 11,000... so a lowered $70 price would result in about 1,000 more bags sold Note that the consumer surplus blue area would increase as a result of the lower $70 price Producer surplus- the difference between the minimum price... a producer is willing to accept for a product and the actual price that producer receives for that product Producer surplus is realized on most sales... only in those cases when the producer does not receive economic profit... does the producer not get producer surplus Most producers would be willing to accept a lower-than equilibrium price... if that is required to sell the product... This is why discounted-price “sale” of handbags at stores... can still often give handbag producers profits As in all business some producers are making more profits than others... even when all of them are selling a comparable product at the same price

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Figure 3w.10 – Example- Producer Surplus – Handbags

In above figure 3w10, the going price for this type handbag is $80 Upper blue triangle producer surplus area shows the difference between: the minimum payment handbag companies are willing to accept for these handbags... and the higher equilibrium price of $80 they receive

For quantity 10,000 the handbag producers receive the dollar total of the amount shown by... the upper blue triangle plus the lower brown quadrangle... = $80 x 10,000 = $800,000 The blue upper triangle area is the total producer surplus = $60 x 10,000 / 2 = $300,000 But to stay in this business the producers as a group only need to receive... the amounts shown in the brown lower quadrangle, or $800,000 - $300,000 = $500,000

Table 3w.2 – Producer Surplus, Handbags

Actual Unit Cost and Selling Price Minimum

Handbag (Equilibrium Acceptable Producer Company Price) Price Surplus

Satel $80 - $20 = $60

Vutoon $80 - $35 = $45 Satchell $80 - $50 = $30

Doir $80 - $60 = $20 Fende $80 - $70 = $10 Gacci $80 - $80 = $0

Table 3w.2 shows the six producers in figure 3w.10 handbag market Due to differences in production costs... we see that lowest-cost-producer Satel’s minimum acceptable selling price is $20... Vutoon’s is $35, and on down the list Since the market equilibrium for this type handbag is $80... the price all these producers can charge is $80, does not matter what their production costs are

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As a result, at equilibrium price $80... Satel receives producer surplus (economic profit) of $60 per bag... and Gacci receives $0 (only a normal profit, just enough to keep it in this business) Why are Satel’s costs so low? perhaps they are making bags with non-union workers.. and/ or they have special production and distribution processes Another illustration of producer surplus is... substituting “lawn care” for “handbag” in figure 3w.10 above... and assuming equivalent lawn care quality from each provider... when you get quotes from lawn care providers for doing lawn work at your home... the quotes you receive are the minimum acceptable prices those lawn care providers are willing to take... if you look long & hard enough... you can find one and only one provider who will do it for $20 a month at that equilibrium price that lawn care provider...

is getting zero producer surplus Producers of handbags and most goods... strive to differentiate their products... with unique styling, coloring, and features... thereby reducing direct competition... moving the supply curve to the left... and resulting in an equilibrium point and price higher than $80

Figure 3w.11 – Combined Consumer Surplus and Producer Surplus

At Equilibrium Price, Resulting In Economic Efficiency

In figure 3w.11 we bring together consumer surplus and producer surplus At quantity 10,000, the combined amount of consumer surplus and producer surplus is maximized This means maximum market efficiency occurs both consumers’ and producers’ satisfaction are maximized Therefore at the $80 price and 10,000 quantity the yellow dot position equilibrium point economic efficiency is achieved Productive efficiency is achieved because competition forces producers to use...

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the best techniques and combinations of resources... in making handbags... so production costs are minimized Allocative efficiency is achieved because the market-desired quantity of production, 10,000 this type of handbag is produced rather than other types of lesser-demanded handbags (or any other product)... that could be produced with the same resources Points on the D demand curve measure the marginal benefit (MB) of these handbags at each quantity level Points on the S supply curve measure the marginal cost (MC) of these handbags at each quantity level The demand and supply curves intersect at equilibrium quantity 10,000 bags that is where MB = MC Therefore, competitive market results include: 1) MB = MC 2) maximum willingness of consumer to pay = minimum acceptable producer price 3) equilibrium prices and quantities that maximize the sum of consumer and producer surplus

Figure 3w.12 – Efficiency Losses – Where Consumer and Supplier Surplus Not Maximized

Figure 3w.12 -Efficiency losses less than maximum combined consumer and producer surplus these result from underproduction or overproduction of a product in this case any production level other than 10,000 bags The left yellow triangle shows combined consumer and producer efficiency loss from underproduction, The right blue triangle shows combined efficiency loss from overproduction What is the sum of consumer and producer surplus (SCPS) at equilibrium quantity 10,000 bags? it is (($160-$20) x 10,000) / 2 = $700,000 which is the area of the triangle FEG If quantity of production was 6000 bags what would SCPS become?

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it would become the area of the quadrangle FCHG the efficiency loss is the triangle CEH... which is ($110-$50) x 4,000 bags / 2 = $120,000 efficiency loss so the SCPS becomes $700,000 - $120,000 = $580,000

How could there be an inefficient 6000 bags level of supply? this could happen because of: output-restricting collusion among producers (e.g. the OPEC oil cartel) government restrictions through licensing requirements that discourage new suppliers organized crime not allowing new suppliers Any non-market restrictions on supply result in efficiency losses What about the case of monopoly due to a single-producer-held patent on a product? e.g. the patent-holding firm decides a price of $110 the blue S supply line would be vertical through the $110 point on the demand curve the concept of consumer and supplier surplus does not apply there is no inefficiency loss because there is only one producer a legal patent is not a non-market restriction on supply What if an over-supply 14,000 bags are produced? Since the difference from efficient quantity of 10,000 bags is again 4,000 bags... the blue triangle area efficiency loss is again $120,000 For all units more than 10,000, the consumer’s maximum willingness to pay... is less than the producer’s minimum acceptable price of $80... Producers could sell 14,000 total bags, but only if the price was $50 Producers have already satisfied the 10,000 consumers willing to pay $80 or more per bag... and to attract enough consumers to sell 4,000 more price would have to be $50 Producers could charge $110 per bag... but only if there were fewer producers in the market... and the supply curve was positioned to the left intersecting the demand curve at point C but fewer producers in the market would be an inefficient situation... there are enough efficient producers to position the shown S supply curve at intersection point E At the 14,000 units quantity point the consumer is willing to pay only $50... but the cost to the producer is $110, so the efficiency loss per unit here is $60 How could there be an artificial 4000 units oversupply of handbags... that was not immediately corrected by the free market and remained over time? In a command system (e.g. communism) the government mandates quantities and prices of each good the quantity could be set by government at 14,000 units at government-set price $110 each to cover costs but only 6,000 bags would be bought leaving a surplus of 8,000 bags resulting in efficiency loss, triangle EBA

End of chapter 3w, next - The Market System Go to the following link for background information for concepts in this chapter: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/web_chapter3/origin_of_the_idea.html

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Chapter 4 – The Market System

Figure 4.1 –Characteristics of Market System

Characteristics of the market system There are various types of market systems, including communism, but here we will discuss... market system = capitalism = free market characteristics of the market system listed in figure 4.1 above include: Private property Property owned by individuals and private companies Property rights to use, buy, sell, property as well as pass it on to children or designated others Property is not just land, but any owned asset such as... a car, shares of stock, money, and intellectual assets (e.g. patent or copyright) Property rights encourage investment and innovation... since benefits come back to the owner/ risk-taker/ innovator E.g. if developing country A... will not guarantee protection of planned new Exxon oil refinery there... Exxon will not make the investment... resulting in fewer jobs and economic development (benefits) in country A... and less sales/ profits (benefits) for Exxon E.g. if theU.S.did not have copyright system, fewer books and less music would be produced Therefore one proper major role for government in the market system: protection of property rights Freedom of enterprise People and businesses can freely buy and use economic resources... to produce and sell goods and services as they desire... this requires the fewest possible regulations and licenses required by government Freedom of choice Property owners can use their property as they want Workers can do whatever job they want Consumers can buy whatever they want Self-interest Each economic unit (person, company) tries to do what is best for itself... without the motive of self-interest the market and life itself would become chaotic

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Entrepreneurs try to maximize profit Property owners try to sell or rent their property at the highest price Workers try to get jobs with best pay and working conditions Consumers try to get the products they want at the lowest prices Self-interest is not the same as selfishness, for example... a businessman who has become wealthy... -1- and then donates much of his fortune to charity... -2- or does not donate at all, but but rather... re-invests all wealth in more capital and business growth... thereby through gaining wealth has “unselfishly” contributed to growth in employment -1- can be seen as giving a fish, -2- can be seen as teaching to fish In economic terms selfishness could be seen as taking a short-term narrow view... which could be detrimental in the long-term I.e., in this sense, one who donates to charity could be viewed as the selfish one Competition Independent sellers (suppliers) and buyers (consumers) in any product or resource market... with freedom to enter or leave the market based on their self-interest With competition no one seller or buyer can set prices nor quantities... as prices rise more sellers enter the market and more buyers exit the market... as prices decline more buyers enter the market and more sellers exit the market Competition is the main regulatory force in the market system... diffusion of economic power limits the potential abuse of that power Markets and prices The decisions made on both sides, buyers and sellers... of the market determine a set of product and resource prices... that guide resource owners, entrepreneurs, and consumers as they pursue their self-interest Through the markets and prices system... society decides what should be produced... how many of each thing should be produced... how things should be produced... and who will buy the products The market system provides opportunity and motivation... for technological advance and development of... complex capital goods and advanced goods and services Roundabout production The market system rewards optimum use of tools and equipment... used by expert workers to produce things... as opposed to non-experts making things directly with their hands Roundabout production seems like common sense but, from Mao’s communist “little red book”: “We must help all our young people to understand that ours is still a very poor country, that we cannot

change this situation radically in a short time, and that only through the united efforts of our younger generation and all our people, working with their own hands, can China be made strong and prosperous within a period of several decades.” Of course it turned out China became prosperous, and very quickly... but only after it adopted the market system and roundabout production Specialization- separation of tasks within a system... the act of producing more of a good than one consumes... the rest of that good being exchanged for other goods (or money)

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With specialization it is often the case... where one does not buy or use what he/she makes... a farmer may sell all his produce which is exported... and then buy all the food he consumes at the supermarket Division of labor- splitting a production process across multiple workers... each performing a different task repeatedly... rather than having a single worker perform all tasks Division of labor allows for specialization, increasing total output from limited resources Geographic specialization- allows each region of the world... to specialize according to locally available resources... for example China now has an abundance of inexpensive labor... so there are many factories making labor-intensive goods Medium of exchange- is the main use of money... with money we can set market prices... without money we would have to use the barter system Barter system – exchanging one good for another Active but limited government- government addresses shortcomings... in the natural workings of the economy... providing goods and services that the market system cannot provide fairly and efficiently Government roles in the market include: maintain optimum environment for operation of market system private property protection contract enforcement anti-trust (anti-monopoly) oversight money supply control tax-setting and collection transfer payments to support for those not adequately provided by the market system provide infrastructure including roads and airports environment protection, e.g. pollution control protection of public non-priced goods, e.g. limits on hunting and fishing

All these are areas of political debate, for example in the U.S., generally: Republican party wants less government involvement in the economy Democratic party wants more government involvement in the economy

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Figure 4.2 –Economic Freedom Level Rank Among 157 Countries Years 2003 and 2007

note, only 156 countries in 2003 index source: Heritage Foundation and Wall Street Journal full list at: http://www.opinionjournal.com/extra/?id=110009530 article about index at: http://www.opinionjournal.com/editorial/feature.html?id=110009529 The figure 4.2 index includes measurements of: property rights protection (the more protection the freer) tax rates (the lower the freer) government regulatory intervention in the economy (the less the freer) monetary and fiscal policy (the more stable = little government intervention, the freer) trade policy (the less restrictions on imports the freer) labor freedom (the fewer restrictions and laws, e.g. affecting hiring and firing, the freer)

Statements by the Wall St. Journal re the 2007 index: incomes of poor individuals across the globe are rising as result of increasing economic freedom gap between the per-capita (per person) income in undeveloped and developed nations is narrowing in those countries where freedom has increased, people are becoming decidedly better off per capita gross domestic product (GDP) of the top fifth most-free countries is now almost $28,000... in the bottom fifth least-free it is less than $5,000 advanced economies in Europe restrict labor freedom (e.g. freedom to hire and fire workers)... at the cost of lowered economic growth and higher unemployment contrary to socialist, pro-increased-government involvement in the economy views... labor freedom and improving social conditions go together The four fundamental questions every economy must address: 1-what goods and services will be produced? 2-how will goods and services be produced? 3-who will get the goods and services? 4-how will the system accommodate change?

1- What goods and services will be produced? Individuals and businesses will produce goods and services that generate profit... and will stop producing those goods that result in losses Economic Profit = Total Revenue (TR) – Total Cost (TC) TR = unit price X number of units sold

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TC = unit cost X number of units sold Economic costs- payments that must be made to secure and retain... the needed amounts of the four resources: capital (e.g. tools and equipment) raw materials labor entrepreneurial ability (owners/managers creative and managerial activities) Costs of capital, raw materials, and labor can be easily assigned with dollar price tags However, the cost of the entrepreneur’s contributions is called normal profit... Normal profit can be considered in one way as the amount of profit... equal to what the interest return would be at the going interest rate... if the money invested in the business was instead invested in bonds Another way to think of normal profit... is to compare a profit person A gains from his new business... with the salary person A can get working for another entrepreneur person B... person A will not want to become an entrepreneur and start his own new business...

if he does not think he will get a normal profit from that new business... at least equal to the salary he now receives working for entrepreneur person B Thus a product will be produced (or new business started) only... if total revenue is enough to pay all economic costs including a normal profit Economic profit is the amount left... after costs and normal profit are subtracted from total revenue, i.e.: economic profit = total revenue – (capital and labor costs + normal profit)

-or simply- economic profit = total revenue – economic costs

Economic profit is a reward to the entrepreneur... for her/his risk-taking, economy-advancing efforts... and also a lure for others to enter the same type business... which increases supply and reduces cost and therefore price of the product Expanding industry- an industry that has economic profits and growing demand... and new companies start up and enter the industry... resources being shifted from declining industries that have no (or negative) economic profit Example, “Green Company” is in expanding industry which makes product X: Least cost combination of resources for making 15 units of X is: 2 units of labor, at $2 per unit ($4 total) 3 units of land, at $1 per unit ($3 total) 1 unit of capital, $3 per unit ($3 total) 1 unit of entrepreneurial ability, $3 per unit ($3 total) so, total costs of above are $13 grand total If selling price per unit of X is $1, will Green Company make the 15 units?... yes, because TR-TC = $15 - $13 = $2 of economic profit So, enticed by the prospect of economic profits new companies also begin supplying X they find more efficient ways to make X driving down the cost and price of X, until price of X drops from $1.00 to $.867 where 15 units x $.867 = $13, and TR = TC the industry will be at “equilibrium size,” and only normal profits are generated

Declining industry- an industry that overall has economic losses... stable or declining demand, and companies leave the industry...

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resources being shifted to expanding industries that offer economic profit

Figure 4.3 – Declining Industry Example – Too Many Suppliers

Figure 4.3 shows how too many suppliers can result in a declining industry Beginning normal profit price/quantity level is P1/Q1: suppliers continue to enter the market resulting in supply curve S2 however, demand is stable, i.e... increasing demand resulting in demand curve continuing to shift to the right... does not occur as new-entrant suppliers have predicted price drops from P1 down to P2 and quantity sold increases to Q2 eventually the higher cost suppliers exit the market S curve moves back to original S1 position (assuming stationary D1 demand curve) Consumer sovereignty- in the market system consumers are in command... the market is built on what consumers demand through their “dollar votes” As long as whatever product X provides at least a normal profit... producers will supply product X... e.g. there is great demand for a $5000 good quality new car... but since an economic loss would be suffered by a supplier at that price it is not supplied Of course what is demanded may not be what is good for consumers... e.g. the failure of the low-fat McDonald’s “McLean” burger in the 1990s... they were rejected by consumers (not enough dollar votes) because they did not taste good enough...

This is one area of beneficial government involvement in the marketplace... for example mandated health warning labels on cigarette package... and laws against addictive and harmful drugs Market restraints on freedom- businesses are not free to decide what will be supplied... consumers make that decision, even for supply of resources that result from derived demand Derived demand- demand for resources B that result from demand for product A, e.g.: since product A autos are demanded buy the buying public therefore resource B auto workers are demanded

so the demand for resource B is derived from the demand for product A 2- How will goods and services be produced? The market system directs resources to the industries whose products consumers want

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The firms that are profitable and prosper are those... that provide what customers want: a certain quality at a certain price at a certain time Because of competition, higher-cost suppliers are eliminated, and lower-cost suppliers prosper if U.S. company refuses to place a factory in low-labor-cost Mexico to protect all its U.S. jobs, but... if French company making the same product does place a factory in Mexico end result can be zero jobs left at U.S. company because it goes out of business Least-cost production means that companies must... employ the most economically efficient technique of production in producing their output This depends on: available technology, the various combinations... of resources (including techniques) that will produce the desired results prices of the needed resources E.g. “Yellow Company” may use the same types of resources as Green Company... But Yellow’s combination of each resource per production output unit... may be inefficient compared to Green’s... Yellow might use too much labor and too little land compared to more efficient Green

Economic efficiency- means obtaining a particular output of product... with the least input of resources The more economically efficient a company is... the higher value of output it gets from the value of inputs... economic efficiency = $ outputs / $ inputs

Table 4.1 Three Techniques for Producing $15 worth of Product X Price per Yellow Company Green Company Tan Company

Unit of Technique 1 Technique 2 Technique 3 Resource Resource Units Cost Units Cost Units Cost

A B (AxB) C (AxC) D (AxD)

Labor $2 4 $8 2 $4 1 $2 Land $1 1 $1 3 $3 4 $4

Capital $3 1 $3 1 $3 2 $6 Entrepreneurial Ability $3 1 $3 1 $3 1 $3

Total Cost of $15 worth of X $15 $13 $15

Note that technique = combination of input resources = technology Table 4.1 shows: Yellow Company uses combination of resources Technique 1 Green Company uses Technique 2 “Tan Company” uses Technique 3 All four types resources are available on the market at the same prices to all three companies Green Technique 2 is least costly therefore most economically efficient... able to make $15 worth (sales value) of product X at cost of only $13... Green will make economic profit of $2 per unit sold... while the other two companies will make only a normal profit If Yellow and Tan later discover/ understand and apply Green’s Technique 2...

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market price of product X will eventually drop to $13... and all three companies will make only normal profit If Yellow and Tan cannot cut costs to $13... e.g. Yellow has a union contract that restricts labor reductions Green could possibly drop its price for product X to $13... forcing Yellow and Tan to either become efficient, or exit the market Resource prices can change, and it is possible Yellow or Tan companies... could become the lowest cost producer without any change in technique 3-Who will get the goods and services? Two conditions of who will get the products produced by the market: each individual’s preferences for various goods each individual’s wealth and income Amount of wealth/income of an individual depends on: the quantities and qualities of property and human resources they supply the prices those resources command in the resource market Price of each resource is: interest and rent from property resources wages and profit from human resources 4-How will the system accommodate change? The most obvious on-going change in the marketplace is consumer tastes... fundamentally we want ever-higher quality at ever-lower price with ever-shorter wait time Technology is always advancing Nature of/ abundance of/ cost of resources are always changing Therefore the market system must adjust and change... suppliers cannot always make product X using production method A and distribution method DM1 e.g. steel suppliers cannot continue to make rust-prone steel... manufacturing with old open-hearth method... distributing by selling only directly from the steel mill Guiding function of prices- increasing demand for a new product Y higher price for new product Y increased supply of new product Y decreased supply of old lesser-demanded product X E.g. increasing demand from customers for higher quality steel innovation and investment at “SteelTek Corporation” a new high quality rust-resistant steel increased demand for this steel made by SteelTek higher prices and economic profits for SteelTek eventual bigger quantity of higher quality steel supplied from SteelTek all other steel producers The initial economic profits gained by the first high-quality supplier SteelTek... not only eventually guides other steelmakers to make higher quality steel... but also gives SteelTek a head-start to acquire/ use more resources... to develop even better quality steel... and therefore gain even more economic profits Thus the market system has produced two changes, that lead to... greater productivity and a higher level of economic well-being for society: technological improvement capital accumulation (allowed by economic profits)

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Note that the economic profits can be used by SteelTek several ways including: Re-invest within SteelTek to increase production capacity of current products Re-invest within SteelTek to develop new technologies including... purchasing advanced equipment and implementing cost-reduction production methods Buy other steel companies or related businesses Distribute profits to shareholders of SteelTek Corporation by paying them dividends Thus high demand leads to high prices leading to... rise of some companies/industries that satisfy the demand and... decline of other companies that do not Therefore, interference in the market system... e.g. government protecting old “ABC Steel Corp.” by preventing steel imports... or by steel companies’ managements giving in to union demands for strict work rules... such as not allowing specialist outside contractors to install and maintain high tech equipment... works against change and meeting customer (society) demand for high quality and low price... and works against overall efficient use of resources... which ultimately result in lower standards of living for society Creative destruction- the process whereby creation of new products and production methods... by one company destroys (puts out of business)... other companies that do not quickly adapt The market system demands and forces rapid spread of technological advance throughout an industry... the companies that do not adapt suffer losses and failure, therefore a great incentive to adapt Why would some companies fail to adapt? some reasons: they don’t fully know about/ understand the new products / technologies they don’t believe the new products / technologies will be successful in the long-run the company is too bureaucratic and cannot move quickly... such as a culture of managers protecting and expanding their “turf”... e.g. strive to keep large budget for department, strive to keep large number of workers in department they don’t need to adapt because of government intervention, e.g... imports of improved and/ or lower-cost competing products are banned or restricted they cannot adapt because of union restrictions, e.g.... favoring maintaining a large labor force... over implementing new labor-saving and cost-saving technologies family-owned company that puts less-than most highly-qualified relatives and friends in key positions owners feel long-term prospects for the industry are dim... or have lost interest and want to get out of the business Invisible hand- consumers and suppliers... through their own self-interest... guide the market system... to promote the wider social interest The term “invisible hand” was used by Adam Smith in his 1776 book “The Wealth of Nations” free market competition lowest prices/costs companies use the least costly combination of resources to make their products maximized conservation of resources

Main virtues of the market system: Incentives, the goal of economic profits... drives companies to conserve resources and improve technologies... and provide goods and services demanded by the public Efficiency, companies use the least costly combination of resources...

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to make their products, maximizing company profits... and maximizing conservation of resources Freedom, wide range of choice of products for consumers... the more socialistic (government-driven rather than market-driven) the system... the less the resulting freedom... and the less efficient resulting use of resources End of chapter 4, next - The U.S. Economy: Private and Public Sectors Go to the following link for background information for concepts in this chapter: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter4/origin_of_the_idea.html

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Chapter 5 – The U.S. Economy: Private and Public Sectors

In this chapter we focus in on the U.S. economy and divide into two sectors: private sector including households and businesses public sector is government, all levels from town to federal With the addition here of government, the circular flow model... shown first in chapter 2, figure 2.6 without government... becomes the extended model shown in following figure 5.1

Figure 5.1 – The Circular Flow Model With G Added

Black lines show flow of money for purchases and tax payments Red lines show flow of the resources purchased with the money... including goods, services and financial capital Resource market (RM) is where resources used to make finished products/ services are purchased...

includes labor from households (H) and... tools and equipment from businesses (B)

There is no line directly from H to B because... the labor resources of H are offered on the RM... e.g. coming out of school you can offer your work skills... to all B in the RM (in this case labor market) Product market (PM) is where finished goods/services are purchased can be physical place such as a retail store... or a general entity such as the market for crude oil Summary of the figure 5.1 flows: 1- money paid by business for resources including labor 2- money income received by H including wages, rents, interest, profit 3- consumption expenditures, e.g. people paying for products at stores

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4- revenue, money received by B for their products 5- net taxes, paid to G (G) by B 6- net taxes, paid to G by H 7- G payments for purchases of resources including labor 8- G payments for purchases of products including jet planes for the military 9- resources received by B, including labor in return for wages 10- labor, land, capital, entrepreneurial ability 11- goods/services, e.g. the products people have bought at stores 12- goods/services, e.g. the products B offer for purchase at stores 13- goods/services provided by G to B such as defense and legal protection 14- goods/services provided by G to H such as defense and legal protection 15- resources received by G including labor 16- products received by the G including jet planes Note flow 5 is net taxes, i.e. net after transfer payments (TP)... these TP are subsidies and payments to B such as low interest loans, tax concessions, and... discount-price land sold to companies to encourage them to start up large factories Note flow 6 also is net taxes, i.e. net after TP... these TP are subsidies and payments to H such as welfare, social security and Medicare Households (H) as income receivers H are both the ultimate suppliers of all economic resources (line 10)... and the major spenders in the economy (line 3) H receive income from both B and G via the RM Functional distribution of income... income is apportioned as one of the following three, all are indicated by line 2: laborers/ workers/ salaried employees receive wages owners of property resources receive rent and interest owners of B, including shareholders of public corporations, receive profits Functional distribution of U.S. income, 2002: wages $5,977 billion 72% corporate profits $787 billion 9% proprietors’ income $757 billion 9% interest $684 billion 8% rents $142 billion 2% Year 2002 personal distribution of income data follows: 50.2% of total income went to highest 20% income group 23.0% of total income went to fourth 20% income group 14.6% of total income went to middle 20% income group 8.7% of total income went to second 20% income group 3.5 % of total income went to lowest 20% income group Note there is much fluidity, mostly upward among these groups... i.e. most of today’s low-income young college student part-time workers... or beginning minimum wage workers... become tomorrow’s middle or high-income group members And conversely, today’s rich do not always stay rich over time

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See article at end of chapter “Income mobility and the fallacy of class-warfare arguments against tax relief” Three ways H use their income, year 2002 data: personal consumption 84% personal taxes paid to G 13% personal savings 3% Personal consumption, how H spend income, year 2002 data: services- such as gas, electric, medical care 59% nondurable goods- goods with life of less than 3 years such as clothing and food 29% durable goods- goods with life of 3 or more years such as autos 12% Personal taxes paid to G, personal income tax is main part... as a percent of income personal income taxes have risen... from 3% in 1941 to 13% in 2002 Personal savings- go to financial assets including... bank accounts, insurance policies, and stocks and bonds Two categories of reasons for saving: security - to preserve wealth, to prepare for unforeseen problems... where regular income would be disrupted... money is put into bank accounts, insured savings accounts, or insurance policies speculation - to try to grow wealth... e.g. money is put into stock market shares of companies Savings amount is a function of income amount... the top 10% of income receivers account for over 50% of total savings Businesses (B) are the second major part of the private sector Definitions of units: plant- physical establishment such as factory or store, that makes or distributes products firm- business organization that owns and operates plants industry- group of firms that produce same or similar products Forms of B, three main types: sole proprietorship partnership corporation Percent of firms in U.S.: percent of U.S. total sales: (year 2002 data) 72% are sole proprietorships 4% of total U.S. business sales 8% are partnerships 9% of sales 20% are corporations 87% of sales Note corporations can be private (stock not sold to the public) and small in size... e.g. many small family-owned manufacturing companies are corporations Sole proprietorship (SP)- firm owned and operated by one person, called the “proprietor” typically the owner (and family) directly manages and supervises the SP easy to set up and organize, no complex paperwork strong motivation for efficiency because owner directly manages business limited financial resources therefore difficult to grow larger

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have high failure rate so often have difficulty borrowing money from banks owner/manager makes all decisions, e.g. hiring, training, producing, accounting, advertising... therefore no benefits of job specialization as in larger companies... proprietor is subject to unlimited liability, if his/her company goes bankrupt... and the sale company’s assets do not cover those debts... the creditors, those who have lent money or sold supplies to the company... can be paid back by sale of the proprietor’s personal property, including his house Partnership- firm owned and operated by two or more individuals- the partners financial resources and management skills are pooled by the partners similar to SP, easy to set up and organize higher success rate than SP’s, so it’s easier to borrow money chance of conflict between partners even though pooled together, financial resources still are limited if one partner withdraws from company the partnership must be reorganized or even broken up as with SP partnerships face unlimited liability, upon bankruptcy... partners’ funds and assets may be claimed to pay debts Corporation- is created as a separate and distinct entity... from the few or many individual stockholders who own it hired managers, not majority owners, typically run large corporations easy to raise financial capital (line 9) for purchasing resources (line 1)... by selling/issuing securities, and getting bank loans at low interest rates Securities – general name for stocks and bonds sell/issue stock- shares of ownership of the company note, the terms “stock” and “shares” are often used interchangeably... to mean the same thing - shares of the corporation sell/issue bonds- each of which act as a direct loan from bond buyers... to the corporation issuing the bond As a corporation grows in size it is more stable and a better risk... so it can issue more shares and bonds... and banks are more willing to make loans to it at lower interest rates Purchase of stocks allows many H to own part of corporations... and share wealth growth and profits, through capital gains and dividends... without having to become involved in managing the corporation Since these stocks can be easily re-sold through the stock market... this adds to their attractiveness as investments in the first place... the investor can sell/buy the stocks at any time Limited liability- owners of corporations, i.e. the H shareholders... only risk what they have invested in stocks, they do not risk their personal assets Because of corporations’ larger size they can realize benefits... of mass production and job specialization You may ask “why aren’t all companies corporations?” some reasons they aren’t: corporations are more complex than sole proprietorships... and require expensive professional legal and accounting services double taxation- corporate profits are taxed two times- both on profit and dividends... for example, double tax amounts shown in blue:

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$1,000,000 corporation revenue (sales) - $900,000 costs = $100,000 profit x 30% corporate income tax rate = $30,000 corporate taxes paid by the corporation to G = $70,000 remaining profit distributed to shareholders as dividends 15% dividends tax rate = $10,500 dividend taxes paid by shareholders to G = $59,500 total net income realized by shareholders In the above example, if this had been a sole proprietorship (or partnership)... only the $30,000 would have been paid in taxes... and the proprietor or partners would have realized $70,000 total net income There are some “hybrid” company structures, such as LLC (limited liability company)... that combine some aspects of partnerships and corporations Principal-agent problem- shareholders “principals” of corporations have one set of goals... but the hired managers “agents” of corporations often have other goals Principals want: maximum profit high stock price large dividends best prospects for future growth of all these Agents often focus instead on: increasing personal wealth through a big salary, big bonuses and stock options heightening personal prestige and power For example the agent corporation chief executive officer (CEO) may push... to acquire other companies just to enlarge the corporation thereby increasing his/her prestige In the 1990s this problem was addressed by paying more stock options to agents... so as the corporation profits and stock price increased so too did the agent’s income However this caused other problems, e.g.... agents used fraudulent accounting practices and outright deception... to cover-up costs and inflate revenues data, to show large profits... typically done at first to meet quarterly targets but then followed by... cover-ups for cover-ups eventually bankrupting the corporation... shares in the corporation finally becoming worthless, e.g. Enron In 2002 laws were passed by Congress... strengthening corporate accounting rules to address this problem... including the Sarbanes-Oxley Act, purposes summarized as follows: To improve quality and transparency in financial reporting and independent audits and accounting services for public companies, to create a Public Company Accounting Oversight Board, to enhance the standard setting process for accounting practices, to strengthen the independence of firms that audit public companies, to increase corporate responsibility and the usefulness of corporate financial disclosure, to protect the objectivity and independence of securities analysts, to improve Securities and Exchange Commission resources and oversight, and for other purposes. http://www.sarbanes-oxley.com/section.php Corporations can finance their activities three ways: from its own retained earnings from profits

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borrow money from banks and other lending organizations issue stocks and bonds Stocks and bonds financing are unique to corporations and are the focus of this section Stocks If you buy one share of stock of a corporation... you own a percent, a “share,” of the corporation.... e.g. if you buy one share of “SteelTek Corporation”... and SteelTek has issued one million shares... then you own one-millionth of SteelTek... you get one-millionth of the dividends (distributed profits)... and have one-millionth of the of the voting power (but you need not vote)... held for matters such as the election of corporate officials Share prices for public corporations typically are $20 to $100... but range from under a dollar up to $10,000 or more As corporations grow they usually split the shares... e.g. give shareholders 2 shares at $50 to replace their current 1 share at $100 For reference you can check the current and historical share price of Apple Computer at: http://finance.yahoo.com/q?s=aapl (note: on June 25, 2006 Apple share price was $58.83) Bonds Bonds are units that each act as direct loans from the individual buyers of bond... to the corporation that sells the bond A bondholder is a lender to, not an owner of, the corporation Bonds have three features: original selling price (also called “face value,” and “principal”) interest rate maturity in years At maturity the corporation pays back the principal to the holder of the bond E.g. SteelTek issues (sells) bonds... at $1000 each interest rate of 5% 10 years maturity And you buy one, so SteelTek... pays you $50 a year in interest and ten years later pays you back $1000 Bonds are less risky than stocks for two reasons: Bondholders have “legal prior claim,” interest must first be paid to bondholders... before dividends can be paid to stockholders The bondholder is assured, unless the corporation goes bankrupt... of receiving the set interest payment each year... and full repayment of the principal at maturity Stockholders have no assurance of dividends payments... nor any assurance of getting back their initial investment amount if/ when they sell their shares Three risks of bonds – corporation stability, interest rate, and inflation Corporation stability bond risk if SteelTek has problems that increase the chance of bankruptcy...

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the market value of your bond will fall... and you will get less than $1000 for your bond if you sell it note bonds are traded on the open market the same as stocks Interest rate bond risk rise of general interest rate of economy bonds paying higher interest rate to be issued market price of previously issued bonds to fall fall of general interest rate of economy bonds paying lower interest rate to be issued market price of previously issued bonds to rise Example: higher interest rate new bonds market price of old bonds to fall: last year you bought one SteelTek ten-year maturity “A-Bond” $1000 face value, interest rate 5% the general economy interest rate was 5% at the time you get $50 per year in interest payments for your A-Bond today, one year later, general interest rate of economy is higher... SteelTek issues new ten-year B-Bonds $1000 face value interest rate 7.5% buyer of one of these new bonds get $75 per year interest payments considering only interest return... your A-Bond market value becomes $667... because $667 x current interest rate .075 = $50 note, actually your A-Bond market price would be somewhat higher than $667... because it has only nine years to maturity... and you still get the full $1000 back at that time as you can see the math involved with valuing of bonds can become complex... even though the concepts are simple

Inflation bond risk Your bond principal of $1000 is paid back to you at maturity after ten years... the present value of your payback depends on... the unpredictable inflation rate over those ten years For example, $1000 invested in a bond today in ten years is worth (present value): 1% average yearly inflation rate $905 in ten years 2% $820 3% $744 4% $676 6% $558 8% $463 Present value calculator at http://www.customcalculator.com/tvwww.dll?User The public sector - government’s role Government (G) provides services and goods... that cannot be efficiently supplied by the market economy Services and goods provided by G that involve the economy include monetary system infrastructure (e.g. roads) development and maintenance contract enforcement protection against fraud

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protection against monopolies and mafias property rights protection protection against crime in general rule of law in general

set and enforce product health and safety standards set and enforce pollution standards By setting and enforcing “rules of game”... the market is stabilized... B are encouraged to expand resources are used more efficiently and overall economic wealth grows As with everything in economics (and in life)... the goal for G is finding the point where... marginal cost (MC) = marginal benefit (MB)... there can be too little G regulation, where MC < MB... or too much regulation, where MC > MB G promotes and maintains a framework of competition in the economy Competition is what makes the market system work, and buyers, not sellers, drive the market G works to prevent monopoly, situation where there is only one supplier of a product or service... or regulate the monopoly if it cannot be avoided, e.g. the local electric company In the case of monopoly the monopolist seller drives the market... and the result is high prices and short supply G redistributes income Although a market system maximizes overall wealth... there are still individuals who are relatively poor G uses three main systems to redistribute part of total income to the poor Transfer payments, e.g. welfare checks, food stamps, unemployment benefits, social security Market intervention, e.g. minimum wage laws, setting minimum prices for farm products Taxation, e.g. progressive tax rates with the rich paying a higher percent income tax There is a debate over redistribution benefits and costs... benefits said to include social stability... costs said to include reduced incentives for B to expand and increase employment G is involved in reallocation of resources two areas where the market fails to properly allocate resources... are “spillover costs” and “public goods”

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Figure 5.2 – Spillover Cost Resulting In Overallocation of Resources

Spillover costs - uncompensated production or consumption costs inflicted on a third party One example of spillover cost is pollution of environment: Firm A can at no cost to itself dump pollutants in a river... lowering its own costs and increasing profits... but at a cost to the public of damaged environment In figure 5.2 since this spillover cost is not reflected in Firm A’s product cost the cost/price is artificially low at P1 overallocation of resources to production quantity of Q1 of this product Firm A benefits from high profits ... because of low product cost/price, S curve is large-quantity S1 the relatively few buyers of the product benefit from the low price P1 ... but society as a whole bears the cost of the pollution

If G mandates emissions standards Firm A must install wastewater treatment equipment... raising cost/price to from P1 to P2 shift of S curve to S2 reduced quantity demanded/ supplied of Q2 in this case firms supplying the treatment equipment receive the P2-P1 amount Rather than mandating emissions standards... G can instead levy a specific excise tax... on each unit of production/sales in the amount of P2-P1 raising cost/price to from P1 to P2 lower quantity demanded/supplied of Q2... in this case the G receives the P2-P1 amount then G can use those tax revenues, e.g. to pay for cleaning the environment

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Figure 5.3 – Spillover Benefit of Education Leading G to Overallocate Resources To Education

Spillover benefits- production or consumption benefits of a good or service... realized by a third party or the community at large One example is education: it directly benefits the immediate consumer (the student) but also results in spillover benefits to the public such as a populace better suited for participation in a democracy more productive workforce, which helps the economy grow less welfare programs and crime

In figure 5.3 demand curve D1 reflects only private benefits... the amount of grades 1~12 education that would be naturally demanded... in the marketplace without G intervention But then G realizes there are spillover benefits to the public from subsidizing grades 1~12 education... that outweigh taxation costs to the public that enable the subsidy... so G begins taxation to pay for grades 1~12 public education In figure 5.2 P1 = $10,000 per year per student P2 = $15,000 per year per student Q1 = 100 students receiving grades 1~12 education Q2 = 150 students receiving grades 1~12 education P1 and Q1 is the situation without G intervention... a parent would have to directly pay out-of-pocket $10,000 a year to educate his/her child... but local property taxes are low, since a big portion go for public education... and the children of parents who cannot afford the $10,000 go without education P2 and Q2 is the situation after G intervention... property tax collections and payments per child are $15,000 a year... “free” grades 1~12 public education is offered (and required) At resulting Q2 society realizes full spillover benefit of education... but per student and overall costs are higher than if education was left to the free market... the total extra costs being (Q2 x P2) - (Q1 x P1)... or $2,250,000 - $1,000,000 = $1,250,000

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At G-supported cost/price P2 enough resources along the S curve... are attracted to meet desired quantity of education Q2... e.g. attract enough people to teach, because of higher salaries G through taxation and then payment to teachers... makes up the difference of P2-P1 payments for education Without G intervention resulting in higher teacher salaries resulting from P2... many potential teachers might choose to work at another job rather than become a teacher Of course this is an area of public debate: How many years of public education results in the optimum private + public benefit? i.e. where does MC > MB...

Conceivably G could subsidize college educations for everyone... as it now does for grades 1~12... but many jobs do not require or realize substantially higher productivity... from being filled by college educated workers

Again, note from figure 5.3 more G subsidies for education greater demand for education higher cost of education Public goods- goods/services that must be provided by G... because private companies cannot profitably or efficiently... supply them in the quantity needed Because the free market does not naturally allocate adequate resources... to some goods/ services that yield substantial economic benefits, e.g. city streets... they must be a public good provided by G and funded by taxes paid by the public Other public goods include the police department, national defense, and environment protection Private goods are characterized by excludability... meaning those who pay for the product enjoy its benefits... but others who do not pay do not enjoy those benefits Public goods, e.g. city streets have non-excludability... because anyone can use the streets as much as they want... whether or not they have paid for them... e.g. the poor who do not pay taxes, or out-of-towners also tax-payers pay for all streets, but often do not use all the streets Once city streets are built there is no practical way... to collect payment only from those who use the streets Free-rider problem- inability to exclude those who do not pay from enjoying benefits of a good/service The free-rider problem makes it unprofitable for private firms to supply city streets service The closest exception to this rule is a private firm is able to supply... limited-access toll-road highway service, because there is no free-rider problem Street entertainers are an example of the free-rider problem anyone walking by can enjoy watching the juggler... but only a few drop money into the hat... those who stop to watch and gain enjoyment but do not drop money being the free-riders Quasi-public good- goods like highways, education, and museums... that can be provided either publicly or privately... but have spillover benefits meaning resources are not adequately allocated to them... and the free market produces too-small quantity

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Reallocation process- reallocation of resources from private goods to public goods If resources are fully employed in an economy making private goods but society needs/ demands more public-goods, e.g. city streets... resources are reallocated by government i.e. society gives up some private goods for more public goods

This is done through taxation for the public goods: e.g. H are taxed (line 6)... then these tax revenues are reallocated by G...

for building and operating the city streets (line 14) Results: purchasing power has been diverted from H to G... people have less money to buy consumer goods, because of taxation... people get more public goods city streets

Another G role in the economy – create/provide conditions of economic stability At times the economy is below or above output capacity... creating a situation of unemployment or inflation Two general ways G can reduce unemployment: fiscal policy and monetary policy fiscal policy - increase G spending and/or decrease taxes monetary policy – increase money supply lower interest rates Fiscal policy One example of increasing G spending to increase employment... was the Tennessee Valley Authority dam and construction projects during the 1930s G can act more quickly than the private business sector... to provide jobs to a large number of people... not having to wait for the business cycle to move out of recession Decreasing taxes increased household net income and spending increased business investment to meet increased spending demand increased production quantity and jobs Private sector is better at providing productive, high-paying, and lasting jobs than G Monetary policy If firms’ expected profit rate is higher than the interest rate... companies will borrow money for new capital and increase production G central bank (Fed in the U.S.) increase the money supply decreased interest rates

lower percent return on sales becomes profitable increased business investment in new capital goods such as factories and equipment increased production and employment

Inflation is a general rise in prices a high rate of consumption and production prices for goods and resources are bid up inflation Two general ways G can address inflation: fiscal policy and monetary policy fiscal policy - decrease G spending and/or increase taxes monetary policy – reduce money supply higher interest rates

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Problems regarding G involvement in the economy G operates in the context of politics, politicians tend to focus on the short-term... strive to get elected then stay in office To stay in office politicians must satisfy their local constituencies... must follow current public opinion G tends to favor giving supply contracts to companies that contribute money... to politicians’ and parties’ election campaign funds... even if those companies are not most qualified nor least expensive for contracted job Difficult to determine optimum amount of public goods should be provided... e.g. how many city streets are enough? Difficult to determine optimum amount of regulations... e.g. perfectly clean environment would mean no fossil fuels burned... for utilities, transportation and manufacturing... thereby greatly increasing costs and reducing wealth and living standards Difficult to determine optimum amount of income redistribution... i.e. taxing those with high income, and transferring those tax funds to those with low income... must balance need to help low income people... with need for incentives to low income people to become more productive... thereby raising their own incomes and overall wealth of society G ventures are monopolies with no competition pressure... with resulting inefficiencies, high costs and waste Monopoly will be discussed in chapter 24 Two types of G spending- purchases and transfer payments (TP) Purchases- products such as labor and jet planes (lines 7, 15, 8, 16) these are “exhaustive,” i.e. they absorb resources and are part of domestic output TP, “net tax” items such as tax breaks to B to encourage business startups (line 5)... and social security payments to H (line 6) these are “non-exhaustive,” do not directly absorb resources or create output... i.e. recipients make no direct contribution to domestic output in return for them Year 1960 G spending: 22% of domestic output went for purchases 5% of domestic output went for TP = 27% of domestic output went for G spending Year 2002 G spending: 18% of domestic (U.S.) output went for purchases 12% of domestic output went for TP = 30% of domestic output went for G spending in 2002 Year 2001 selected countries % of domestic output going for G spending (overall tax rates approximately = G spending rate) Sweden 52% France 46% United Kingdom 38% Canada 33% U.S. 29% Japan 28%

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Three Categories of G – Federal, State, and Local Federal expenditures and tax revenues Federal expenditures, recent, main areas: pensions & income security, including welfare & social security, 38% of total federal expenditures health, including Medicare, 21% national defense, 17% interest on public debt, 9%, instead of raising taxes G often borrows money by selling bonds... and interest on this public debt must be paid off Federal tax revenues (collections), main sources: personal income tax, 46% of total taxes collected payroll tax (FICA and Medicare), 38%

corporate income tax, 8% excise tax, 4% all others 4% Personal income tax- tax individuals must pay on their personal income This is a progressive tax- the higher the income the higher percent rate of tax paid in year 2003 those with annual income of $14,000 paid 10%, those with $310,000 paid 27% Marginal tax rate (MTR)- tax rate paid on each additional unit of taxable income the federal income tax system is set so you pay progressively higher tax rate... on successively higher amounts of income

E.g. if in 2003 your income was $50,000: taxable income amount MTR tax paid amount first $14,000 10% $1,400 next $36,000 15% $5,400 total income $50,000 total income taxes paid $6,800 Average tax rate- total income tax paid divided by taxable income... in the above case 6800/ 50,000 = 13.6% average tax rate

Figure 5.4 – Percent of Total Federal Income Taxes Paid in the U.S. By Income Level, year 2003

http://www.rushlimbaugh.com/home/menu/top_50__of_wage_earners_pay_96_09__of_income_taxes.guest.html Payroll taxes- tax on income used to finance Social Security (FICA) and Medicare Social Security is mostly for income for retired people

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Medicare is mostly for healthcare for retired people For both of these, the company where an individual is employed pays half the tax... and the individual employee pays half Social Security tax rate is 15.3% (7.65+7.65) on the first $94,200 (year 2006)... of an employee’s annual earnings Medicare tax rate is 2.9% (1.45+1.45) on the total amount of an employee’s annual earnings Federal corporate income tax- paid by corporations on their annual profit... 35% tax rate for most corporations in 2006 Federal excise taxes- taxes on retail sales of specific items... including gasoline, airline tickets, alcohol and cigarettes State expenditures and tax revenues State expenditures, main areas of spending (averages for the 50 states): Education, 36% of total state expenditures Public welfare, 25% Health and hospitals, 8% Highway construction and maintenance, 8% Public safety, 5% State tax revenues, main sources of tax collection (averages for the 50 states): Sales and state excise taxes, 47% of total taxes collected Personal income taxes, 36% Other tax revenue sources include corporate income taxes and license fees Local G expenditures and tax revenues This includes counties, cities, towns, school districts Local expenditures, main areas of spending, averages: Education, 44% of total local G expenditures Welfare, health, hospitals, 12% Public safety, 11% Housing, sewerage, parks, 8% Streets and highways, 5% Local tax revenues, main sources of tax collection Property taxes- each year owner pays a percent of property’s assessed value... 72% of total taxes collected Sales and excise taxes, 17% Tax revenues collected by local G cover less than half of their expenditures... the remaining funds come from grants from federal and state G G-owned utilities such as local water service are generally self-supporting... e.g. fees H pay for water service cover all costs of the water service End of Chapter 5, next – The United States in the Global Economy Go to the following link for background information for concepts in this chapter: http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter5/origin_of_the_idea.html Article - Income Mobility and the Fallacy of Class-Warfare Arguments Against Tax Relief by D. Mark Wilson – Heritage Foundation March 8, 2001 The dynamic U.S. economy is characterized by an extraordinary degree of income mobility that has been all but ignored in the recent debate on reducing federal income tax rates and phasing out the death (estate) tax.

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Opponents of tax relief are criticizing commonsense reforms because they claim that "only the rich" will benefit. Yet the notion that low-income or high-income groups are composed mostly of the same people over time is an illusion. The comparison of average incomes and taxes paid by groups would be meaningful only if America were a caste society in which the people comprising one group remained constant over time. Most Americans, however, understand that family incomes change frequently, and the research on income mobility reveals that most family incomes increase significantly over time. This is one reason why Americans with modest incomes tend to resist "soak the rich" class-warfare arguments: They hope to be rich themselves one day. Policymakers should ignore this class-warfare rhetoric and redesign America's tax code so that its barriers to upward mobility are reduced. PATTERNS OF INCOME MOBILITY Many academic studies have found remarkably consistent results that suggest there is substantial income mobility in the United States. For example: -A 1992 Treasury Department study showed that between 1979 and 1988, 86 percent of those in the bottom income quintile moved to a higher quintile, and 35 percent in the top income quintile moved to a lower quintile. -A 1995 Federal Reserve Bank of Dallas report showed that almost 75 percent of those in the bottom quintile in 1975 were in a higher quintile by 1991, and almost 40 percent in the top quintile moved down to a lower quintile over the same period. -A 1996 Urban Institute study showed that large numbers of Americans move into a new income quintile, with estimates ranging from 25 percent to 40 percent in a single year. The same study found even higher mobility rates over longer periods: about 45 percent over five years and 60 percent over 9-year and 17-year periods. -In 1998, the Census Bureau reported that, on average, over 41 percent of Americans increased their inflation-adjusted income by 5 percent or more per year from 1984 to 1994. The primary reasons for changes in income from year to year were changes in marital status, changes in the number of workers in the household, and moving into or out of full-time, year-round employment. -A 2000 Economic Policy Institute study showed that almost 60 percent of Americans in the lowest income quintile in 1969 were in a higher quintile in 1996, and over 61 percent in the highest income quintile had moved down into a lower income quintile during the same period.