DemiDec Fundamental Economics Resource

Transcription

2012
2013
EDITION
18
YE
AR
S
ING
OU
RB
ECONOMICS
ECONOMICS
Post-Soviet
Communist
Recovery
DO
AUTHOR
Niha Jain
EDITOR
Tania Asnes
®
the World
Scholar’s Cup®
ALPACA-IN-CHIEF
Daniel Berdichevsky
EST
, SO
YO
U
CA
N
DO
YO
U
RS
Table of Contents
Table of Contents............................................................................................................1
Preface .............................................................................................................................5
I. The Fundamentals .......................................................................................................7
The Basic Economic Problem—Scarcity ............................................................................................ 8
Production of Goods and Services ................................................................................................... 10
Increasing Costs............................................................................................................................... 11
Pareto Efficiency .............................................................................................................................. 12
The Factors of Production ............................................................................................................... 13
Benefit-Cost Analysis – Marginal Decision-Making......................................................................... 14
Marginal Utility and Waffles ........................................................................................................... 15
More on Marginal Utility and the Effect of Prices ........................................................................... 17
Individual and Social Goals ............................................................................................................. 18
Positive and Normative Economics ................................................................................................. 19
Economic Systems and their Characteristics .................................................................................... 19
The Basic Economic Questions ....................................................................................................... 20
What and how much to produce? ................................................................................................. 20
How to produce? .......................................................................................................................... 21
Who receives the benefits of production? ...................................................................................... 21
Responses to Positive and Negative Incentives ................................................................................. 22
Characteristics of a Mixed Market Economy ................................................................................... 23
Economic Freedom ...................................................................................................................... 23
Private Property ............................................................................................................................ 23
Economic Incentives..................................................................................................................... 23
Competitive Markets .................................................................................................................... 23
Limited Role of Government ........................................................................................................ 23
Voluntary Exchange ........................................................................................................................ 24
Specialization and Division of Labor ............................................................................................... 25
Introduction to Trade...................................................................................................................... 26
III. Microeconomics ......................................................................................................27
Markets ........................................................................................................................................... 27
Prices ............................................................................................................................................... 27
Demand .......................................................................................................................................... 28
Demand vs. Quantity Demanded .................................................................................................... 29
Changes in Consumer Income......................................................................................................... 30
Changes in the Number of Consumers ............................................................................................ 31
Changes in Consumer Expectations ................................................................................................. 31
Changes in Prices of Substitutes and Complements ......................................................................... 31
Changes in Consumer Tastes ........................................................................................................... 32
Seasonal Changes............................................................................................................................. 33
Supply ............................................................................................................................................. 33
Supply vs. Quantity Supplied .......................................................................................................... 34
Changes in the Costs of Factors of Production ................................................................................ 35
Technology...................................................................................................................................... 35
Expectation of a Price Change ......................................................................................................... 35
Number of Suppliers ....................................................................................................................... 36
Market Equilibrium......................................................................................................................... 36
Summarizing Equilibrium Changes ................................................................................................. 38
Price and Wage Controls ................................................................................................................. 38
Utility and Income .......................................................................................................................... 39
Elasticity .......................................................................................................................................... 42
Market Structures ............................................................................................................................ 44
Perfect Competition ........................................................................................................................ 44
Monopolistic Competition .............................................................................................................. 45
Oligopoly ........................................................................................................................................ 46
Monopoly........................................................................................................................................ 47
The Production Decision ................................................................................................................ 49
Price Discrimination........................................................................................................................ 50
The Institutions of a Market Economy ............................................................................................ 50
Financial Intermediaries .................................................................................................................. 51
Labor Unions .................................................................................................................................. 51
Property Rights................................................................................................................................ 52
Private Property Protection in the United States .............................................................................. 53
Types and Nature of Income ........................................................................................................... 54
Factor Markets and Derived Demand .............................................................................................. 55
The Labor Market ........................................................................................................................... 55
Wage Rates ...................................................................................................................................... 56
The Hiring Decision .................................................................................................................... 56
Human Capital Development and Labor Productivity .................................................................... 57
Returns on Investment in Education ............................................................................................... 57
Other Factors That Influence Income.............................................................................................. 58
Investment and Economic Growth .................................................................................................. 58
Entrepreneurs .................................................................................................................................. 60
IV. Macroeconomics .....................................................................................................61
Gross Domestic Product and National Income................................................................................ 61
Methods of GDP Measurement.................................................................................................... 62
The Expenditures Approach to GDP Measurement...................................................................... 63
The Income Approach to GDP Measurement .............................................................................. 63
The Output (Value-Added) Approach to GDP Measurement ...................................................... 65
Real GDP and Nominal GDP ...................................................................................................... 65
The Circular Flow of the Economy .............................................................................................. 66
Enter the Government .................................................................................................................. 67
Exports and Imports in the Circular Flow..................................................................................... 67
Economic Growth ........................................................................................................................... 67
The Business Cycle .......................................................................................................................... 68
Economic Indicators ........................................................................................................................ 69
Aggregate Demand .......................................................................................................................... 70
Consumption and the Marginal Propensity to Consume ................................................................. 73
The Multiplier Effect ....................................................................................................................... 74
ECONOMICS RESOURCE | 3
“Ideal” vs. “Real” Multipliers ........................................................................................................... 75
Aggregate Supply and Economic Equilibrium.................................................................................. 75
The Labor Force .............................................................................................................................. 76
Categories of Unemployed Persons .................................................................................................. 77
Kinds of Unemployment ................................................................................................................. 78
Four Portraits of Unemployment..................................................................................................... 78
Money and Currency....................................................................................................................... 79
The Three Functions of Money ....................................................................................................... 80
Types of Money and the Money Supply .......................................................................................... 81
Inflation and Price Indices ............................................................................................................... 81
Interest Rates ................................................................................................................................... 86
Roles of the Government in a Market Economy .............................................................................. 87
Sales, Value Added, and Excise Taxes ........................................................................................... 88
Sales Taxes and Deadweight Loss ................................................................................................. 89
Lump Sum and Property Taxes .................................................................................................... 90
Income Taxes ............................................................................................................................... 90
Promoting Competition .................................................................................................................. 91
Positive and Negative Externalities of Public Policy ......................................................................... 92
Social Security ................................................................................................................................. 93
The American Welfare System ......................................................................................................... 93
Unemployment Compensation........................................................................................................ 94
Fiscal Policy ..................................................................................................................................... 95
Federal Taxes in the United States ................................................................................................... 96
Shortcomings of Fiscal Policy .......................................................................................................... 97
Budget Deficit and National Debt ................................................................................................... 97
The Federal Reserve System ............................................................................................................. 98
Monetary Policy Goals and the Employment Act of 1946 ............................................................... 99
Monetary Policy — History and Methods ....................................................................................... 99
Monetary Policy Tools .................................................................................................................. 102
Money, Supply and Demand ......................................................................................................... 103
Less Direct Controls over the Money Supply in the United States .............................................. 103
Key Terms .................................................................................................................................. 104
Advantages of Monetary Policy ...................................................................................................... 104
Disadvantages of Monetary Policy ................................................................................................. 105
Other Notable Economists ............................................................................................................ 106
Phillips Curve ............................................................................................................................. 106
Lorenz Curve .............................................................................................................................. 107
Laffer Curve ............................................................................................................................... 107
Say’s Law ....................................................................................................................................... 108
V. Trade and Globalization .........................................................................................109
Relative Price and Comparative Advantage .................................................................................... 109
Absolute Advantage ....................................................................................................................... 111
Exchange Rates .............................................................................................................................. 112
Economic Development Thresholds and Trends ........................................................................... 113
Why is this Country Different from All Other Countries? ............................................................. 113
Economic Development Organizations ......................................................................................... 114
International Monetary Fund (IMF) ............................................................................................. 115
The World Bank ........................................................................................................................... 116
The Gold Standard ........................................................................................................................ 116
Selected International Organizations ............................................................................................. 117
The Rise of GATT and the WTO ................................................................................................. 117
Trade Blocs and Free Trade Associations ....................................................................................... 119
Opposition to Globalization and Free Trade ................................................................................. 120
Trade Sanctions ............................................................................................................................. 121
Important Trade Blocs and Free Trade Agreements ....................................................................... 121
V. The Global Economic Crisis ...................................................................................123
The Economy Takes a Bubble Bath ............................................................................................... 123
The Great Recession ...................................................................................................................... 128
The Recession in America .............................................................................................................. 129
Opening the TARP Door ........................................................................................................... 129
Unpaid in America ..................................................................................................................... 130
Political Consequences ............................................................................................................... 131
The European Sovereign Debt Crisis ............................................................................................. 132
The Crisis Unfolds ..................................................................................................................... 132
All for On€................................................................................................................................. 138
Political Consequences ............................................................................................................... 138
The Crisis Elsewhere ..................................................................................................................... 138
Conclusion: Act V .......................................................................................................138
About the Authors .......................................................................................................138
Preface
You don’t have to be reading this. You could be somewhere else
instead. You could be with your best friend watching The Hobbit, or
drinking tea. You could be taking surveys on the Internet for five
dollars an hour. You could just be sleeping.
What would you most like to be doing1?
Whatever it is, that’s what economists call your opportunity cost. You
can’t do it and study economics at the same time.2 It’s a trade-off: you
have to choose. Economics is about making choices in a world where you can’t have it all.
How do you decide what to do? Maybe you flip a coin. But most
economists will tell you that, as a rational person, you’re choosing the
activity that is the most valuable to you. They might describe your
decision with fancy terms, like indifference curves and budget lines.
Don’t worry about what all these things are, though. We’ll get to
them much later.
For now, think of economics as the study of common decisions—and
the science of common sense.
It’s about how you decide whether to eat a burger or a bowl of noodles.
It’s about how a country decides whether to invest in education or in the military.
It’s about whether the government should help you if you can’t find a job.
Of course, it gets more complicated. It’s also about how the central bank of Turkey will try to slow
down inflation—which is when the same amount of money buys you less today than it did a year ago.
And it’s about whether American Airlines and British Airways will someday be allowed to merge.
Economists are the advisors that help governments make these decisions. You don’t bring an economist
with you when you go shopping, but many economists believe you carry an economist inside of you.
They call this economist rational self-interest. You are motivated to do what is best for you. Even if
you’re buying someone a gift, these economists say you are buying it because you benefit from giving
the gift. Maybe someone gives you a gift in return, or says nice things about you to a potential date. Or
maybe if you don’t buy it, the person expecting the gift will be upset with you.
Is it worth spending $20 to prevent someone from being upset? Maybe. Is it worth spending $2,000?
Maybe not.3 Looking at these numbers is an example of economic analysis.
1
The correct answer is not “snogging”.
e.g. If you try reading this book while singing karaoke, your song will be strange and your friends will laugh at you.
3
Unless it is a very powerful someone.
2
In this resource, we will look at economic analysis in three different areas. First, we’ll consider the
fundamentals of economics. We’ll think more about trade-offs and consider what consumption and
production actually are.
Then, we’ll move into microeconomics. Micro means small. Microeconomics is mostly about local
decisions, the sort you make at the mall: what you buy, and whether a store stays in business. If the
price of tea goes up, you may drink more coffee—and buy less tea.4 A fast food restaurant advertises that
its new burger is the tastiest in town, even though it is almost the same as any other burger. When you
finish the microeconomics chapter, you’ll understand when and why these things happen.
Third, we’ll consider macroeconomics. Macro means large. We’ll look at ways to calculate how strong
an entire economy is, and at different ways for the government to create jobs and encourage growth.
We’ll consider what money really is and how banks work. We’ll also consider other economic models,
such as communism, and dispel the notion that the United States is a completely free market society—
just as the Soviet Union was never a completely communist society.
These larger issues will lead us to international trade and development. Most economists agree that
trade is basically good. China has prospered since opening to trade in the late 1970s; Americans use
Samsung cell phones in New York while Malaysians eat at California Pizza Kitchens in Kuala Lumpur.
There was even a Starbucks in China’s Forbidden City until 2007. Is everyone happier? We’ll
investigate why and how trade works even between very different countries.
In the last section, we’ll consider the global economic crisis—which brings together concepts from
throughout this guide to help us understand a case study all of us are living through. Whether you are
following the American presidential election or trying to decipher Russia’s economic outlook, you need
to understand the context: a global economy facing its worst crisis since the Great Depression.
No wonder many critics believe economics is a “dismal”—or sad—science. Don’t listen to them.
Economics does deal with a lot of problems, from shortages of iPhones to this so-called Great Recession,
but it also gives us the tools to start understanding and solving these problems.
This guide will introduce you to those tools. After studying it, you may begin to recognize how lots of
things you already know about the world and about how people behave connect. Newspaper headlines
will make more sense to you5, and you’ll find yourself not just making decisions on the margin—but
making them that way on purpose.
Remember, you don’t have to be reading this.
I hope you’ll decide to.
Daniel Berdichevsky
4
5
I will never buy less tea.
At least until there are no more newspapers.
I. The Fundamentals
If economics is a science, it is the science of common sense.
Rocket science is hard because we aren’t always building rockets.6
Economics is easier because we all live in economies and make
economic decisions.
The formal study of economics is intended to make a model out of
markets and monetary movements. A model is a representation of a
system that allows us to make predictions about changes. For example,
you might have a model for the behavior of your parents. If you get good grades, your parents take you
out to celebrate. If you get bad grades, your parents may take away your videogames. This model helps
you decide whether to get good grades.
In economics, models help predict what will happen to the economy. If a terrorist releases smallpox in
Moscow and millions of Russians die, what will happen to the demand for automobiles? An economic
model suggests that, if there are fewer customers, there will be less demand.
Models in economics get much more complicated than this, of course. The key is to remember that
they only represent the real world. They try to include as many important factors and relationships as
possible, but the real world is very complicated.
Some people like to point to the butterfly effect when discussing complex systems that are hard to
model. Imagine if a butterfly7 flapped its wings in Vladivostok. This seems like a small thing8, but
weather is so complicated some scientists believe it could start a storm in Florida—9,000 miles away.
In economics, you can never know every factor
Debate it!
that will affect people. Maybe on Wednesday,
Resolved: That economic models mislead lawmakers.
Iran will reveal it has nuclear weapons, causing
stock markets to crash.9 If models were perfect, economists (and countries!) would all be rich.
Supply and demand, the distribution of goods and services, the cost of energy production, the
dangers—and even benefits!—of monopoly: these are just some of the areas in which economists create
models to help countries and companies make economic decisions.
Economics is a social science. Some of you have never studied a social science, but may be familiar with
the so-called “hard” sciences, such as chemistry. Hard sciences use experiments and logic to answer
questions about the natural world. Social sciences try to do the same with questions about societies—
questions such as “does using Facebook lead to having fewer close friends?”
Economics assumes people are rational actors—that they can weigh costs and benefits and decide what
is best for them at any given time. If you’ve ever eaten too much dessert, or procrastinated on a paper,
6
My high school classmate Kevin did, filling them with dry ice and launching them at the gym.
Or Mothra.
8
Unless it were Mothra.
9
Find a model to predict the behavior of North Korea and you’ll probably win a Nobel Prize.
7
you know this isn’t necessarily always true. But, for the sake of argument, economists pretend we always
make the best possible decisions.
A problem common to all social sciences is that they cannot isolate one factor at a time. It is hard to
look at one variable—such as daily hours of Facebook usage—without getting it mixed up with
everything else about people—such as their education level. It is also tough to conduct experiments on
whole societies. Later we will discuss different theories for what caused the Great Depression. Though
the results would be very interesting, no one will ever give an economist the power to repeat the Great
Depression several times, adjusting one factor at a time, just to prove a theory.
You shouldn’t worry too much: models may not be perfect, humans may not always act rationally, and
social sciences may not be exact, but there is a lot we do know for sure about economics through history
and observation. On Academic Decathlon multiple choice exams, therefore, questions will usually have
clear “best” answers. In World Scholar’s Cup debates you may have to deal with trickier issues, but no
one expects you to come up with detailed economic policies on a moment’s notice.
One thing that will make economics easier to study is a principle called ceteris paribus. It is a Latin
phrase for “all else held equal.” It means that, in considering economic problems, we only think about
one thing changing at a time. If we want to know how many people are going to the movies, and
someone tells us that the price of movie tickets has doubled, we assume that everything else is the same:
the popcorn isn’t any better or any worse, the seats are no more and no less comfortable. If we didn’t
adopt the principle of ceteris paribus, we would always have to worry about other factors mixing things
up, and we could never answer anything for sure, even hypothetically.
The Basic Economic Problem-----Scarcity
There just isn’t enough of everything for everyone. That’s the basic economic problem: scarcity. If
everyone could pluck whatever they wanted off trees, there would be no need for the formal study of
economics.10 You could have all the iPhone 5s in the world for free11. Without scarcity, there would
never be difficult decisions to be made by firms and people.
But there is scarcity. One could even say there’s too much of it.
Economists begin with a key assumption: that
Debate it!
humans have unlimited wants and that the world
Resolved: That people do not really have unlimited wants.
has only limited resources. Sure, there are times
when we seem to have everything we want. And some people are easier to satisfy than others. Maybe
you have a friend who just needs pizza and a pillow to survive quite contentedly. Still, the assumption
about unlimited wants is generally accurate. Even a billionaire cannot be in Dubai and San Francisco on
the same night for dinner with two different people.12 She has to make choices.
Economics also assumes we try to do the best we can with what we have. And it assumes we try to do
this rationally—making the best possible choice at any given time.13
10
Horticulture, however, would become rather fashionable.
This assumes a very strange tree.
12
Unless she owns a military jet and can travel at Mach 5.
13
Studies are casting doubt on whether humans are truly rational. For example, we are often more afraid of losing $20 than
enthusiastic about winning $20—and love can throw us totally out of whack. What does this imply for economics?
11
Of course, some resources are less limited than others. Some even seem to be available in sufficient
amounts to everyone who wants them. Economists call these free goods. The most classic example of a
free good is air. We breathe all the air we need and we don’t pay for it… do we?
Let’s think some more about air. While we never go to “air restaurants” to order scoops of chocolate air,
our societies do put a lot of effort into air. The government enforces pollution regulations and air
quality standards. If factories release too much smoke, they are punished. As citizens, we pay taxes to
fund the agencies that set standards and enforce regulations. Air is a free good, but clean air is not.
Anything not a free good—just about
everything—has a cost. When we study
economics, we need to consider two main kinds
of costs. The accounting cost of a good or
service is the amount of money we spend on it.
For example, the accounting cost of a lava lamp
might be $59.99.
Earlier we talked a bit about opportunity cost.
We deal with opportunity cost whenever we
make choices. Suppose that on Sunday, you can
work at the Caribou Coffee in Youngstown for
$50 or at the Nile Café for $35. You like the
Nile, but you need the money, so you go work
at Caribou. What does it cost you to make $50
at Caribou? It costs the $35 you could have
made at the Nile. That $35 is your opportunity
cost: the value of the best choice you didn’t
make.
Economists define opportunity cost as the value of the next-best alternative. Every choice has an
opportunity cost. The opportunity cost of listening to Mozart might be the value of listening to Justin
Bieber. The opportunity cost of attending college may be the lost salary from the job you could have
had selling cars instead.14
Economists care about both kinds of costs. For most of their analysis, they measure economic cost,
which includes both the accounting cost and the opportunity cost (plus other costs that we will talk
about later, like damage to the environment and negative impacts on society).
The economic cost of the lava lamp includes its accounting cost, the time and money you’ll spend
driving to and from the store, the environmental impact of the synthetic materials used to create the
lamp, and the social stigma you’ll experience when your friends see the thing in your room.
14
My cousin tried this, and reports the opportunity cost is not very high.
Production of Goods and Services
Suppose you live on a farm with five acres of land. Your family is in the
business of producing juices. You can plant either orange trees or blueberry
bushes on your land. If you use all the land to plant orange trees, you can
produce 1,000 oranges per year. If you use all the land for blueberry bushes,
you can produce 10,000 blueberries per year.
The table displays some of your production possibilities. You can produce
various blueberry and orange combinations. You might grow 800 oranges and
1,000 blueberries—or 9,000 blueberries and 100 oranges. The combinations
are limited only by your total land. For example, you cannot grow 10,000
blueberries and 1,000 oranges. You don’t have enough land.
Choosing the best mix is not easy. Some land is probably better for orange
trees, some for blueberry bushes. If you grow only
oranges, you will “waste” some land that is better for
blueberries. If you produce mostly blueberries, you will
make poor use of land perfect for oranges.
We can represent all possible combinations of oranges
and blueberries on a Production Possibilities Frontier
(PPF). A PPF is one of the most fundamental diagrams
in economic decision-making. It shows all possible
combinations of two goods that a producer or country
can output, given its resources and technology.
The first graph highlights some of the combinations in
which you might produce oranges and blueberries. If
you choose to produce at point A, you’ll grow only
blueberries—10,000 of them—and no oranges. At B,
you’ll grow 5,000 blueberries and 400 oranges; at C,
1,000 blueberries and 800 oranges.
Suppose we try to move away from the PPF, both
inside and outside of it. The second graph highlights
some production possibilities—X and Z—that do not
fall on the frontier, as well as one, Y, that does.
Imagine what would happen if you produced at X.
You’d grow only 200 oranges and 800 blueberries. You
might have your own reasons for producing at this
point, but you’d probably frustrate an economist.
Producing at X is considered inefficient because it
doesn’t employ all available resources. To produce at Y,
or any other point along the frontier, would be
efficient. You’d be employing all available resources.
PRODUCTION POSSIBILITIES
Oranges
Blueberries
0
100
200
300
380
400
450
600
700
800
1,000
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Suppose you decided to produce 5,300 blueberries and
2,300 oranges. This combination is represented by
point Z. Because Z is outside the frontier, it is
unattainable (except through trade—more on this
later). You just don’t have the land or technology to
produce that much fruit on your own.
The PPF illustrates the trade-off we face when we
decide how much to produce of each of two goods: to
produce more of one, we must produce less of the
other. Whenever we move along the frontier, from one
point to another, we make a trade-off. In the third
graph, a movement from point 1 to 2 indicates a tradeoff of 400 oranges for 4,000 more blueberries.
The PPF can help us see a trade-off, but it won’t decide
for us. We use goods and services to satisfy wants, but different people want different things in different
amounts. Culture plays a role in this, too. Even two producers with exactly the same resources, and thus
the same production possibilities, might produce different quantities to satisfy different wants.
Increasing Costs
Sometimes a PPF represents production possibilities
for two very similar goods. In the graph to the right, a
manufacturer compares production possibilities for
black shoes and brown shoes.
Since the cost and most of the materials involved in
producing black and brown shoes are the same, the
greatest number of shoes that can be manufactured in
this example is always 80, whether the shoes are all one
color or some are of each color. The materials and
labor available will allow no more than 80 shoes to be
made per day. At each point on the line, the total
number produced is always 80. At point D, 60 black
shoes and 20 brown shoes are made—again, 80 in all.
Note that the PPF for black shoes and brown shoes is a straight line. When the PPF for any two goods
is a straight line, we can infer that the opportunity cost of any change in production is the same
anywhere along the line. For every black shoe made, one brown shoe is not made, and vice versa. It is a
constant tradeoff.
In the real world, most PPFs represent two very different goods. Often, PPF are used to represent a
nation’s trade-off between military goods (usually referred to as “guns”) and civilian goods (usually
referred to as “butter.”)
Another important trade-off is between capital goods, like factories, and consumer goods, like iPads and
tofu. In this guide, we use “milk or missiles” for our PPFs, but the actual items don’t matter very much.
What matters is that the items, like milk and missiles, are very different.
The curve to the right is the “standard” PPF. Unlike a straight line, it is “bowed” or curved outward
from (concave to) the origin. At either end, the trade-offs are greater because opportunity costs are
higher.
If Decalon moves from A to B, it will produce 100
more missiles and give up only 50 billion quarts of
milk. The more Decalon concentrates resources on
missiles, the greater the trade-off will become. If
Decalon moves from C to D, it gains another 100
missiles, but now it loses 220 billion quarts of milk.
This reflects the law of increasing opportunity costs:
the more you produce of a good, the greater the
opportunity cost of producing it becomes.
The law is not always true, but it usually holds for two
main reasons. First, required resources become scarcer.
We may need to dig deeper in mines to find metal for
additional missiles. Second, as we require more inputs,
we turn to those of less quality. Even if our mines had all the metal we needed, we would still need
miners. Not everyone makes a good miner. Some people may even be claustrophobic. As we need more
and more missiles, we are forced to assign resources to mining the metal—such as farmers and cows—
that are much better at producing milk. Consider the situation at point D. Here, even if Decalon were
to sacrifice all its remaining milk—320 billion quarts—it could only eke out another 50 missiles.
PPFs can’t tell us which point is best. They can only tell
Debate it!
us the possibilities and their opportunity costs. Yes,
many resources great for making milk will be used Resolved: That a country should favor capital goods
over consumer goods.
inefficiently if Decalon moves from D to E—but if
Decalon is at war, those extra 50 missiles could make the difference between victory and defeat. If
zombies are taking over the planet, Decalon might choose to produce only milk, to hold one last ice
cream party prior to extermination.15
Pareto Efficiency
We’ve been using the term efficiency without stopping to consider what it means. The term can be used
in many ways—for example, I’m not the most efficient editor because I constantly check the Internet
for political news updates and brew cups of tea—but, for the purposes of this guide, we will focus on
one specific kind of efficiency: Pareto efficiency.16
If you can’t make anyone better off without making someone else worse off, you’ve achieved Pareto
efficiency.
Suppose an isolated town in Decalon, Acastan, produces 1,000 bottles of milk. As the mayor, you hire
former Blockbuster employees to deliver milk all across town in a Pareto efficient way. There are exactly
100 people in Acastan. Soon, each one, including you, has received 9 bottles of milk.
15
Producers of The Walking Dead, take note.
Named for the Italian economist Vilfredo Federico Damaso Pareto (1848-1923). It would have been inefficient to call it
Vilfredo Frederio Damaso Pareto Efficiency.
16
“We’re done delivering milk,” the chief deliveryman reports. “Everyone has more than enough. We’re
going to watch the Clippers game. Blake Griffin is a nasty dunker.”
“But wait,” you tell him, “There are 100 bottles of milk still sitting in the warehouse.”
The deliveryman sighs. He realizes what you’re about to say: this distribution of milk is not Pareto
efficient. He could deliver more milk without taking milk away from anyone who already has it.
“Okay,” he sighs, “I’m on it.”
He takes the 100 bottles of milk, hands them to you, and says, “You now have 109 bottles of milk.
There are none left in the warehouse. It’s Pareto efficient. Now I’m going to the game.”
You want to stop him, but, as you lift a hand, you realize he’s outsmarted you: he can’t deliver any more
milk to anyone else without taking some away from you. In any given situation, there are usually several
possible Pareto efficient outcomes, and they are not necessarily all equally desirable—or equally fair.
Sighing, you go home to make a lot of ice cream.
The Factors of Production
We’ve talked about PPFs without analyzing what
kinds of resources are required to make goods and
services. In one example, we talked about land for
growing trees or bushes; in another, we talked about
manufacturing cows and nuclear missiles. Trees would
also require humans to collect fruit, just as the cows
would need humans (or robots) to milk them. For
nuclear missiles, we would need factories to produce
the metal casing17; missiles don’t just grow on trees.18
Let’s classify these different resources. Economists call
them the factors of production and divide them into
four categories.
Natural resources include land and anything found in nature. Land used in production—such as the
space occupied by a factory—is a natural resource. In fact, most economists just refer to natural
resources as land. This can be confusing, since rivers and trees are counted as land too, even though they
are made of water and wood. In economic terms, producers pay rent to use natural resources. (This is
not the same as the rent you pay for an apartment.)
Capital refers to factors of production produced to help produce other goods and services. It includes
factory equipment, laptops, nuts and bolts—anything made to make something else. Capital also
includes intermediate goods, or natural resources processed into a new form. For example, coal in a
mine is considered land. But once extracted, it is an intermediate good, or capital. In economic terms,
producers pay interest for the use of capital.
17
18
We might also need the Russian mafia to provide us with enriched uranium.
We now know two things that do not grow on trees: iPhone apps and nuclear missiles.
Labor includes any physical and mental efforts by humans. In fact, it is also called “human resources.”
When you work at a store, you are a human resource. In the language of economics, firms pay wages for
the use of labor. The quality of human resources depends on a person’s human capital. Human capital
includes education, experience, skills, and other training.
Entrepreneurship refers to the ability to come up
Debate it!
with business plans, improve processes, or invent new
products. Entrepreneurs figure out what to do with Resolved: That all young people should be taught how
to be entrepreneurs.
land, labor and capital. When a student drops out of
college to start a social networking site, he is an entrepreneur. So is someone who opens an octopus
burger stand outside an SAT school in Korea, betting the students will be hungry when they come out
of class at 2 am. This word—betting—is crucial. Like gambling, being an entrepreneur means taking
risk. A new business may fail. Most do. Entrepreneurs are rewarded with profit if they succeed, but they
face a stiff opportunity cost; they could be working for someone else instead for a safe, steady salary. In
some cultures, entrepreneurship is highly valued; in others, parents prefer that their children find stable,
secure jobs as soon as possible.19
Benefit-Cost Analysis --- Marginal Decision-Making
Economics is largely a study of decision-making. When a
person weighs the benefits of something against its costs,
he is conducting a benefit-cost analysis. A rational
person or firm will decide to do something when its
benefits outweigh its costs.
If Anthony has studied economics, we can assume he
will conduct a benefit-cost analysis before he decides
whether to kill Ike.
Consider Anthony, an ex-Decathlete pursuing his sworn enemy, Ike, through the badlands of Texas.
Anthony plans to kill Ike. When Anthony catches up to Ike in front of a Krispy Kreme, several police
officers are lingering out front. Anthony pauses to weigh the costs and benefits of killing Ike on the
spot. The benefit is obvious: his sworn enemy will be dead. The costs are uncertain, but potentially
significant. Anthony knows that, in Texas, murder carries the death penalty. The police will witness his
crime; he will end up imprisoned or executed.20
If Anthony decides that Ike being dead is more valuable than the years of his life he will waste behind
bars, he will kill Ike. However, if he decides that a dead Ike is no good to him if he loses his freedom, he
will probably let Ike go—this time. We cannot make the decision for Anthony, because every person
will measure the benefits and costs of that decision differently. Some of us might prefer freedom, others
the death of a nemesis. What we do know is that if Anthony is rational, he will conduct a benefit-cost
analysis before he makes his decision—even if he doesn’t call it that.
Not all costs are the same. Some may be sunk costs: costs that cannot be avoided. Sometimes, this is
because the sunk costs have already been paid; other times, they have been committed to.
The sunk costs in a typical apartment lease represent both types. Suppose you are six months into a
yearlong lease. You have already paid six months of rent—and, if you want to move somewhere else,
you are still stuck paying the next six months (or some agreed-upon penalty).
19
20
These parents are usually not thrilled when their children choose to study English or Philosophy.
Unless he hires a very good defense attorney.
Sunk costs should never affect a rational decision—but they often do. People are often reluctant to give
up something they have already paid for, even if doing so might save them money or improve their lives
in the long run. Psychology plays a large role in real world economics.
For Anthony, the distance he ran before catching Ike are a sunk cost. As he hyperventilates, he might
think, “I’ve already run two miles to catch Ike. That counts for something! I should kill him!” Maybe
so—but, to an economist, those two miles don’t count for anything. He can never get back the time
and energy he spent running. Perhaps the future benefit of killing Ike would outweigh the past cost of
running two miles. But Anthony should kill Ike only if the future benefits of having him dead outweigh
the future costs of killing him.
Of course, real economic decisions rarely involve questions of murder. Dramatic economic decisions
might include whether to double the prices of all tickets to Miami Heat games—but most economic
decisions are even more mundane. From month to month, a firm might simply decide whether to
increase or decrease production of a product—say, donuts. It would weigh the benefits of producing
one more donut against the costs of producing it. That “one more donut” is said to be at the margin. It
would not consider the past cost of leasing a donut factory or of training the donut makers.
Marginal decision-making is the act of weighing the benefits of an incremental change against its costs.
The marginal benefit of an increase in production is the added revenue from the sale of one more unit.
The marginal cost is the cost of producing it, including labor and materials.
Suppose Sue’s Spaghetti is a small company that grows pasta on Noodlebushes®. Sue is deciding how
many to plant. She must first evaluate her marginal benefits and costs. For Sue, the marginal benefit of
another Noodlebush is the money she will receive from the sale of the noodles it produces. The
marginal cost is the cost of producing another Noodlebush, including labor, time, land, and materials.
Below is a table of the marginal costs versus marginal benefits as production increases.
How many Noodlebushes should Sue plant to
Noodlebush # Marginal Cost Marginal Benefit
maximize her benefits? Consider one marginal
1
2
7
decision at a time. Each Noodlebush yields one
2
3
7
box of spaghetti, and the selling price of a box is
3
5
7
4
8
7
$7. Thus, the marginal benefit from each
5
12
7
Noodlebush is $7. (Marginal benefit is not always
6
17
7
this constant.) The cost of producing the first box
of spaghetti is $2, so Sue will plant the first bush: she will earn more than $2 in revenue. She will also
plant the second bush, because the $3 cost is still outweighed by the $7 benefit. The same goes for the
third bush. But for the fourth, the marginal cost is greater than the benefit—$8 of cost versus $7 of
benefit. Using marginal decision-making, Sue stops at three bushes.
Marginal Utility and Waffles
If we have unlimited wants, how is it that we ever feel we have
enough of something? Blame the law of diminishing marginal
utility (also known as diminishing returns): as we obtain more
of a product or service, we tend to derive less value from each
additional unit of it.
Debate it!
Resolved: That students should allocate
their study time on the margin.
Before we begin, you need to know a few terms. Utility is the satisfaction a person derives from
consuming something. Marginal utility (MU) is the satisfaction derived from one more of something.
Total utility is the sum of all the satisfaction a person derives from however many units of something he
has consumed.
Economists express utility in imaginary units they call
utils. If a meat-loving person obtains 10 utils from a
cheeseburger or 1 util from a slice of tofu, we can
quantify how much more satisfaction he will derive
from the cheeseburger. Utils don’t exist, but they make
it easier to discuss utility. (Keep in mind that utils are
not the same as units of happiness—economists aren’t
able to measure happiness directly.21)
Consider the case of a man I knew in high school,
Steve. Steve ran track, and has a typical runner’s
metabolism. He eats twice as much as the rest of us,
but stays rail-thin. He is also always hungry. Steve
claims to have been full only once in his life—when, on
a whim, he decided just to eat as much as he could. He
sat down at his table with a toaster, syrup, and several
boxes of frozen waffles.22
Steve was very hungry, so the first few waffles tasted
great. He wolfed them down as quickly as they popped
out of the toaster. Steve’s marginal utility for each
waffle was very high.
Around number 12, the waffles began tasting like
cardboard. Since Steve still didn’t feel full, he
continued eating. The marginal utility Steve derived
from each waffle was falling, but still positive. Though
Steve wasn’t enjoying the waffles, they were still
reducing his hunger, so they offered some utility.
By number 25, Steve hated waffles. His jaws were sore
from chewing. But he was not full yet, so he kept
eating. Steve is very stubborn and had set out to do
something. That was enough to keep his marginal
utility positive and to keep him going.
When it was over, Steve had eaten 36 waffles.23 At that
point, he finally felt full, and the marginal utility of
eating another waffle would have been negative. It
would have caused him more trouble than it was
21
Only Disneyland has a handle on that science.
I prefer mine with peanut butter, cream cheese and fresh blueberries.
23
Steve should probably go into hot dog eating contests.
22
worth—stomach sickness, a migraine, death. When I asked him if he ever wanted to try it again, he said
no, once was enough. Even the feeling of being full suffers from diminishing returns.
Even when Steve began to find the waffles less satisfying, he continued eating because he continued to
derive some utility from them. Even when marginal utility is diminishing, total utility continues to
increase as long as marginal utility remains positive. The graph below represents Steve’s total utility.
Note how it continued to increase all the way to waffle 36—when marginal utility turned negative.
More on Marginal Utility and the Effect of Prices
Imagine that you crawl out of the
desert near Baghdad and find an
abandoned pawnshop. Inside it are
bottles of water and diamond rings.
All are free. What would you do,
assuming your MU for each
product is as displayed?
Your first thought is of water.25
You’re
half-dead
of
thirst.
Weighing the MU of the first water
bottle against that of the first ring,
you decide to start with water. It
doesn’t matter whether it’s from
Fiji or from Aquafina’s sewage
purification plant.
Next, you weigh the MU of a
second bottle (2,000 utils) against
the MU of a first ring (1,500 utils).
Thirst still wins out, so you grab
another bottle.
Quantity
MU of a Bottle of Water
MU of a Diamond Ring
1
2
3
4
5
6
7
8
1,000,000
2,000
50
30
10
20
10
5
1,500
1,200
1000
900
850
800
750
700
Apple TV and Marginal Utility
I recently gave my mom-----the DemiMom!-----an Apple TV. ‘‘I want to watch TV
shows while I exercise,’’ she said. On installing it I showed her she had two
options. One was to rent shows for 99 cents each from iTunes. The other was
to pay $7.99 per month for unlimited shows from Netflix. With the first
option, she was carefully deciding what she might rent. When I explained the
second option, she said, ‘‘Now I can try an episode of something I’m not sure
about.’’ Consider this reasoning in terms of marginal utility and marginal cost.
With iTunes rentals, each show had a marginal cost of 99 cents; my mom
wanted to be sure a show had at least that much marginal utility before
renting it. With the Netflix model, the marginal cost on any given show was
effectively 024-----so she could risk unknown shows more easily.
By now you’re feeling better—in fact, you’re wondering where to find a toilet. When the third round of
consumption comes around, a ring is worth 1,500 utils to you and a bottle of water only 50. You grab
your first ring.
You can see how this is going. It’s doubtful you’ll take any more water for a long, long while.
Let’s add prices. You see, the pawnshop isn’t abandoned. In fact, a Halliburton employee is running it.
He insists you buy the water at $20 per bottle. He’s also charging $750 for each diamond ring. You
have enough money to buy whatever you want, but you don’t want to waste it. What to do? The answer
lies in the ratio of marginal utility to price: MU/P. MU/P is the amount of utility something will bring
you per dollar spent. In other words, MU/P tells you what will give you the “best bang for the buck.” In
theory, you will spend each dollar where it will do you the most good.
24
Of course, as an economics student, you would want to remind her about opportunity cost: an hour spent watching Sarah
Palin’s Alaska is an hour that could have been spent watching Pushing Daisies—or cleaning lint out of your socks.
25
Unless you’re about to propose to a desert lizard and haven’t bought a ring yet.
Quantity
MU for Water
MU/P for Water
MU for Ring
MU/P for Ring
1
2
3
4
5
6
7
8
1,000,000
2,000
50
30
25
15
10
5
50,000
100
2.5
1.5
1.25
.75
.5
.25
1,500
1,200
1000
900
850
800
700
600
2
1.6
1.3
1.2
1.13
1.07
.93
.8
You’ll buy goods in the order of their marginal utility per dollar, starting with the highest (50,000 for
the first water bottle). From there, you’ll get two more bottles with ratios of 100 and 2.5 respectively,
followed by two rings with ratios of 2 and 1.6. Next, you’ll want another bottle (your fourth) at 1.5, a
ring (your third) at 1.3, another bottle (number five) at f 1.25 and three more rings at ratios of 1.2,
1.13, and 1.07, respectively. Eventually, your dollars just won’t be working very hard for you, and you’ll
choose to keep the money rather than buy either a ring or water.
Individual and Social Goals
When people make decisions out of rational
Discuss it!
self-interest, they optimize by maximizing their
Are you familiar with examples of groupthink in your own
individual utility. But what happens when a
group of people gets together and tries to make experience and in your own country? Discuss these examples
with your teammates and online with teams at other schools.
a decision? Most rational people do what is best
for them individually, so putting them together in a group with a common goal can result in interesting
outcomes (as any Decathlon or World Scholar’s Cup team will prove).
When the group’s output can only be measured collectively, each member knows no one will notice if
he or she contributes a little bit less. This behavior is called shirking or social loafing26 and is, like all
economic phenomena, the result of rational self-interest. Shirking reduces the productivity of the group
and makes a manager necessary to ensure all individuals are putting in maximum effort.
Groups aren’t always less productive than individuals; having different perspectives is often crucial to
economic decision-making. But even diverse groups with good intentions can be counterproductive.
Social psychologist Irving Janis researched various government fiascos and coined the term groupthink,
a condition in which everyone agreeing to a bad decision is blinded by its popularity.
In the United States, many critics have argued
Watch it on YouTube
that the invasion of Iraq in 2003 was in part the
result of groupthink. Intelligence services such In 1961, President Kennedy authorized what turned into one of
the greatest disasters of his presidency-----the invasion of Cuba
as the CIA affirmed the president’s statements
by a CIA-trained group of Cuban exiles. The operation failed
about the looming threat of Iraqi weapons of spectacularly. The lead-up to the Bay of Pigs disaster is often
mass
destruction;
military
officers
cited as a textbook example of groupthink. Learn more at
underestimated the difficulty of bringing peace
http://www.youtube.com/watch?v=rKlnM_n1s1E
to Iraq after an invasion. The militant
atmosphere in Washington arguably kept anyone from voicing—or even contemplating—strong
26
Social loafing can also be explained by a game of tug-of-war. If there are many people tugging the rope at the same time,
then each person would give less effort, thinking that the rest of the group would pick up the slack.
opposition to the president’s certainty about the merits of an invasion.
Positive and Normative Economics
There are two types of analysis in economics: positive and normative. A
positive economic statement is a statement that can be proven or disproven
with facts. As with positive statements in philosophy, a positive economic
statement is falsifiable. That is, it could potentially be shown to be wrong.
A positive statement does not need to be correct. It can even be about the
future. A statement such as “The world will end in 2012” is positive
because we will know if it is right or wrong by 2013.
NORMATIVE ECONOMICS
opinionated,
subjective economics
POSITIVE ECONOMICS
factual economics, unbiased
statements of theory
Like scientific theories, economic theories are stated positively. Theories are stated without biased
language, usually in the form of “If X, then Y.” Here’s a theory: if you read this guide, your score will
increase. This could be proven wrong if you read this guide and your score decreases.
A normative economic statement is a judgment, a statement of opinion. It may interpret facts, but it
can be neither proved nor disproved with facts. A normative statement might express something that
“ought to” or “should” be an economic goal, or it might express how a goal “ought” to be pursued.
“The World Bank should focus on rebuilding Haiti in 2011” is a normative statement.
Let us review. To make a positive economics statement, you might say, “If we raise the excise tax on
tobacco, then people will buy fewer cigarettes.” You could also say, “They raised the excise tax on
tobacco last week.” To make a normative statement, you might say this: “We should raise the excise tax
on tobacco in order to punish smokers for their stupidity.”
Economic Systems and their Characteristics
There are different kinds of economic systems.
We can tell them apart by how resources are
owned and by how economic decisions are made.
A traditional economy relies on what has been
done in the past to determine what should be
done today. Traditional economies do not have
much contact with the rest of the global
economy. Some examples can be found in parts
of Bhutan, Brazil and Burkina Faso. Even in
developed countries, remote areas often maintain
aspects of traditional economies.
Watch it on YouTube
North Korea is one of the last remaining closed societies on
Earth. For a glimpse of this fascinating, unpredictable
country-----in which a dead man continues to hold supreme
power-----check out one of several documentaries on
YouTube, filmed with varying degrees of permission from
the North Korean government. Here’s one to get you started:
http://www.youtube.com/watch?v=FJ6E3cShcVU
Discuss It
Some people suggest the economy should be overseen by
experts without political ideologies. Do such experts exist?
In a pure market economy, all economic resources are owned by private parties. Those individuals (and
entities such as corporations) make all economic decisions, and there is no government intervention.
Such economies do not actually exist, though some come close, with only minimal government
intervention for things like national defense.
In a planned economy, like North Korea’s, all land is publicly owned. A single central authority, such
as Gosplan in the former Soviet Union, makes all economic decisions. When this authority has absolute
power, the system can also be described as a command economy. Command and planned economies
are often designed around master plans, which dictate how everything will be produced and distributed.
In reality, there are no pure economies of any kind. All real-world economies are mixtures of different
systems. The United States has a mixed market economy. It promotes private enterprise, but the
government intervenes to help achieve certain goals (such as lowering unemployment27). The United
States also has traditions that affect economic activity. For instance, Thanksgiving affects the total
production and consumption of turkeys, and very few restaurants open on Christmas.
The Basic Economic Questions
All economic systems exist to fight scarcity. To do so, each must answer basic economic questions:
What and how much to produce?
Should we produce more capital goods or more
consumer goods? Should we produce more
hybrid cars or more minivans? How many more
of one than the other?
In a market economy, the interaction between
buyers and sellers in “the market” answers the
question of what to produce. Suppliers produce
and sell what consumers want to buy, and vice
versa. Of course, individuals who own the means
of production can always go against the market,
but this would be to their detriment. No one
wants to sell something no one wants to buy.
Running (a long way between) the tables
When I ate at a restaurant in former Soviet Georgia in 2000,
I saw plenty of evidence of the country’s communist past. A
handful of small tables dotted a large room, there were a
dozen waiters, and there was no menu. Why would
something like this happen? Since until recently no one had
paid rent based on square footage, there was no incentive to
use space efficiently. The government had supplied the
wages, so it was no big deal to have too many waiters. And
since the menu depended on what food happened to be
available, there was no sense in printing one.
Debate it!
Resolved: That the postal service should be allowed to go
In a command (or planned) society, the
bankrupt.
government or a central group decides what to
produce. Long-term plans are often implemented—such as the famous Five Year Plans of China and
the Soviet Union. Such plans may not work perfectly, since it is hard to dictate things like the weather
or worker productivity—but, even when they fall short, they steer the economy one way or the other.
The United States relies mostly on the market to answer this question. The government accounts for
over a quarter of GDP, and many government programs play important roles in everyday life. The
government also cajoles people and firms to take certain actions with tax incentives. For example, the
“clash for clunkers” program gave people tax credits if they exchanged gas-guzzling older cars for more
efficient newer models. The tax deduction on mortgage interest encourages home ownership. The
government also imposes regulations on private industry, dictating pollution limits, safety standards,
and consumer rights. If the government chose to, it could even regulate caffeine as a drug.
27
Or, if you’re in San Francisco, forbidding Happy Meals.
How to produce?
This is a question of how we use our scarce resources to produce the goods and services we want. Should
we subsidize farmers who farm organically? Should the United States outsource all customer support
services to call centers in India—or, as Indian wage rates rise, to Indonesia?
In a pure market economy, suppliers decide how to produce goods or services. To a producer, the best
method of production is usually the method that maximizes profit.
In a command (or planned) economy, the government or a central authority decides how to produce.
This has resulted in some disasters, such as Mao’s decision to have the production of steel undertaken
by rural villages instead of large, urban factories. The resulting steel was useless; desperate farmers even
melted their tools to meet his demands, contributing to a famine that killed millions.
In a mixed market system, this question is answered by both the market and the government. Firms
generally try to produce in the ways that maximize profit. The government sometimes subsidizes less
efficient industries to ensure they can compete or deliver needed services. For example, the United
States government runs the postal service, because, if it were a private company, it would cut back on or
raise prices on mail delivery to rural communities.28
The government also imposes regulations. For example, in most developed countries, firms can’t set up
sweatshops to produce goods (though they can cheerfully import goods from sweatshops abroad).
Who receives the benefits of production?
While the first two questions were mainly questions of efficiency, the third is mainly a question of
equity. Is it fair that only those who can afford food and shelter should survive? Should age be a factor in
determining who should have jobs and resources? What about race or gender? Is the current distribution
of wealth and resources desirable? Should Paris Hilton enjoy a cut in her inheritance tax or should
middle-class households be given a cut in their income tax?
In theory, a major advantage of a communist command economy is that it ensures everyone shares in
the benefits of production. No one will starve, and everyone will have a place to live. That kind of
idyllic promise is what drew people to such economies in the first place. But, of course, the central
authority may be corrupt29 or incompetent—or it may value equity at the expense of opportunity.
In the United States, a mixed market economy, this question is again answered by both the market and
the government. Public education is offered to everyone, and there are many government programs that
transfer money to needy individuals—welfare, housing projects, health insurance for veterans,
subsidized student loans, and so forth. All Americans benefit from highways, trash collection, and water
projects. Still, they can’t all drive fancy cars or eat sushi every night; market forces decide who will
receive those less fundamental benefits.
We can differentiate economic systems by comparing who answers the basic economic questions:
28
Think about how much more expensive it must be to deliver a letter to rural Alaska—or to American Samoa—than to
Boston. Yet each costs the same stamp. That is not an efficient market.
29
Sure, says the communist ruler, everyone is given a place to live. Mine just happens to be nicer than everyone else’s.
Market
Planned/Command
Mixed
What and How Much to Produce?
the market
a central authority
the market and the government
How to Produce?
individuals and firms
a central authority
individuals, firms, and the government
For Whom to Produce?
the market
a central authority
the market and the government
Responses to Positive and Negative Incentives
Economics assumes people respond in predictable ways to incentives. A self-interested individual or firm
will consider all relevant benefits and costs when making decisions—trying to maximize benefits and
minimize costs. Since we know (in economics) that people make these calculations, consciously or
subconsciously, we can come up with incentives to motivate people to make the decisions we like.
A positive incentive is a reward for behavior meant to encourage that behavior. An airline will give out
frequent flyer miles to people for flying that airline. The goal is to give people a reason to keep flying
that airline, by promising that the points will lead to rewards and privileges—such as upgrades.
A negative incentive is a punishment (cost) for behavior deemed undesirable by whoever is dishing out
the punishment. For example, police departments will issue fines to discourage speeding, and the
government will audit suspicious tax returns to discourage cheating.
An example: if Jonathan is a typical high school student and you tell him you will give him $50 to bring
you a yogurt, it is easy to predict he will do it. Similarly, if you hold a gun up to Jonathan’s head and
tell him you will shoot him unless he brings you a Coca Cola, again, he will probably do it30. To
Jonathan, the $50 are a positive incentive for bringing you the yogurt, and being shot is a negative
incentive for not bringing it. That you might be executed for killing him is probably irrelevant to his
decision-making; he wants to live more than he wants you to die.
Jonathan’s responses are predictable because he responds in the way that maximizes his utility, whether
it is maximizing his gain or minimizing his loss. The money offers positive utility, so he brings you
yogurt to increase his total utility. A bullet through his skull promises negative utility (think of the
hospital bills). To avoid decreasing total utility, he brings you the Coke.
Of course, $50 might not be enough of a positive incentive to someone else. Jonathan’s classmate
Jacqueline might see taking your orders as such an insult that the negative utility of doing what you
want outweighs a $50 gain. We never know exactly how a person will respond to an incentive; people’s
values vary too much. But, if we know a person sees something as a positive incentive, we can predict he
will take it. If we know a different person sees the same thing as a negative incentive, we can predict she
will avoid it. They make different choices, but both are maximizing their utility.
Economists assume people behave according to rational self-interest. An economist does not see people
as good or evil, just as rational, well-informed and self-motivated. Recent research suggests people may
not be that rational after all.31 Still, in aggregate, the assumption that they are rational and motivated by
self-interest will help us understand the economy.
30
31
Unless he’s actually Jack Bauer, in which case he’ll find a way to kill you with the Coca Cola.
I’m surprised this took a while to figure out.
Don’t mix up self-interest with money. Yes, people are (almost always) interested in money. But they’re
also interested in other things, such as family, respect and leisure. People can be motivated by both
monetary and non-monetary incentives.
Suppose you’re a manager at a multinational
Debate it!
corporation hoping to make its low-wage
workers more efficient and enthusiastic. You Resolved: That people are motivated mainly by self-interest.
could raise their wages. But suppose you wanted to use non-monetary incentives. Perhaps you could call
employees “associates” or “team members” and award the most effective of them special prizes each
month. You might also remind them frequently of how important they are to you and of what a
difference they are making in the lives of your clients. Such non-monetary incentives can motivate
employees even in the absence of larger paychecks.
Characteristics of a Mixed Market Economy
Economic Freedom
A market economy requires freedom of choice for consumers and producers, so they can decide which
goods and services to consume and produce, and so they can independently determine what prices they
are willing to spend and charge for them.
Private Property
Businesses, land, and homes are owned by individuals or by shareholders, not by the government.
Decisions are made by independent women and men, looking out for their own interests.
Economic Incentives
The most common incentive is “profit motive.” Most people desire more things. Those who work
harder tend to earn more and can purchase more of the goods and services they desire, reaching a
higher standard of living. People can thus “move up” in society. A market economy cannot sustain a
rigid class system because it would prevent people who work hard from becoming wealthier.
Competitive Markets
There is economic “rivalry” between producers and between consumers. Businesses compete for buyers.
Competition leads to better, cheaper goods for consumers. Consumers compete to obtain goods and
services from sellers. Some consumers are willing to pay more to ensure they will get what they want.
In a competitive market, inefficient firms and producers are forced out of business if they don’t
continually improve their offerings or their prices.
Limited Role of Government
Most market economists believe efficiency will decline if the government interferes too much with
natural market forces—say, by restricting trade—leading to higher prices and less output. However,
even the most passionate market economists agree the government has some indispensable roles. For
example, it enforces laws that protect private property, and has the authority to pursue and punish
criminals and to deploy armed forces to protect the country. A more controversial government role is
to “level the playing field” by regulating or even breaking up monopolies and trusts.
Voluntary Exchange
When you make an exchange, you trade one thing for another. You can exchange something for money,
or for another resource, good, or service. In this guide, we’re mostly concerned with voluntary
exchanges—but consider what an involuntary exchange might be. If the government seizes your house
to build a bypass, paying you something for your trouble, you have enjoyed an involuntary exchange.32
Voluntary exchanges are easy to imagine; we engage in them all the time. Both parties in a voluntary
exchange expect to gain. When you buy a house, you expect to gain shelter, property and social status.
The person selling it expects to gain cash. When two baseball teams trade players, both expect benefits;
no one ever makes a trade to lose.
One form of voluntary exchange is barter, which happens
Even the most primitive economies have
when we exchange resources, goods, or services for other
found ways to avoid barter.
resources, goods or services. No money is involved.
Normally, we have no trouble making the occasional exchange
without money, but we would have a terrible time trying to run a
whole economy that way. Barter only works if there is a double
coincidence of wants. It isn’t enough for you to have something I
want. Unless you also want what I have, we cannot barter.
Suppose you live in a barter economy and you fish for a living. You’re
sick of sleeping on the beach33, so you decide to build a house. You
need a hammer, some nails and a pile of wood. You go to see the
hammer-maker and offer her 10 fish for a hammer. She replies that
she’s allergic to fish but would love to trade a hammer for 15 eggs.
Okay—you go to the chicken-grower and ask him if he’ll trade 10
fish for 15 eggs. He says that fish make him gag but he loves
spaghetti. It just so happens that his neighbor grows spaghetti and loves fish. Progress! You walk next
door and offer the neighbor 10 fish in exchange for the fruit of one Noodlebush, take the spaghetti to
the chicken-grower and get the eggs, and bring the eggs to the hammer-maker and get your hammer.
Now you need to find some nails and wood. See the problem? Bartering demands tremendous time and
effort. Imagine an economy full of people trying to barter, and you can understand why most societies
have found ways to avoid it. Money is the most straightforward solution: it eliminates barter by
functioning as a medium of exchange. You could have sold your fish for money. Then you could have
approached the hammer-maker and offered her money for a hammer. You could then have bought all
the other items you needed to build your house. With money, there would have been no need to deal
with the Noodlebushes, or to carry around dead fish.
A market would have helped your situation even more. A market is a mechanism that brings buyers and
sellers together to make exchanges. Some markets are real places, such as grocery stores, swap meets, and
used car lots, where buyers and sellers physically come together. Some markets are online, like eBay and
Amazon. In the example above, you could have gone to a fish market and waited for someone to come
buy your fish—then walked over to the hardware market for supplies.
32
33
It’s not the end of the world, but it’s not ideal, either. Or, it could in fact be the end of the world.
It gets old, especially when the tide rises and takes away your backpack.
Specialization and Division of Labor
If you have ever read Laura Ingalls Wilder’s semi-autobiographical novel Little House on the Prairie, you
may have been impressed by her family’s self-sufficiency. Her mom ground wheat into flour, baked,
raised chickens and cows, cooked, did laundry, pumped water, sewed clothes, and raised children. She
made sugar from tree sap and soap from pig fat. Her father chopped down trees, grew crops, and built
houses and wagons. He trained horses and slaughtered pigs. He even shot raccoons to make fur hats.
Laura’s parents bought a few things, but did nearly everything for themselves.
Imagine we sent this guide back in time. Laura’s mom finds it in the prairie and opens it to this section.
After reading it, she realizes she’s had it all wrong. She runs from farm to farm and rallies farmwives for
“something really important.” Soon, five are gathered in her living room. She asks each about her chores
and notes how much they produce. Laura’s mom realizes each of the wives is particularly skilled at one
thing. On a chart, she circles each woman’s productive specialty.
Name
Anna-Lee
Barbara-Jean
Laura’s Mom
Mae-Belle
Mae-Jean
Sarah
Group Total
Pounds of Flour
Ground
Children Raised
3
2
2
4
3
5
1
2
1
1
2
10
6
22
Productive Output for One Month
Loaves of Bread Chickens Raised
Baked
16
6
15
8
14
7
13
5
4
20
8
6
86
36
Cows Raised
1
1
1
Loads of
Laundry Done
12
15
28
16
20
26
117
3
2
1
9
Clearly, Anna-Lee is the best flour-maker. Mae-Jean can produce the most loaves of bread. Mae-Belle
raises more cows than any of the others, even though she has three children.
After a short pep talk from Laura’s mom, the women agree: they are overworked and have not time for
fun. There has got to be a better way. Laura’s mom proposes theyen pool their efforts. Each can specialize
in the thing she does best. Everyone can do her specialty for the whole group, and then no one will have
to handle all those chores alone. It’s an easy sell. The women agree to become interdependent.
Fast-forward a year. The women have finally had the chance to enjoy some time off. Laura’s mom calls
a meeting to discuss group productivity. She estimates their new productive capacity:
Anna-Lee
Barbara-Jean
Laura’s Mom
Mae-Belle
Mae-Jean
Sarah
Group Total
Previous Total
Increased Productivity
Pounds of Flour
Ground
30
0
0
0
0
0
30
10
20
Children Raised
0
0
0
0
0
22
22
22
-
Productive Output for One Month
Loaves of Bread Chickens Raised
Baked
0
0
0
36
0
0
0
0
200
0
0
0
200
36
86
36
114
-
Cows Raised
0
0
0
9
0
0
9
9
-
Loads of
Laundry Done
0
0
150
0
0
0
150
117
33
It turns out the cooperative produces 20 more pounds of flour, 114 more loaves of bread, and 33 more
loads of laundry than the women on their own. And the women now have leisure time.34
Like the women in the co-op, most people today are specialists. Sure, some fix cars or bake for fun, but
most specialize in the fields where they can be most productive, and use their income to buy other
goods and services. Like the women in the co-op, they grow interdependent. We count on other people
to specialize in other things, and to pay us for our specialties.
Consider an example from the professional world. If, in college, you like critical thinking and you have
writing skills, you could go on to specialize in law. On the other hand, if you prefer biology, you might
become a doctor. This is far more practical than for everyone to try to become both lawyers and doctors.
If we did that, people wouldn’t get out of school until they were 40, and many of them would be very
mixed up. As a lawyer, if you become sick, you will be dependent on a doctor to help you; if, as a
doctor, you are sued, you will need to sign up a lawyer to represent you. In either profession, you will be
dependent on other specialists. The result is overall interdependence.
The assembly line is another example from the real world. It reflects division of labor: splitting
production into separate tasks. The advantage is that workers on the line only have to learn one small
part of the production process. They become very specialized. The disadvantage is they are so
interdependent that if one worker fails to complete his job, the whole process could fail. Workers can
also grow bored, or depressed, and can often be replaced with machines.
Introduction to Trade
A country, too, can improve the quality of life for its people by trading with other countries. Any
country (even North Korea) can export goods—sell them to other countries—or import goods—buy
them from other countries. When the United States sends Fords to Mexico, it is exporting. If you buy
French cheese in a Kuala Lumpur supermarket, you have purchased an import.35
Unless a country happens to import exactly as much as it exports, it will either import more than it
exports or export more than it imports. The balance of trade is the ratio of a country’s imports to its
exports. It is simply a measure of whether a country is importing more or exporting more and by how
much. If we import more than we export, we are running a trade deficit. If we export more than we
import, we are running a trade surplus. We can run a trade deficit with one country—like China—and
a surplus with another—like Samoa—at the same time.
Sometimes countries want to import less of something from abroad. To achieve this they impose trade
barriers, or restrictions on trade. Trade barriers are a form of protectionism. They protect domestic
markets from global competition, but can also be used to pressure or punish a country. One trade
barrier is a tariff, a tax on an import. Another is a quota, a limit on how much of a good that may be
exported or imported. Typically, quotas are imposed on imports. The most restrictive trade barrier is an
embargo, which prohibits any exchange. Embargos can be imposed on a single good, an industry, a
country or any combination of these (e.g. all cigars from Cuba).
We will come back to this topic, and to larger issues in trade and development. First, we will turn to the
markets within a given country.
34
35
The space-time continuum has probably been destroyed, but who’s counting?
This is true even if the supermarket in Kuala Lumpur is owned by the French, as it very well might be.
III. Microeconomics
Traditionally, the study of economics is divided into two
broad areas: microeconomics and macroeconomics. In
microeconomics, we study the economic decision-making of
individuals and firms and the consequences of those decisions.
In microeconomics, we isolate the behavior of individual markets and
we try to explain how they function and what will cause their behavior
to change. When you decide how much salmon to buy at Carrefour
and when Toyota decides how many cars to manufacture in Osaka,
these decisions are being made at a microeconomic level.
In macroeconomics, we look at the overall economy and try to understand how all the parts interact.
We might try to measure the size of the economy or we might try to assess its health. We might also
predict, rightly or wrongly, how a policy change could affect the economy.
In this resource, we first explore microeconomics, then macroeconomics. While not everything you’ll
learn in the study of microeconomics will apply directly to macroeconomics, most of what you’ll learn
in “micro” will be foundational to your understanding of “macro.”
Markets
Earlier, we defined a market as any mechanism that brings buyers and sellers together to exchange
goods, services, and/or money. A swap meet is a classic example, but a store, a restaurant, a garage sale, a
hotel, eBay, Amazon.com and the New York Stock Exchange are all markets.
In economics jargon, buyers demand goods and services. Sellers supply them. When buyers and sellers
interact—that is, when supply and demand interact—they create markets. As you have learned, in a
pure market economy, markets handle the problem of scarcity. Markets ensure scarce resources, goods,
and services are allocated to the people who can afford (and desire) to buy them.
Naturally, when we study economics, we talk a lot about supply and demand. In fact, according to an
old saying, if you teach a parrot to repeat, “supply and demand,” you will have created an economist. In
this section on microeconomics, you will certainly have to read about supply and demand, but we won’t
stop there. Supply and demand are only the beginning.
Prices
Without prices, markets would make little sense. Remember the barter economy? Imagine how
frustrated you would be if you were trying to sell your house and you had to measure its value in potted
plants to one prospective buyer and in dental cleanings to another. How would you know which was
the better offer? How could you compare them? Prices eliminate this problem. With prices, we have a
common measure for making exchanges. Prices are expressed in a consistent way—in terms of dollars,
won, or what-not36—so people can use them to make rational decisions.
36
Or, technically, what-notes.
To an economist, prices are especially important because people respond to changes in prices with
changes in behavior. Sometimes, people shape their careers (or have their parents shape them) on the
basis of what they expect the “prices” (salaries) will be for different jobs.
Master’s of Low Wages
When the Harvard Kennedy School accepted me to a two-year program leading to a Master’s in Public Policy, it sent me a
brochure describing the career opportunities that lay ahead. Graduates were helping to build houses in Haiti, running for
office in small towns, and volunteering at neighborhood schools. Inspiring! But the career statistics were oddly grim. The
average salary for someone coming out of the Kennedy School was lower than that of someone from the undergraduate
college. After a burst of panic, I realized it was a case of self-selection bias-----people choosing the Kennedy School most
likely weren’t looking for high salaries as much as they were for the more meaningful pursuits that had drawn them to the
program in the first place. Surely I could choose to attend and then find a more balanced career. Of course, after graduating,
I started a nonprofit and stopped taking a salary. My parents probably wish I had gone to the business school.
Now we’ll look into the meat of economics, supply and demand, to
see what determines prices.
Demand
In the language of economics, “demand” is the relationship between
the price of a good or service and the quantity demanded of that
good or service—the quantity buyers are willing and able to buy. As
its price decreases, the quantity demanded of it will increase.
DEMAND SCHEDULE FOR TVS
Price per
Number of TVs
3D TV
Demanded
$1100
200
$1000
300
$900
500
$800
900
$700
1300
$600
1800
$500
2400
$400
3100
Put another way: the quantity demanded of any good or service
increases as the price of the good or service decreases.
This inverse relationship is called the Law of Demand.
A demand schedule shows the various quantities of a
good or service consumers are willing and able to buy
at different prices. The table to the right is a demand
schedule for 3D TVs. Notice how, at lower prices,
such as $400 per TV, the quantity demanded is high;
at the higher prices, like $1000 per TV, it is far lower.
If we plot the data from a demand schedule into a
graph, we form a demand curve. To the right is a
curve representing demand for TVs.
Now let’s look at the demand for another good:
DECADOGS, a new line of scholarly hot dogs. The
second table to the right is a demand schedule for DECADOGS.
If we plot its data, we find the demand curve for DECADOGS.
It turns out most demand curves are similar. Compare the
demand curve for DECADOGS with that for TVs. Notice both
are downward-sloping. On the left, both curves are high above
the origin, but, as we move along either curve, from left to right,
Demand for DECADOGS
Price ($)
.10
.25
.50
.70
1.00
2.00
Quantity Demanded
100
75
30
15
5
2
the curves move downward. The downward slope is a graphical representation of the law of demand: as
price decreases, quantity demanded increases.
One reason the demand curve slopes downward is the
income effect. If a good’s price falls, consumers are left
with more income to spend both on it and on other
goods. To consumers, the price decrease feels like an
increase in overall income. It results in a higher quantity
demanded of that good—and of all other goods!
Another reason the curve slopes downward is the
substitution effect: as a good’s price falls, consumers
choose it over other goods with a similar purpose. If beef
becomes cheaper, you might buy less chicken and more
beef; again, moving down in price means moving to the
right on quantity.
Demand vs. Quantity Demanded
We must be clear about the difference between demand
and quantity demanded. Every economics exam tests this
pesky detail.
Demand refers to the entire curve—to an entire set of
prices and quantities. If price goes down, quantity
demanded goes up—but the demand curve remains
unchanged. We still face the same conditions—just at a
new point on the curve.

If price changes, there is movement along the
curve until we land at a new quantity
demanded.

If demand changes, there is a movement of
the demand curve. The whole curve will shift
to the right or left.
I know an economics teacher who throws a foam brick at
anyone who claims that changes in price change demand. It’s less scary the second time—diminishing
returns—but the lesson remains: demand and quantity demanded are not the same.

When demand increases, the curve shifts to the right. At each possible price, the
corresponding quantity demanded is higher.

When demand decreases, the curve shifts to the left. Again, for each possible price, the
corresponding quantity demanded is lower.
A demand curve might shift for one of several reasons. Notice again that these reasons are different from
a change in price or quantity, which would cause movement along the demand curve. Use the device
INSECTS to remember them:






a change in consumer income
a change in the number of consumers
a change in consumer expectations
a change in the prices of complementary or substitute goods
a change in consumer tastes
a change in the season
Changes in Consumer Income
Normally, when consumers have more money, they
demand more of any given good. That is, an increase in
consumer income will cause the demand curve to shift to
the right. At each price along the new demand curve,
consumers will be willing and able to buy greater
quantities. If the demand for a good increases when
consumer income increases, the good is said to be a
normal good. A television is an example of a normal
good; if you get a raise, you might buy a new, larger TV.
Sometimes, when people have more money, they buy
fewer of certain goods. When they have less money, they
buy more of these goods. These are called inferior goods.
You’ll discover inferior goods as soon as you live on your
own for the first time. Ramen noodles are an inferior
good. So are macaroni-and-cheese dinners (the kind in a
box with little white envelopes full of bright orange
cheese-powder). College students eat a lot of ramen
noodles and macaroni-and-cheese. Some happen to like
these foods. For the rest of us, what it comes down to is
this: you can buy whole lot of them for a dollar. Many
students go to school all day; they only work part-time, if
at all, and for little pay. Students are also fairly new at
the art of personal finance, and often find themselves
strapped for cash when rent or tuition is due. That’s
about the time when the demand for ramen and
macaroni-and-cheese will shift to the right.
Unsurprisingly, when student loan checks come in,
students suddenly start eating out, and the demand for
ramen decreases; it shifts to the left.
Luxury goods include Ferraris and caviar. They are like
normal goods in that people buy more of them as their
incomes increase, but different in that, as people make
more money, they spend a larger percentage of their
income on them. (This should make sense, as you would
spend none of your income on most of these—like
private jets—until you were deliriously rich.)
Changes in the Number of Consumers
The number of consumers in a market affects the demand curve. If half of the consumer market for
DECADOGs suddenly perished of smallpox, the quantity demanded for DECADOGs at each price
would decrease by half, so the demand curve for DECADOGS would shift to the left. A fall in
population will usually shift the demand curve to the left, and a rise in population to the right.
Changes in Consumer Expectations
When Apple announces that, on August 1, iPads will go on sale for half the current price, most people
will stop buying iPads until the price comes down. Only a few consumers, those desperate for iPads,
will stay in the market for them at the current price. Meanwhile, because demand is falling, the current
equilibrium price will actually decrease prior to the official price cut.
Current demand will always decrease if consumers expect prices will be lower in the future.
Similarly, if consumers expect that something is going to become more expensive in the future, they are
more likely to buy it right away. This increases the number of consumers currently on the market,
raising demand and leading to a higher equilibrium price.
Current demand will always increase if consumers expect prices will be higher in the future.
Economists conclude that consumer expectations are self-fulfilling prophecies. The belief that prices will
increase leads prices to increase. The belief that they will fall leads them to fall. This analysis is referred
to as the theory of rational expectations37.
Changes in Prices of Substitutes and
Complements
A substitute good is one consumers are willing to use in
place of another: Pepsi and Coke, iPhones and Android
phones, bagels and English muffins, plastic bags and
paper bags, etc. Even private colleges and public
universities are substitute goods. When the price of a
good increases, the quantity demanded of that good
decreases—leaving more people looking for a
replacement good (since presumably there was a reason
they wanted the original good in the first place). This
means the demand for the substitute good will increase,
as the number of people in the market for it has
increased.
Suppose that, on hot days, you drink iced chai or
lemonade. Both beverages cost the same amount. You
usually choose chai because, like me, you like it better.38
But suppose the price of chai went up. You’d probably
37
This theory is also reflected in politics: when people expect a certain candidate to lose, they’re less likely to vote for him,
making it more likely that he will lose.
38
I liked chai better, too, until overdosing in Dubai.
buy less of it. To continue quenching your thirst, you’d buy more lemonade. You would join the
population of people who buy lemonade. By increasing
the number of lemonade consumers, you would have
caused the demand curve for lemonade to shift to the
right.
A complementary good is one associated with another
because the two goods are consumed together. Peanut
butter and jelly are complements. Printers and toner
cartridges are complements. If the price of a good
increases, then the quantity demanded of the good will
decrease, and the demand for the good’s complement
will decrease as well, since fewer people will need it.
Consider an example. You’re lounging in your luxury
office at DECADOGS, Inc. You’ve just discovered a
mustard stain on your shirt collar when your assistant
charges into the office.39 You offer her a chair, but she
refuses to sit. She places both hands on your desk and
leans in. Between gasps, she whispers, “I just…
received word… that… the price of hot dog buns…
is… rising.”
You jump from your seat. As CEO of DECADOGS,
and an astute economist, you know it is bad news. You think, if the price of hot dog buns rises, then the
quantity demanded will fall… which means people will eat fewer hot dog buns… which means they’ll
need… nnoooo... fewer DECADOGS! You drop to your knees, lift your head and scream, “The demand
curve will shift to the left!!!”
Keep this in mind: a change in the price of a good will never change the demand for that good, but it
can and often does change the demand for its substitutes and complements.

Two goods are substitutes if they can replace one another.

A price increase in a good causes an increase in demand for substitute goods.

Two goods are complements if they go
together.

A price increase in a good causes a decrease in
demand for complementary goods.
Changes in Consumer Tastes
Changes in the tastes and preferences of consumers can
cause the demand curve to shift to the right or left.
Advertising, social perceptions, the weather, and even
medical research can play a part in this component of
39
They got the mustard out!
demand. If consumer taste changes to favor a good, then the demand for that good will increase—its
demand curve will shift to the right.
Tickle-Me-Elmos were once so popular as Christmas
gifts that Americans literally threw punches as they
fought to buy them for up to $300 each——twenty
times their list price! Effective advertising and social
pressure caused more consumers to join the population
willing to pay $300 for a Tickle-Me-Elmo. For a short
time, the demand curve shifted far to the right.
The same phenomenon has repeated often in the toy
industry: Wiis, Furbies, even, long ago, Cabbage Patch
Kids. Sometimes, people expect it to occur, but it doesn’t—such as with Apple’s first iPhone. Some
folks bought extras, planning to resell them on eBay. But no one was interested in buying them at a
premium, as there were enough iPhones to go around.
The Atkins Diet—which urged people not to eat carbohydrate-rich foods such as bread, pasta, and xiao
long bao—caused a similarly drastic change in consumer tastes and preferences. It convinced many
consumers to leave the population willing and able to buy and eat baked goods and spaghetti.40 The
demand curves for bread shifted to the left.
Seasonal Changes
Some goods are more useful at some times of the year than at others. When a seasonal good is “in
season”—that is, when it is most useful to consumers—demand for it will increase, and the demand
curve will shift to the right. When it is “out of season,” the demand curve will shift to the left. Seasonal
goods include things like ski equipment, parkas, Easter candy, Valentine’s Day cards, and swimwear.
Who wants Christmas wrapping in July? Or Easter candy for Halloween?
Supply
In the language of economics, supply is the relationship between the
price of a good or service and the quantity supplied of it.
Mathematically, supply is a function that maps price to quantity
supplied. Supply is not an actual number, quantity supplied is.
SUPPLY SCHEDULE FOR TVS
Price per
TV
$1100
$1000
$900
$800
$700
$600
$500
$400
Number of TVs
Supplied
3100
2400
1800
1300
900
500
300
200
The general relationship between price and quantity supplied is the
law of supply, which states that as the price of a good or service
increases, the quantity supplied of it will also increase. We can say
price has a positive relationship with quantity supplied because an
increase in a good’s price will result in an increase in the quantity supplied, and vice-versa.
A supply schedule shows the various quantities of a good or service that producers are willing and able41
to produce and make available for sale at each price within a range of prices. The table below is a supply
40
What would the impact be on the demand for Noodlebushes?
The United States government also uses this phrase to decide if you are entitled to unemployment insurance: you need to
be looking for a job and “willing and able” to start immediately. You can’t go on vacation and collect unemployment.
41
schedule for TVs. Notice that at the lower prices, like $400 per TV, the quantity supplied is low,
whereas at the higher prices, like $1000 per TV, the quantity supplied is high.
At any price greater than production cost, there is a
producer that will supply a good (or service.) If the
price is low, producers will usually make smaller
quantities of it, because they can’t generate as much
profit from each sale. The opportunity cost of
producing the good becomes higher. If they can get
away with charging more, producers will make a greater
quantity of it.
As with demand, if we plot the data from a supply
schedule into a graph, we will form a supply curve. To
the right is a curve for the supply of TVs.
Recall that a demand curve is typically downwardsloping. Notice how the supply curve above is the
opposite—it’s upward-sloping. A typical supply curve
has a positive slope.
Supply vs. Quantity Supplied
As in the case of demand, we must be very clear about
the difference between supply and quantity supplied.
When price changes, there is a corresponding change in
quantity supplied. That’s what the supply curve tells us.
It answers the questions “What is the quantity supplied
at price X?” and “What price will result in Y-units
supplied?” If there is a price change, there is a
movement along the supply curve until we land at a
new quantity supplied. If supply changes, there is a
movement of the supply curve. The whole curve will
shift to the right or left.
There are a number of reasons why the supply curve
might shift. The main ones:




a change in the cost of the factors of production
a change in the technology used for production
the expectation of a price change
a change in the number of suppliers
In the coming pages, we’ll discuss each of the factors that affect supply.
Changes in the Costs of Factors of Production
Economics assumes that producers supply goods and
services in order to make a profit. (Profit can be defined
very broadly to include social benefits that the producers
find valuable; this helps explain why some people are
willing to work in the non-profit sector.) If the factors
of production become less expensive, the profit margin
increases, so more producers grow willing to make the
product. In perfect competition, new producers also
enter the market. At each price along the supply curve,
there will therefore be a greater quantity supplied—
which means the supply curve will shift to the right. On
the other hand, if the factors of production become
more expensive, some producers will be unwilling to
continue producing, so at each price along the supply
curve, there will be a lower quantity supplied. The
supply curve will shift left.
Let’s go back to DECADOGS. If the price of lowquality meat goes up, so will your costs of producing
DECADOGs; at any given price you will not be willing
to sell as many as you did before. You might not have
the dramatic meltdown you had during the hot dog bun
crisis, but you will certainly need to call a strategy
meeting to try to come up with ways of saving in other
areas of production. Perhaps you can reduce processing
time or use squirrels instead of more expensive beef.
Until you can lower your production costs again, your
supply curve will remain to the left of where it was
originally.
Technology
When the technology used in production improves,
suppliers can supply a greater quantity at each possible price: the supply curve will shift to the left.
For example, suppose a bright intern at DECADOGS creates a new Dog-o-Lator, a machine that
produces DECADOGs in half the time of the old process. With this new technology, DECADOGS,
Inc. can supply twice as many DECADOGs at any given price. To reflect the sudden increase in
quantity supplied, the supply curve will shift to the right.
Expectation of a Price Change
If suppliers expect the market price for their good or service to go up in the future, they will be less
willing to supply it now (at the same time, remember, consumers will be more eager to buy it.)
Suppliers will want to hold onto their product so they can have more of it to sell when the market
selling price is higher. Before the price increase happens—and of course, there is the risk it won’t
happen—quantity supplied will decrease at each
possible price. To reflect the change, the supply curve
will shift to the left. On the other hand, if suppliers
expect the market price of their good to decrease in the
future, they’ll want to sell more of it now, while they
can still sell it for the higher price. At each possible
price along the supply curve, they’ll be willing to
supply a higher quantity, so the supply curve will shift
to the right.
You might find it helpful to think like a supplier. If
you sell pens and you expect the price to go up next
week, you’ll hold onto your supply this week so you
can sell more next week at a higher price. And if you
have reason to believe the price of Tickle-Me-Elmos
will go down next month, you’ll be willing to sell more
at every price today, because you’ll probably make
more money now than next month. Similar reasoning
motivates day-before-Christmas sales.
Number of Suppliers
If there is an increase in the number of suppliers of a
particular product, then at each possible price along
the supply curve, there will be more suppliers who are
willing and able to produce and sell. All along the
curve, quantity supplied will increase. The supply
curve will shift to the right. Similarly, a decrease in the
number of suppliers will cause the supply curve to shift
to the left.
Suppose half the suppliers of bicycle wheels are hit
with the bubonic plague. The plague also destroys all
their shops and equipment. (Don’t ask how. It’s an
example.) At every given price, quantity supplied
decreases by about half, because there are only half as
many suppliers who can produce and sell bicycle
wheels. The supply curve shifts to the left.
Market Equilibrium
If we plot the supply and demand curves on one
graph, the curves intersect. The point where they
intersect is the point of market equilibrium. At this
point, quantity supplied equals quantity demanded, so
the market “clears.”
At market equilibrium, buyers purchase everything
producers are willing to sell. Every unit produced is
cleared out—warehouses are left empty. In this way,
the interaction of supply and demand determines the
market price. This interaction helps to allocate scarce
resources, goods, and services. The equilibrium price
and quantity are also called the market clearing price
and clearing quantity.
There are two components to market equilibrium.
One is the exchange price, or the selling price. The
other is the exchange quantity, or the quantity
demanded and supplied—the total quantity of a
particular good that is sold for the exchange price. You
can use a graph of market equilibrium to predict the
net effect of a shift in supply or demand on the market
for a particular good.
For instance, suppose you want to know what will
happen to the macaroni-and-cheese market if the
income of college students increases. Because
macaroni-and-cheese is an inferior good, the increase
in income will cause the demand curve to shift to the
left, but it won’t affect supply. In the new equilibrium,
the exchange price and quantity will be lower.
Let’s consider another example: the hot dog bun
shortage confronting DECADOGS, Inc. The price of
hot dog buns rose, causing the demand for
DECADOGs to shift to the left. The price change did
not affect supply. In the new equilibrium, both the
exchange price and quantity were lower:
DECADOGs, like most hot dogs, are made of poor
quality, low-grade meat. When the price of this meat
went up, you had to reduce your supply of
DECADOGs. Nothing happened to the demand
curve, but the supply curve shifted to the left, resulting
in a new equilibrium. In the new equilibrium, the
exchange quantity was lower, but the exchange price
was higher:
When your intern at DECADOGS, Inc. came up with
that new Dog-o-Lator, you were able to increase
production of DECADOGs. After the supply curve
shifted right, the exchange price fell—good news for
customers—but the exchange quantity increased—good news for you.
Now suppose you had just returned from overseeing the first run of the Dog-o-Lator when your
assistant told you the price of hot dog buns was on the rise. Your supply curve had just shifted to the
right. Your demand curve was suddenly shifting to the left. Without more details, the overall change in
quantity exchanged would be ambiguous. There would be no way of knowing the new quantity. All we
would know for sure is that, in the new equilibrium, the exchange price would be lower.
Summarizing Equilibrium Changes
When supply and demand
move in different directions,
the equilibrium price follows
what happens to demand. If
supply decreases and demand
increases, price increases.
If supply
increases…
If demand increases… If demand decreases…
Equilibrium price change is
ambiguous.
Equilibrium quantity
increases. Equilibrium price decreases.
Equilibrium quantity change is
ambiguous.
Equilibrium price change is
If supply Equilibrium price increases.
When supply and demand
ambiguous.
decreases… Equilibrium quantity change
move in the same direction,
is ambiguous. Equilibrium quantity decreases.
equilibrium quantity goes in
that direction too. If both supply and demand increase, so does equilibrium quantity.
Price and Wage Controls
Sometimes—as the United States did during World
War II—governments enact price and wage controls.
They set maximum or minimum prices for a good or
service.
By definition, effective price controls interfere with
market equilibrium. It can be tempting to impose a
high minimum wage, to ensure everyone is paid enough
to afford food and shelter, but such a policy can also
result in consequences such as higher unemployment.
Society must decide if those consequences are
worthwhile.
There are two main kinds of price controls. A price
floor is a minimum price for which something may be
sold. For a price floor to have an effect, it must be above
the market equilibrium price. Since price is higher than
at equilibrium, there will be less quantity demanded
than supplied. The result: a surplus.
A price ceiling is a maximum price for which something
may be sold. A price ceiling must be set below the
market equilibrium price to have any effect. The result
of a price ceiling below the equilibrium price is a
shortage, or an excess of quantity demanded over
quantity supplied.
Consider a minimum wage—an example of a price floor. It imposes a minimum price at which laborers
may sell their labor. When a minimum wage is enacted, a surplus of labor results: there are more
workers willing to work for a minimum wage and not as many employers willing to pay them. Indeed,
there are usually workers who would be willing to work below the minimum wage but are no longer
allowed to. Since labor factors into the cost of production, higher labor costs reduce supply.
Price floors are often imposed on agriculture in the
United States, to help keep farmers in business. The
result: farmers grow more crops than consumers want.
The government buys up the surplus and stores it, or
sends it abroad as foreign aid.
Price ceilings work the opposite way. They are
common in the rental market. Some rent controls are
outright limits; others restrict how quickly rent can
increase. Rent controls distort the market. Current
renters benefit from lower rent—but current landlords
collect less rent than they otherwise could. They may
avoid improving units or even use them for more
profitable purposes—even illegal ones, such as
methamphetamine labs! Would-be renters face a
shortage of units; would-be landlords have less reason
to purchase buildings, depressing property values.
Those squeezed out may take part in a black market—
one that works outside the law. Black markets were
common in communist economies, such as the Soviet
Union, and emerge in prisons for goods such as
cigarettes. Black markets are referred to as the
underground economy.
Be careful not to confuse price floors and ceilings. If
we put them on the same graph, they form an upsidedown house: the floor is above the ceiling.42
PRICE FLOORS ARE USUALLY HIGHER THAN THE EQUILIBRIUM PRICE. THEY LEAD TO A SURPLUS.
PRICE CEILINGS ARE USUALLY LOWER THAN THE EQUILIBRUM PRICE. THEY LEAD TO A SHORTAGE.
Look again at the graphs of price floors and ceilings. The arrows point at gaps where the floor and
ceiling intersect supply and demand. Those gaps are the surpluses and shortages, respectively.
Utility and Income
Suppose you are at a bookstore trying to decide between economics books and autobiographies. Perhaps
you gain 10 utils from each economics book you read, and four utils from each autobiography. In other
42
I’m sure this would be very uncomfortable. Economics isn’t always about common sense.
words, you’ll get the same satisfaction from two economics books as you will from five
autobiographies—20 utils in all.
An economist would tell you that you are indifferent between the two combinations. Both offer the
same total utility. How will you decide which combination to buy? As a normal person you would say
that you would buy whichever combination costs you the least money, giving you the “best bang for the
buck.” But as an economist, you’ll have to learn to say
that you will buy at the point where your indifference
curve intersects your budget line.
An indifference curve is a graphical representation of
the many ways in which two goods (or two activities,
etc.) can bring you the same amount of happiness.
If a curve sits close to the origin, the goods along the
curve are not bringing you much satisfaction. If a
curve is further from the origin, it means that all the
possible combinations of the two goods are more
satisfying than all the possible combinations on the
curve closer to the origin.
The indifference curves represent the utility you get
from combinations of Mounds Bars and Almond Joys.
You might notice the curves are, well, curved. They
bow inward toward the origin. This is because
economists have observed that people, in general, like
variety. As in the case of Mounds and Almond Joy,
sometimes you feel like a nut, and sometimes you
don’t. Most people prefer a combination of two goods
over a lot of only one good.
Now look closely at curve A on the graph. At any point
on this curve, your total utility is the same. You would
be just as satisfied with five Mounds and one Almond
Joy as you would be with two of each. On curve B, the
story is the same. No matter which point you choose
along the curve, you’ll be just as content as you would anywhere else along the curve. The difference
between the two curves is that curve B is further from the origin, so your total utility along B is higher
than along A.
Recall that utility is a tricky and subjective matter of economics. We have no way of knowing how much
more utility you’ll get from curve B than from A; we only know you will get more. Utility is just not
something we can truly quantify.
Something we can measure about utility is the marginal rate of substitution. This is the amount of one
good you are willing to give up to get one more of the other good at a given point on an indifference
curve. On the graph, it is the slope of the indifference
curve at a given point43. As you move from point x to
point y, the marginal rate of substitution is 3, because
you’ll give up three Mounds bars for just one Almond
Joy. At point y, it is 1, and from point y to point z it is
1/3 (you give up 3 Almond Joys to get one Mounds).
This should remind you a lot of the Production
Possibilities Frontier.
Unfortunately, when we walk into a store, we don’t
simply grab all the candy bars we’d like. If that were
the case, it would be very difficult to pick a point on
an indifference curve. In the real world, we have to pay
for our candy bars, and that’s part of how we decide
what to buy.
Suppose you have $2, and each kind of candy bar costs
50 cents. You can get 4 Mounds, or 3 Mounds and an
Almond Joy, or 2 of each, and so on. If you plot all
your purchasing possibilities onto a graph, the points
form a budget line. Where an indifference curve
represents what you want, your budget line represents
what you can afford. A budget line is nearly always straight because the prices of goods are generally
fixed. Everything to the right of the budget line is infeasible, and every point on it or under it is a
potential point of consumption.
The budget line also represents a slope on the curve, or a particular marginal rate of substitution. In this
case, that rate of substitution is 1:1—as the prices are identical. In actuality, a budget line can have any
slope. The graph shows your budget line for the $2 you plan to spend on Mounds and Almond Joys.
According to your budget line, you just can’t have five of either bar.
To determine how to maximize your utility with the $2 you plan to spend, you will have to buy at the
point where one of your indifference curves is tangent to your budget line. If a curve crosses the line, it’s
no good—there must still be another curve further out that touches your budget line and that you could
therefore afford.
As it turns out, the indifference curve that matters here is curve A. If there were another curve, closer to
the origin than A, it would cross the budget line. Curve B, on the other hand, doesn’t even touch your
budget line. It would make you happier, but you just can’t afford it. The budget line is tangent to curve
A at point y. That is the point that will bring you the greatest satisfaction within your budget—and
that, then, is where you should make your purchase. You should buy two of each bar.
Indifference curves are a good lesson in thinking like an economist.
43
This, for all you calculus buffs, is
d ( Mounds)
d ( AlmondJoy)
. – Craig
Elasticity
Suppose that if you increased your study time 10%,
your score would rise 30%. This would be a useful ratio
to know. A ratio like this one measures the elasticity of
your score based on your study time. Elasticity indicates
how responsive one variable is to changes in another.
In economics, we focus on elasticity of variables related
to price. Ordinarily, elasticity refers to the relationship
between a change in price or some other factor and the
corresponding change in quantity demanded or supplied.
The most common measure of elasticity is the price elasticity of demand, which describes how much
quantity demanded changes when price does. A common way to calculate it is:
PED = % change in quantity demanded
% change in price
If the PED for a good is greater than one, then the demand for that good is price elastic. This means
quantity demanded changes a lot based on price. Maybe a 5% increase in price results in a 15% decrease
in quantity demanded—a PED of 15/5, or 3.
If PED is less than one, then demand is price inelastic. The percent change in quantity demanded is less
than the percent change in price—for example, a 5% increase in price might result in a 2.5% decrease
in quantity demanded—a PED of 2.5/5, or 1/2 .
If it equals one, then demand is unit elastic with respect to price. A 10% increase in price leads to a
10% decrease in quantity demanded—a one to one relationship.
If the PED is 0, then demand is perfectly inelastic with respect to price. A change in price has no effect
on quantity demanded.
And if the PED is infinite—that is, if a tiny change in price leads to a decrease of quantity demanded all
the way to zero—then demand is perfectly elastic with respect to price.
Our demand for the goods we find most necessary tends to be price-inelastic—a change in price is
unlikely to stop us from buying them. “Necessary” goods include medicines, alpaca finger puppets, and
salt. If the price of salt went up 20 percent, your demand for salt would be unlikely to change. Even if
you noticed the price change, you would probably still prefer to pay a bit more for salt than to find a
salt substitute. Conversely, if the price of salt went down, you probably wouldn’t increase your
consumption of it very much. What could you do with more salt?
Hamburger meat is an example of a non-necessary good. The demand for hamburger meat tends to be
more price-elastic than the demand for salt. Hamburger meat is not that expensive, and many consider
it a necessary part of their diets. But, because they have many substitutes, demand for hamburgers is
more elastic than you might expect. If the price went up significantly, people could eat ostrich, chicken
or even veggie burgers instead. These are all substitutes. So while the demand for food itself is inelastic,
the demand for hamburger meat is not.
There are three main reasons why the demand for a good might be price-inelastic:
A good is considered a “necessity.” Prescription drugs, for many people, are a necessity.
A good has few substitutes. Until it was retired, there were very few close substitutes for the
Concorde supersonic jet: you were stuck with it or with a much slower plane, like a Boeing 747.
The price of a good represents a small portion of a consumer’s income. Salt is just not expensive
enough for a person to stop buying it when the price goes up. However, a Lexus is expensive enough
that if the price increases ten percent, a rational person will consider a different car.
A supplier can benefit from understanding the price elasticity of the demand for his product. If demand
is price-elastic, then he has to be careful about raising his price so much that he loses revenue. On the
other hand, if a seller knows that demand is price-inelastic, then he has the power to increase his
revenue simply by increasing his price. Some producers spend enormous amounts of money on
advertising, hoping to convince their customers that their products have no substitutes. If consumers
believe a product has no substitute, they will tolerate a price increase.
Suppose you own a store that sells outdoor clothes and equipment. On average, you sell 200 pairs of
Teva sandals per day for $60 per pair. You decide to raise your price to $70 per pair, hoping to increase
your total revenue. After the price increase, you sell only 150 pairs per day. As you know, you can use
this information to calculate the price elasticity of demand for Tevas in your store:
PED (Tevas) =
% change in quantity demanded
% change in price
=
200 pair - 150 pair
200 pair
=
$60 per pair - $70 per pair
$60 per pair
0.25
=
1.4997
0.1667
As it turns out, demand for Tevas is price-elastic. You have to be careful about raising prices, because
they could decrease quantity demanded so much that your store will actually earn less revenue.
This leads to a second way to determine whether demand is elastic or inelastic: compare total revenue
before and after a price change. In the example above, you were selling 200 pairs for $60 apiece, so you
were earning $12,000 in revenue each day. After your price increase, you sold 150 pairs for $70 apiece,
so you were earning only $10,500 in revenue per day.
As a rule of thumb, if you raise prices and…
… total revenue decreases, then demand is price-elastic.
… total revenue increases, then demand is price-inelastic.
… total revenue does not change, then demand is unit-price-elastic.
… total revenue plunges to zero, then demand is perfectly price-elastic.
… quantity demanded doesn’t change at all, then demand is perfectly price-inelastic.
You increased prices and total revenue decreased, so you could have inferred the demand for Teva sandals
was price-elastic. Had revenue increased, it would have meant demand was price-inelastic.
The third way to determine PED is just to look at the demand curve. If the curve is vertical, demand is
perfectly price-inelastic. If it is horizontal, demand is perfectly price-elastic. And if it’s perfectly diagonal,
demand is unit-elastic with respect to price:
Here’s a memory aid to help you analyze the price-elasticity of a demand curve:
Brick walls are vertical, and very inelastic.
Inelastic demand curves are more vertical, like brick walls.
Elastic demand curves are more horizontal.
They are like a rubber band you would shoot at somebody.
Market Structures
As you know, a market is a mechanism that brings
buyers and sellers together. Some of the examples of
markets we have mentioned have included eBay,
supermarkets, and farmers’ markets. To continue our
discussion, we are going to expand that definition. In
microeconomics, we define a market as all the buyers
and sellers of one particular product or service. For
example, there is a market for shampoo, a market for
travel guides, etc.
We can then classify each market by its market
structure, which is defined by several characteristics.
One is the number of buyers and sellers in the
market. Some markets have only one seller. Others
have many of them. Some have only one buyer and others have many buyers.
The second defining characteristic of market structures is the sort of competition among suppliers. In
some markets, suppliers engage in price competition, or the raising and lowering of prices, to increase
revenue or attract customers. In others, individual suppliers cannot change their prices, so they must
engage in non-price competition.
A third feature of market structures is the uniformity of the product from one seller to the next. In
some markets, the product is exactly the same from one producer to the next. In others, there is only
one seller because his or her product is so unique.
Another feature of market structures is the presence of barriers to entry. If there are no barriers to entry,
sellers can easily enter or leave the market. This greatly affects the degree of competition.
We’ll explore four distinct market structures. In the coming pages, they’re presented in the order of
most competitive to least competitive, as they are seen on the spectrum below:
Perfect
Competition
(Most Competitive)
Monopolistic
Competition
Oligopoly
Monopoly
(Least Comeptitive)
Perfect Competition
The most classic example of perfect competition is the market for wheat. There are many farmers
selling an indistinguishable product; everyone has to charge the same amount, because there is no way
to set apart one kind of wheat from another. New farmers can easily set up wheat fields, and existing
wheat farmers can easily leave the market and use their land to cultivate something else.
A perfectly competitive market has numerous buyers
and sellers. There are no barriers to entry or exit, which
means suppliers can join or leave the industry
whenever they want. The product in a perfectly
competitive market is completely homogenous.
Consumers don’t have any preference for one supplier’s
product over another, because they are all identical.
Finally, a perfectly competitive market assumes that all
participants have perfect information, a condition in
which all buyers and sellers, actual and potential, have
equal and free access to knowledge about the price and
availability of the product and about one another.
Examples of perfectly competitive markets include
nearly all commodities, such as farm products or
natural resources, like gold or coal.
In perfect competition, the price is set at the market
level based on supply and demand. Any individual firm has a negligible impact on the market and must
sell at whatever the market price happens to be. The demand for any one firm’s product is perfectly
elastic with respect to price. The demand curve for a firm is perfectly horizontal. Consumers have no
preference for one supplier’s product over another, so if a supplier raises its price, consumers will take
their business elsewhere.
In perfect competition, firms are forced to be price takers; they “take” their price from the market. If a
producer raises his price, consumers will no longer buy from him. On the other hand, if a producer
lowers his price, he will only cost himself revenue he could have had by selling at the market price.
Thus, producers have no incentive to change their prices in order to compete. Also, because there are so
many buyers in a perfectly competitive market, a firm can sell, at the market price, as much of the good
or service as it wants to. A firm has only to analyze its costs to decide how much to produce.
Monopolistic Competition
Monopolistic competition is the second-most
Debate it!
competitive market structure. It features many
Resolved: That companies should not be allowed to
buyers and sellers, and relatively few barriers to
exaggerate distinctions between their products.
entry. The products are all similar, but each seller
tries to convince consumers that its product is unique. To the degree that they succeed, the sellers are
price makers. Rather than the horizontal, perfectly-elastic demand curve of perfect competition, in
monopolistic competition each seller faces a somewhat downward-sloping demand curve. They can
choose different price points at which different quantities of their product will be demanded—but
demand is more elastic than in a monopoly because close substitute goods exist.
Each producer tries to achieve product differentiation. Some products are made to seem different from
(and presumably better than) their rivals in taste, color, texture, or packaging. Most product
differentiation down to effective branding. If advertising and word-of-mouth convince consumers that a
product has no close substitutes, they will tolerate higher prices. Two brands of pain medication aren’t
very different, but you’d never know it from the television commercials. One bottle of ketchup is a lot
like any other, but most people still have a favorite brand—say, Heinz.
The more a monopolistically competitive firm differentiates its product, the less price-elastic its demand
will be, and the more control it will have over the price it can charge. In other words, each firm in
monopolistic competition is trying to create a monopoly over its own version of a product.
Oligopoly
In an oligopoly, there are only a few, large sellers and many buyers. Their products are either
homogeneous or only slightly different. Because there are so few sellers and each is large, they tend to be
interdependent; each one’s decisions affect all the others.
Barriers to entry are steep in an oligopoly. Natural barriers to entry exist when economies of scale favor
an established firm that has already developed the infrastructure and client base to realize the savings of
large-scale production. For instance, it would be expensive to start a new steel company, and it would
need to begin by producing less steel than its established competitors.
Artificial barriers to entry include patents, government regulation, import quotas and tariffs. If three
firms have patents for all the ways to manufacture anti-depression medication, it can be difficult for
others to enter the market until those patents have expired, even if the drugs are inexpensive to produce.
Similarly, the United States government does not permit Australian-owned Qantas Airlines to sell
tickets on its flight from Los Angeles to New York—it
can only pick up fuel, not passengers. If airlines were
completely deregulated, there would be no such
constraint.
In an oligopoly, the demand for any firm’s product is
kinked. This model of oligopoly pricing was
developed during the Great Depression. The
economist Paul Sweezy noticed that, while most prices
plummeted during the Great Depression, the prices of
goods produced by oligopolist industries remained
stable. The kinked demand curve helps to explains
why this is so. This model concludes that if one firm
lowers its prices, other firms will follow, but no one
will follow an increase in price.
The firms in an oligopoly are limited to mostly nonprice competition. For example, an airline might offer
more comfortable business class seating or an in-flight
meal. Of course, it could also lower its fares to attract business, and airlines often do, but this usually
initiates a price war: competing airlines simply lower their prices too, and, in the end, all of them risk
losing revenue.
To stay competitive, each firm watches the pricing and non-price incentives offered by the other firms.
Oligopolistic firms that discuss pricing with one another in order to maximize profits are creating a
cartel—which is illegal in the United States and in most of the world.
The markets for U.S. domestic cars, breakfast cereals, and major airlines are examples of oligopolies.
Monopoly
A monopoly is a market in which there is only one seller of a product with no close substitutes. Any
consumer who wants the product must buy from the sole seller.
The barriers to entry into a monopoly are steep. They can come about for various reasons, each of
which defines a different kind of monopoly.
Natural monopolies develop in markets with high
capital investment costs—such as public utilities, gas
pipelines, or railroads. Imagine the fixed cost of
building high speed railroad tracks for the entirety of
China. It would be very expensive for a second
company to enter the market and lay down its own set
of tracks. Similarly, it would be very expensive for a
second electric utility company to string power lines to
all the houses in a city.
Exclusive ownership of a
natural resource can also
produce
a
monopoly.
Suppose you control the only
source of water on a desert
planet. Everyone in the
region has to buy their water
from you. You have total
market power, since there are
no real substitutes for water
and no alternate sources. In
the real world, the most
famous example of this
phenomenon is in the
market for diamonds. One
firm, DeBeers, controlled
80% of the world’s diamond
production until the year
2000. While 80% was not a
complete monopoly, it was a
large enough share to give
De Beers tremendous power
over the diamond market.44
Creative Destruction
Yes, it would be impractical for a second company to
string power lines to all the houses in a city-----but a
bright entrepreneur might come up with a way for
houses to power themselves, perhaps through home
microfusion devices. Such an innovation might put a
traditional power company out of business. Later in
the resource, you’ll learn the term for this kind of total
market upheaval: creative destruction.
The market price of
widgets is $5, but
some consumers are
willing to pay more.
When they buy
widgets for $5, they
pay less than they
would be willing to.
This money they are
saving is the
consumer surplus.
A monopoly reduces
quantity and raises
the price to maximize
producer surplus.
The result is reduced
consumer surplus
and a deadweight
loss. Deadweight
loss is utility lost to
both the consumer
and the producer.
Governments
can
also
authorize monopolies in
44
They also had complete control over diamond slogans. In the 1940s, they coined the phrase Diamonds are Forever.
certain markets. In a technological monopoly, a firm is the sole seller of a product because no one else
has the technology to produce it—and it stays that way because the government grants patents to
protect the ownership of the technology. For example, the government grants drug companies patents
that prevent other companies from copying their drugs for 20 years. These temporary monopolies end
when the patents expire, allowing rivals to manufacture generic versions of the drugs.
Sometimes, the government
creates
an
artificial
monopoly—as when it granted
the Postal Service a monopoly
on door-to-door mail. UPS and
FedEx can deliver packages to
front doors, but not letters into
mailboxes. The government
authorizes such a monopoly
when it has a special interest in
a market. In this case, it wants
to make sure that everyone has
access to mail service.
A monopoly firm has market
power; it is a price maker. Of
course, the monopoly still
confronts a downward-sloping
demand curve. A higher price
means fewer units sold. But the
monopoly creates all the
supply47 in the market. It
decides the quantity to
produce, which determines the
price at which a product is sold.
A monopoly can pick the level
of output that maximizes its
own profits.
Economists point to three main
problems with monopolies.
The first is contrived scarcity,
which occurs when a monopoly
limits production so it can
charge a higher price. Suppose a
monopoly that produces towels
45
Electric utilities
Many state governments authorize a single
electric utility to operate as a monopoly. In
exchange, the utility agrees to let the state
set its prices. The state sets a price a few
percentage points above the utility’s costs,
guaranteeing it a specific rate of return. But
what if a technological advance could lower
the cost of electricity production? Should
the utility invest in it? If the state forces the firm to keep the original rate of
return, then, after the utility makes the investment, the state will lower the price it
is allowed to charge. Assuming people’s consumption of electricity is relatively
price-inelastic, the utility’s profit won’t change much at all.45
Suppose it weren’t forced to adhere to its original rate of return. What if the state
were to set a price and then allow the utility to keep any profits from innovations?
The company would have an incentive to develop better technology. On the other
hand, the consumer wouldn’t necessarily benefit, because market prices might
remain the same even as the utility’s marginal cost decreased. Should the state
look out for consumers, or for the utility? A hybrid solution may be the answer. 46
The Patent Wars: Apple vs. Samsung
In summer 2012, a California jury handed down a massive verdict in a patent
lawsuit between Samsung and Apple. Samsung, the jury decided, had maliciously
violated a number of Apple patents on the look and feel of its flagship product,
the iPhone. From an economics perspective it’s worth considering the market
implications. Smartphones are an example of monopolistic competition: there are
a fair number of vendors producing reasonably similar products-----IPhones,
Blackberries, Windows Phones, Android phones, etc.-----and the barriers to entry,
while high, are not impossible to scale. (Mozilla, for instance, is about to release
the first Firefox-based smartphones.) By defending patents on very basic aspects
of the iPhone-----for example, rounded corners and pinch-to-zoom-----Apple is
attempting to raise those barriers to entry and to strengthen its ‘‘mini-monopoly’’
within the larger market. At the same time, imagine if the first car company had
patented something as basic as the steering wheel: that might have seriously hurt
market innovation and made it difficult for consumers to switch between car
companies. (It would be tough for someone growing up driving a car with a
steering wheel to switch to a car driven with a joystick.) Some critics argue that
certain patents come at the cost of public welfare-----and that the system is broken,
granting patents too easily on innovations that are too vague.
If the demand for electricity were very price-elastic, then many more consumers might purchase a lot more electricity—so
even the same rate of return might produce more total profit.
46
Let’s Go travel guides are written by Harvard students. Let’s Go presents its writers with the average airfare to different
destinations. If a researcher finds a cheaper rate, she can buy her own ticket. She then splits the savings with Let’s Go.
47
It is said to “face the entire demand curve.”
could sell 1,000 towels for $12 apiece, profiting $1 per towel. Or, it could sell 800 for $14 apiece,
profiting $3 per towel. If the firm were in a more competitive market, it would have to sell at a lower
price or consumers would choose another supplier. As a monopoly, it can opt to sell fewer units at a
higher price, making $2,400 profit.
The second problem with monopolies is deadweight loss. A monopoly will try to maximize its own
producer surplus—taking it from the consumer surplus. But some surplus is simply lost. The vanished
surplus is the welfare loss due to monopoly.
A third problem is X-inefficiency. Monopolies have less incentive than firms in other market types to
reduce costs, and may end up using resources inefficiently. They lack the competition that would drive
out inefficient firms.
Some economists believe monopolies do enjoy dynamic efficiency, or more internal innovation. For
decades, the researchers at Bell Labs could perform world-changing research (they invented the laser!)
because they were funded by a monopoly, AT&T. Smaller firms would not have had the luxury to
support such innovation.
The Production Decision
In theory, all firms aim to maximize profit.
A firm must produce up to the point where
the marginal revenue from selling one more
unit does not exceed the marginal cost of
producing it. Hence, firms produce the
quantity at which marginal revenue equals
marginal cost, or MR=MC. Even
monopolies are guided by this rule.
We can find the point where MR=MC by
plotting the marginal revenue and marginal
cost curves together and seeing where they
intersect.
For a firm in perfect competition, the
marginal revenue of every unit sold is always
equal to the market price. A perfectly
competitive firm is a price taker: it must
take the market price of the good for every
unit sold. If the market price is $5, selling
an additional unit always brings in $5 of
marginal revenue.
These
illustrations show
the production
decision faced by
a firm in perfect
competition----one with no
control over the
price it can set.
Marginal revenue
always equals
market price, PE.
For nearly all firms, marginal cost varies
with each unit. At first, marginal cost is high
because to produce just one unit, a factory has to be set up and a minimum amount of staff has to be
hired. Materials have to be bought. But as a firm produces more units, marginal cost will decrease.
Eventually, the marginal cost will begin to rise again, as per the law of diminishing marginal returns.
Stated another way: there is a point at which additional units of resources will produce fewer and fewer
units of output. The cost for every additional unit of output rises.
Price Discrimination
Next time you take a flight, look at the person squeezed in next to you.48 The odds are good he paid a
different amount for his ticket than you did. He might be a business traveler paying extra to take a oneway flight, while you’re flying on a web special requiring you to stay overnight on Saturday and fly
home on the Sunday red-eye. Or he might be a friend of an employee flying standby for next-tonothing—but risking not having a seat if the plane is full.
Airlines aren’t alone in charging different people different prices. Popular restaurants offer early bird
specials to lure people in for an early dinner—because they can only handle so many diners later in the
evening. Movie theaters offer cheaper matinees for the same reason: to fill seats at times when they
would be empty. Restaurants working with GroupOn offer 50% discounts to customers willing to pay
for a certain dollar amount of food in advance—betting that
people buying GroupOn vouchers would be unlikely to visit
their restaurants otherwise.
The demand curve shows that, for any good, some people are
willing to spend a lot, and others much less. Take a second look
at the consumer surplus diagram for widgets. Of the 100 people
able and willing to buy widgets for $5 each, some would be
willing to buy them for $6, or $7, or even $9.99 each. If a
producer could charge each person the highest price he or she
was willing to spend, it would radically increase its profit. It
would do even better if it could also charge some less than $5—
thus, the early bird dinner.
Some critics believe price discrimination results in some people unfairly paying more than others; many
economists think it helps create a more socially efficient market. Your position on this may depend on
whether you’re in seat 19K for $29 or in seat 19L for $920.
The Institutions of a Market Economy
In market economies, strong institutions help individuals and groups achieve their goals. An institution
can be an organization, a practice, or even a code of laws. Important institutions include:
•
•
•
•
•
financial intermediaries (banks, etc.)
labor unions
corporations
legal systems
property rights
We will focus here on financial intermediaries, labor unions, and property rights.
48
Don’t look too long. It’s bad airplane manners.
Financial Intermediaries
A financial intermediary is an institution that stores money that firms and individuals are saving, using
it to make loans to or to invest in other individuals and firms that need money. We can divide financial
intermediaries into three major categories:



depository institutions
contractual savings institutions
investment intermediaries
You are probably more
familiar with depository
institutions than with
other intermediaries.
Depository Institutions
Banks
Savings and loan associations
Credit unions
Contractual Savings Institutions
Insurance companies
Pension funds
Government retirement funds
Investment Intermediaries
Finance companies
Mutual funds
Money market funds
Depository institutions accept deposits from customers and in turn pay interest to customers for the
use of their funds. To earn a profit, depository institutions invest the funds they have collected. They
earn profits on those investments—more profit than what they pay their depositors in interest. Some
examples of depository institutions are banks, savings and loan associations, and credit unions.
Depository institutions are integral to a market economy because they enable people to smooth
consumption over time; that is, with their help, people can save for the future and borrow money to
make investments in the present.
A contractual savings institution is one that acquires funds periodically according to some kind of
contractual arrangement, and, in turn, invests those funds to earn interest. Contractual savings
institutions include insurance companies, pension funds, and government retirement funds.
You’re probably most familiar with insurance companies. An insurance company will collect a premium
from its customers, called policyholders. In exchange, the company promises to pay certain benefits in
the event that something happens—perhaps to cover medical bills if a person is hurt, or to pay for a
home destroyed in a fire. To earn a profit, the company adjusts its premiums based on careful
predictions and makes long-term investments with the funds it holds.
Labor Unions
Workers may band together in labor unions to increase their market power as labor suppliers. Union
members typically earn more than non-union workers doing the same job. They also tend to receive
better benefits, such as health care and vacation time.
Labor union membership peaked in the United States in the 1940s and has been declining more or less
ever since. About 12% of workers in the United States belong to unions today.
Trade and craft unions are comprised of
Labor Unions and Company Competitiveness
workers with a common skill. Such unions date
Critics of American labor unions claim they lock employers
back to the guilds of the Middle Ages; they
into expensive contracts that make them uncompetitive in the
restrict supply by imposing rules around
face of foreign competition and fast-changing markets.
licensing and apprenticeship. Economists view
professional associations such as the American Bar Association (ABA) as trade unions. They restrict
membership, and they enable members to earn higher fees for services.
Industrial unions bring together all the workers in a given industry. For example, an autoworkers’
union might cover all workers in the auto industry—from welders to painters.
Public employees’ unions consist of government employees. In the United States, nearly all public
school teachers belong to such unions—including the Chicago teachers’ union that recently went on
strike, generating national headlines in September 2012—as do police officers and other public servants.
Labor unions engage in collective bargaining to negotiate wages, hours, and benefits with employers.
Collective bargaining is effective at securing better deals because it limits the ability of the employer to
divide and conquer employees and new hires. In other words, labor unions have more market power.
When negotiations with an employer go sour, labor unions might call for a strike. Striking union
members refuse to work until their demands are met. Those who don’t honor the strike are derogatively
dubbed “scabs.” Scabs might suffer payback in the future. Strikes can backfire when companies hire
temporary replacement workers to stay in operation—or when they annoy consumers so much that
public sentiment turns against the labor union.
Picketing generally occurs in conjunction with
a strike. When workers picket, they patrol
outside their workplace, carrying signs and
shouting slogans. Picket lines can target both
customers and other workers. Picketing is legal,
but the government can restrict the time, place,
and number of picketers, as it has sometimes led
to violent confrontations.
Watch it on YouTube
In 1981, the Professional Air Traffic Controllers Organization
launched a strike, grounding most air travel in the United
States. President Reagan reacted swiftly-----giving the
controllers 48 hours to return to work or be replaced. Watch
footage of the strike and of Reagan’s reaction here:
http://www.youtube.com/watch?v=e5JSToyiyr8
Property Rights
Private property rights are essential in a market economy. When people have property rights, they can
decide whether to use, rent, or sell the resources, goods, and services they own or produce. They reap
the benefits and suffer the costs, so are likely to use property more carefully and productively.
We can divide goods into two categories, according to how they are owned:
Private goods are goods or resources owned by private individuals or groups of private individuals.
When there are clearly-defined and well-enforced property rights in an economic system, the owners of
private goods may use their property however they choose. Private goods are said to be excludable
because owners have the power to exclude others from using them. I can exclude someone from typing
on my laptop. Private goods are also said to be rival because people will compete to own them. If there
are only five Nintendo Wiis for sale at Wal-Mart and 800 people are there to buy them, 795 are going
to be disappointed.
A public good is one that, once produced, is equally available to all people, regardless of whether they
paid for its production. One example of a public good is national security. The United States spends
about $1000 annually per person on national defense. No matter what country you live in, you can’t
ask the government for your national defense money in cash and tell it to forget about defending you.
Once your neighbors are protected, so are you. Some other examples of public goods include the
atmosphere, national security, breathable air, and national parks.
The Tragedy of the Commons is a story that serves as a reminder for why we need private property rights
or regulation. Hundreds of years ago, there were open pastures in Europe called “commons”. People
brought their animals to graze in the commons. In fact, the term ‘commoner’ referred to people who
depended on the commons. Since none owned the commons, they did not worry about the cost of
overusing them; in fact, each family had an incentive to bring as many animals as possible. The result
was the depletion of the commons.
Consider an example that involves eating animals instead of animals eating. Suppose a group of people
goes to a steakhouse for dinner with the understanding that they will split the bill evenly. Each member
has an incentive to order something expensive, since the additional cost will be split among everyone. If
everyone obeys this incentive, everyone’s bill will be much higher. If only a few people obey it, they
exploit the others at the table.
When you reap the benefits of a public good without paying for it, you are a free rider—or a free
loader. Property rights are one solution to this free rider problem. In Europe, open pastures gave way to
enclosures. People who own a resource have an incentive to use it responsibly. Another solution is
regulation: the government can either ban harmful behavior or can actually produce public goods.
Private Property Protection in the United States
In the United States, an owner’s rights to private property are protected by the Constitution. The Fifth
Amendment holds that “No person shall… be deprived of life, liberty, or property without due process
of law.” Due process refers to a consistently applied and fair legal proceedings.
Laws also protect non-tangible forms of property through copyrights, patents, and trademarks. All
three help to protect human ideas, or intellectual property.
A copyright is a form of protection afforded to the creators of “original works of authorship,” such as
economics resource guides. It protects the author’s right to control “expression” of the work, which
includes reproduction, distribution, public performance, or display.
There are several exceptions to this right. Nonowners are legally entitled to fair use, which
means they can use “original works” for purposes
such as teaching and news reporting. Also, the law
provides for compulsory license, which means the
owner of material can sometimes be required to
license it.
Patents vs. Copyright
Both patents and copyrights protect intellectual property. To
distinguish these two terms, consider a physics textbook.
Probably none of the ideas in the book-----say, those related to
circuits-----are protected by patent. Introductory physics has
been around for a while; Galileo’s laws of motion are public
domain. But the book itself is copyrighted: that particular
expression of those ideas is protected. This means that after
taking the class, you are free to write your own textbook on
those same ideas. But you must write your book from scratch.
As we saw in studying monopolies, a patent is a
form of protection the government grants
innovators for their new products and designs. A patent offers exclusive rights to the production, use,
and sale of an invention for a specified period (usually 20 years, though design patents—essentially
patents on the look of something—only last 14).
A trademark is a unique commercial mark or symbol, such as the “swoosh on nearly everything made
by Nike. Names of products can be trademarked, as long as they are somewhat original. For example,
Intel used to name computer chips with numbers: 286, 386, 486. Because numbers are not original,
they could not be trademarked. Competitors such as AMD and Cyrix soon manufactured compatible
chips using similar numbers. In the early 1990s, Intel named its newest chip the “Pentium” and
trademarked the term immediately. Competitors were forced to look for their own snazzy names, such
as AMD’s Athlon. Short marketing phrases can also be trademarked, such as McDonald’s “I’m lovin’
it”—or DemiDec’s “We do our best, so you can do yours.”
Trademarks cannot be used by non-owners without permission. In early 2007, Apple was sued by Cisco
for announcing the “iPhone”— Cisco already had a trademark on a product of the same name for
making calls over computers. Apple quickly settled the lawsuit and continued selling the iPhone.
Types and Nature of Income
For most of us, the income we earn is determined by the value of the resources, goods, or services we
sell. There are four categories of income. Each corresponds to a different kind of resource.
If the resource you sell is your labor, you earn a wage. Your wage is a function of the market value of
the thing you produce, how good you are at doing your job, and the condition of the labor supply.
Typically, “wage” is represented as the amount of money earned in exchange for an hour of labor,
regardless of whether you are paid by the hour or by a fixed salary.
If you sell a natural resource, you earn rent. In economics jargon, “rent” has a far broader meaning than
the monthly payment made for an apartment. Pure economic rent is the total payment to a factor of
production whose supply curve is perfectly inelastic. Land is one such factor. There is only so much
land to go around, no matter what the price. This is why the supply curve is inelastic: as price increases,
quantity supplied of land (barring colonization of a new planet) cannot increase.
Economic rent refers to the difference between a payment to a factor of
production and the factor’s opportunity cost. Economic rent is any
payment made to the owner of a factor of production above the amount
necessary to keep that it involved in the desired occupation. If it would
take $15 an hour to keep someone working for you, and you pay her $25
an hour, the extra $10 an hour is economic rent.
If you supply…
You earn…
Labor
Natural Resources
Capital
Entrepreneurship
Wage
Rent
Interest
Profit
If you sell or rent capital resources, you earn interest. The term “interest” also refers to the money you
earn when you deposit funds in a bank, or that you spend to borrow funds. In this context, though,
interest is a type of income. You earn it in exchange for capital resources.
If you provide entrepreneurial resources, the income you earn is profit. There are different measures of
profit, accounting profit and economic profit. When we use the term profit in everyday conversation,
we usually mean accounting profit, or total revenue minus total cost.
Consider an entrepreneur who opens a cafe that costs $100,000 to operate the first year and earns
$106,000 in revenue. His accountant congratulates him on his $6,000 in accounting profit. However,
we can measure economic profit by taking the difference between total revenue and economic cost.
Economic cost considers not just accounting but also opportunity cost. Unlike an accountant, an
economist will remind the entrepreneur he could have made a 6.5 percent annual return had he simply
put his money in a savings account. “Therefore,” she would tell him, “I’m afraid you made no economic
profit. In fact, you have an economic loss of $500—or even more, if you could have gotten a different
job while earning the $6,500 in interest.
Factor Markets and Derived Demand
A factor market is a market for any of the factors of production. In free market and mixed market
economies, there are factor markets for natural resources, capital, labor, and entrepreneurship. In its
economic reforms of the last 30 years, China has aimed to create and regulate these markets.
In a factor market, firms demand resources. Households or other firms supply those resources. The
demand in any factor market is said to be derived demand, because it is derived from the demand for
every final good or service the resource is used to produce. The total demand for any resource is the sum
of the demand for that resource in each of its possible uses. For example, the demand for lumber is the
sum of the demand for lumber used to make pencils, plus the demand for lumber used to make houses,
plus the demand for lumber used for firewood, and so forth.
Remember that demand curves for most goods and services slope downward—the higher the price, the
lower the quantity demanded. In the same way, the demand curve for any of the factors of production is
also downward-sloping. As the price of a resource falls, quantity demanded increases: firms are willing
and able to buy more of it.
The Labor Market
The labor market is a factor market. The demand for
labor is derived demand: it is the sum of the demand for
all the labor needed to produce every good and service—
pencils, potatoes, pistols, Porsches, etc. We’ll focus on
the demand for one type of labor: economists.
This is like any other supply and demand curve, but the
price is the wage rate and the quantity is the
employment level. In the market for economists, the
supply curve represents the number of economists
willing and able to work at each possible wage rate,
“W.” The wage rate is the cost a firm must pay in
exchange for one hour of labor. The labor supply curve
is upward-sloping, because more economists will want
to work for a higher wage.
The demand curve for economists represents the total number of economists firms are willing and able
to hire at each possible wage rate. The economist demand curve is downward-sloping for a few reasons.
As a firm hires more economists, later hires add less
value than early hires—an example of the diminishing
marginal productivity of labor. The economists can
only analyze so much information, no matter how
many of them there are. In fact, as more of them get
together, they start arguing about their theories. It
takes them longer to reach consensus.
Remember Price Discrimination?
Just as companies might want to charge different
customers different prices, they might want to pay
different wages to different economists. If the
government of Kazakhstan were hiring an economist,
perhaps economists from less prestigious universities
would be paid less-----or those willing to relocate to
Kazakhstan would be paid more.
A second reason the demand curve slopes downward
is the substitution effect. Rather than pay high salaries to several average economists, a firm might find
it more cost-effective to hire two top-notch, pricy economists, and a number of cheap research assistants
to help them. The firm has the option to substitute cheaper labor options for more expensive ones.
The third reason: as the wage paid to economists rises, the prices of goods and services provided by their
employers will also rise to reflect the higher cost of production. Consumers will be less willing and able
to buy those goods and services, so quantity demanded of the good or service will decrease, and the
quantity demanded of economists will decrease in turn. Because the “scale” of demand has changed, this
is called the scale effect.49
Wage Rates
In general, wages include hourly rates and salaries that firms pay in exchange for labor. More
specifically, the wage rate is the amount a firm must pay for one hour of labor, regardless of whether the
laborer is paid by the year (in the form of a salary) or by the hour.
We can use the real wage rate to compare wages from different time
Nominal Wage
periods. The real wage rate is the wage rate adjusted for changes in how
Real Wage =
much money is worth over time—in other words, adjusted for inflation.
Price Level
The nominal wage rate is the rate actually paid to the worker—not
adjusted for inflation. If inflation is high, nominal wages could skyrocket without real wages changing
very much at all. Later in this resource, we will discuss inflation and the price level. For now, just know
that, to determine the real wage, we divide the nominal wage by the price level.
The Hiring Decision
A profit-maximizing firm will decide how much labor to hire in the same way a consumer will
determine how much to consume: the firm will conduct a benefit-cost analysis. Firms often do this
explicitly, while consumers may do so less consciously.
Every additional hour of labor produces a little more product for a firm. The marginal benefit to a firm
of one more labor hour is the output produced by this hour of labor—multiplied by the revenue earned
from selling that output. The actual output of an additional labor hour is the marginal product of labor
(MPN); the revenue generated by this output is the marginal revenue product (MRP). Marginal
revenue product is found by multiplying MPN by the product’s market price:
MRP
Marginal Revenue Product
49
=
MPN
Marginal Product of Labor
x
P
Price
It might also be called the “boomerang” effect, except economists don’t use fun terms like boomerang.
Firms maximize profit by producing at the point where marginal cost is equal to marginal revenue.
Beyond this point, a unit would cost more to produce than the revenue it would generate. In the same
way, a firm maximizes output by hiring at the point where the marginal cost of labor is equal to its
marginal benefit—in other words, where the wage rate is equal to the marginal revenue product:
W
Wage Rate
MPN
Marginal Product of Labor
=
x
P
Price
Human Capital Development and Labor Productivity
The production process converts the factors of production into goods and services. Productivity is a
measure of the efficiency of production. It is expressed as a ratio of a specific output to a specific input.
In a widget factory, the output might be widgets, and the input might be labor hours. The productivity
of laborers in the factory could be expressed in terms of “widgets per labor hour.”
Labor productivity is the most frequently-used measure of productivity. It measures the output of a
unit of labor input. There are two ways to improve labor productivity. One is to improve physical
capital. This can mean replacing a slow computer with a faster one or buying a printing press that
makes fewer errors. When laborers are better-equipped, they tend to be more productive. The second is
to invest in human capital. Human capital includes laborers’ knowledge, training, skills and experience.
Workers who are better-educated or more skilled tend to be more productive (though recent studies also
show workers who have faster Internet connections tend to procrastinate more).
Labor Productivity
Suppose two workers each
work eight hours in a widget
factory one day:
=
16 labor hours
At the end of the day, the two
workers have produced a
total of four widgets:
Labor productivity is a ratio of
output to input. In the widget
factory, labor productivity is
equal to four widgets per 16
labor hours, or one-fourth
widget per labor hour:
=
per labor hour
16 Labor Hours
Returns on Investment in Education
One way to invest in your own human capital is to become more educated. Those who are more
educated tend to make more money. In the United States, the average 35-year-old male who has
completed four years of college earns about $25,000 per year more than the average 35-year-old man
who completed only high school.
Economists debate why the better-educated are
better-paid. The most intuitive explanation is that
education increases productivity. In some fields,
like engineering, medicine, and teaching, this is
true. But how much does a bachelor’s degree from
Yale in Latin increase an office administrator’s
productivity? Why would an employer prefer to
hire her over a high school graduate?
Read it Online
The recent economic crisis has made it hard for college
graduates in the United States to find jobs-----but the situation
is much worse in China, where hundreds of new universities are
churning out millions of college graduates who are unable to
capitalize on their education. Check out these articles for more:
http://www.nytimes.com/2010/12/12/world/asia/12beijing.html
http://blogs.wsj.com/chinarealtime/2010/11/22/value-of-achinese-college-degree-44/
The answer may be that higher education also acts
as a screening device or a signal. Even if the college degree is unrelated to the job, it still screens out
non-college-graduates who may be, on average, less inclined to work hard and to succeed. The office
administrator probably had to do well in high school and on standardized tests to get into college,
especially an elite college like Yale or Princeton. Rather than screen all applicants for promptness, ability
to learn, and willingness to follow directions, employers can assume a college-educated person already
has these qualities. If your parents are ever wondering if it is worth sending you to Amherst to study
literature, remind them of this.
Other Factors That Influence Income
In addition to education, other factors influence income. My college professor in Science, Technology
and Society has much more schooling than an average attorney, but makes less money. Since he could
have easily gone to law school, we can infer personal choice is a factor in his career decision. He likely
prefers the intellectually stimulating environment of a university to the shark-eat-shark-eat-dolphin
world of a private law office. Other factors that correlate with differences in income include:
Region: In the United States, the median household income is highest in the Northeast, where the
median annual household income is nearly $40,000. It is lowest in the South, at about $35,000. In
most countries, incomes are far higher in urban areas than in rural areas; certain regions—such as
Beijing and Shanghai in China—attract more investment and opportunities than others.
Type of household: Married-couple families earn more than families headed by a single person.
Type or nature of job: In every country, certain jobs will pay more. High school teachers will tend to
earn more than textile workers, while bankers will tend to earn more than high school teachers.
The Equal Pay Act of 1963 was intended to close the “wage gap” between men and women and
between races in the United States. The gap is closing, but by less than a penny a year. Much of the
ongoing difference may be due to factors that are hard to address—from differences in educational
access and cultural preference, to gender-related lifestyle choices (for example, more women than men
choose to leave the workforce to raise children, making them riskier investments for employers). Some
of the difference is no doubt the legacy of discrimination at home and in the workplace. In many
countries, women and certain ethnic groups face less favorable economic circumstances.
Investment and Economic Growth
As you have read, in order to improve labor productivity, we have to invest in human and physical
capital. In fact, we invest in human and physical capital to improve the productivity of any resource. We
don’t just improve productivity for the sake of having more things. By investing in technology, physical
capital, human capital, and the health of people, we raise our future standard of living.
The standard of living is generally defined as the real value of the goods and services consumed by the
average member of an economy. Take note: it’s not the average value of goods and services consumed;
it’s the value of goods and services consumed by the average person in the economy. This turns out to be
an important distinction—if income is concentrated in the top few percent, as it tends to be in
developing countries, average income can be a misleading figure.
Calculating standard of living can be
difficult. Normally, we use Gross Domestic
Product per capita to compare the standard
of living from one country to the next. Gross
Domestic Product (GDP) is something we’ll
cover in macroeconomics; put simply, GDP
is a measurement of national income. GDP
per capita is national income per person.
If GDP per capita increases over time, we can
say economic growth is occurring, or that the
standard of living has risen. In the very, very
long-run, most economists believe economic
growth can only result from technological
advancements. Over shorter periods of time,
investment in human and physical capital can
also result in economic growth.
When Destruction is a Good Thing
Once upon a time, if you wanted to book a ticket from San Jose,
California, to Newark, New Jersey, you had to visit your local
travel agent. He or she would bring you a cup of coffee and find
you a decent fare. Then the Internet came along. Entrepreneurs
realized that people might want to book their own tickets online,
comparing prices at home without changing out of their pajamas.
They launched companies like Expedia and Travelocity. Before
long, traditional travel agencies were running for their lives.
This process by which entrepreneurs invent a new industry by
destroying an old one is called creative destruction. The term,
coined by the economist Joseph Schumpeter in the 1970s, is
massively overused; every Internet entrepreneur wants you to
believe that his or her idea is going to revolutionize an industry.
But the truth is that some do. The rise of word processors
obliterated typewriters. The emergence of Apple’s iPhone sent
other mobile phone makers back to the drawing board----suddenly the flip phone looked as dated as VHS. First services
such as NetFlix and now downloadable movies have wreaked
havoc on the neighborhood movie rental business: it’s no
coincidence Blockbuster went bankrupt. E-books-----led by the
Kindle-----are tormenting traditional bookstores. Why is Barnes
and Noble trying to sell its own e-reader, the Nook? Because it
wants in on the new industry before the old one is gone.
Creative destruction happens all the time; look for it in the
products and services you choose to use from year to year. And,
if you can figure out a way to creatively destroy something, you
might end up very rich.
Suppose you live on a small planet where
everyone picks fruit from trees in order to
eat. You are limited to eating the amount of
fruit you can pick with your two hands.
Suddenly a large spaceship lands nearby,
carrying the entire population of a planet that
suffered a nuclear war. The aliens are
peaceful, but hungry. They are two-handed,
just like you. And there are exactly as many
of them inside the ship as there are people on your planet. Your planet’s population has just doubled.
There is an immediate shortage of food, and the standard of living has just been reduced by half.
In the short run, an investment in physical capital could restore the initial standard of living. In other
words, someone needs to plant some more trees. Quickly.
Skip ahead. The new trees have been planted. The population crisis has subsided. Everyone is living
peacefully again now, eating exactly the same amount of fruit as before the spaceship landed. In the long
run, there has been no change in the standard of living of the original residents.
Now, the aliens come out with a product to make trees infinitely fruitful. No matter how much is
picked, the trees never run out. This is an improvement in technology. Unfortunately, it is a useless
advance, because everyone still only has two hands. No one can pick any more than they could before,
so no one can eat any more than they could before.50
At long last, a quiet little alien develops a potion that gives two more arms to everyone on the planet.
Now there is endless fruit and twice as much picking power. People even invent fruit art. With the right
investment in technology, the standard of living has improved in the long run.
Entrepreneurs
An entrepreneur combines the factors of production to make goods and services. Profit—of one kind or
another—is the reward for entrepreneurship. But profit is never a sure thing. If it were, we’d all be
entrepreneurs. The risk of entrepreneurship is that an entrepreneur will lose his investment.
Consider Jason, an enterprising eight-year-old who mixes lemons, sugar, and water to make lemonade.
He opens a lemonade stand on his street corner. If he can sell enough lemonade to recover the cost of
his lemons, sugar, ice, and cups, then he’ll make a profit. But any number of things could go wrong,
and Jason could lose his investment. If a storm rolls in one day, people might not be willing to buy
Jason’s lemonade. He won’t collect enough revenue to cover his costs, so he’ll lose the money he spent
buying his resources. If Katie, his adorable six-year-old sister, opens a stand next to Jason’s, people
might choose her stand instead of his. Again, he won’t collect enough revenue to earn a profit.51 If
Jason’s grandmother uses his lemons to make lemon bars, Jason will have to replace the lemons before
he can even open up for the day—and he’ll have to sell enough lemonade to cover the cost of his usual
resources and the replacement lemons.
Jason can’t know what the weather will do. He can’t control
his sister any more than he can control any other profit-hungry
kid in the neighborhood. He certainly can’t control his
grandmother. The risks of the lemonade business are vast, but
Jason is an entrepreneur because he is willing to take them.
Property rights can minimize the risks of
entrepreneurship. When the police find Jason’s
lemon bars in his grandmother’s kitchen, they
can arrest her for possession of stolen
property.
There are ways to limit the risks of entrepreneurship. If there is an insurance company out there that
insures lemonade stands, Jason can pay it a premium for protection against the loss he could suffer on a
rainy day. Jason could buy insurance and never end up collecting a penny in benefits. But he could also
buy insurance cheaply on a sunny day, and then it could rain for the next 14 days. Insurance mitigates
risk, but at a cost that must be recouped.
Well-enforced property rights can also help minimize the risks of entrepreneurship. Suppose Jason uses
his own original recipe. As a business-savvy eight-year-old, he might have been smart enough to apply
for a patent on it before he started doing business. That way, when Katie copied his recipe, he could
have sued her. The court could have fined Katie and ordered her to pay Jason for his lost business.52
Similarly, when Jason came upon his empty fruit bowl, he could have filed a police report. Upon
discovering the lemon bars in his grandmother’s kitchen, the police would have had probable cause to
arrest his grandmother for possession of stolen property. The court could have ordered Jason’s
grandmother to reimburse him, and to pay him for the damages his business suffered.
50
The squirrels are happy, though.
Not until he hires an even cuter girl from down the street to man his stand.
52
Granted, Katie is only six. But years from now, Katie will probably thank her brother for teaching her a valuable lesson.
51
IV. Macroeconomics
“We’re all Keynesians now,” American president Richard
Nixon once said. Richard Nixon was a Republican, belonging to
a political party traditionally opposed to Keynesian economic
policies—yet even he had continued to implement and even
expand them.
Times have changed. We’re not all Keynesians anymore: Keynesian
economics, in which the government adjusts taxes and spending to
smooth out the business cycle, is just one approach to managing the economy. The main alternative,
monetary policy, focuses on manipulating the money supply. This section will help you understand
how the macroeconomy is measured and what kinds of issues shape these different policies.
Gross Domestic Product and National Income
Everyone in an economy, combined, produces a lot of stuff. It’s important to measure that stuff in order
to gauge how the economy is doing—and in order to guide future economic policy.
By definition, Gross Domestic Product (GDP) is that measure: it is the sum total of the market value
of all final goods and services produced within an economy in a given period of time (usually yearly).
Let’s take this definition apart.
“Market value” is how much a good or service sells for. If people purchase a product for a given
price, that is its market value. GDP is the total of the prices of final goods and services.
“Final goods and services” are those ready to be sold to consumers. They are NOT goods
headed to a factory to become part of another product. A new car is a final good, but the XM
satellite radio receiver inside the car is not a final good. Only the sale price of the car is counted
in GDP. This provision avoids double-counting.
“…within an economy….” GDP only includes final goods and services that are physically
produced within the borders of an economy. If an American manufacturer produces shoes in
Taiwan, those shoes are not part of U.S. GDP. However, if a Taiwanese manufacturer produces
shoes in the U.S., the shoes are included in U.S. GDP.
“…a given period of time.” GDP is usually reported as an annual statistic, although it is tracked
and calculated every quarter. In the press, you might read something like, “GDP increased this
quarter at a slower rate than expected.” In economics textbooks, you’ll often see charts that track
GDP from one year to the next.
GDP per capita, mentioned in the last chapter, is the average output of an inhabitant in a country. It is
determined by dividing a country’s GDP by its population. GDP per capita is often used to gauge the
standard of living in a country. As with any simple average, however, GDP per capita does not reveal
the equity of the distribution of income, so an impoverished country with a few wealthy people could
appear to have a high standard of living if we only counted GDP per capita.
Not long ago, the U.S. measured its output in terms of Gross National Product, or GNP. GNP is the
sum total of the market value of all final goods and services produced by the citizens of a country during
a given period of time. GNP is like GDP, except GNP counts the goods and services that are produced
by the citizens of a particular nation, regardless of where.
If a Chinese-owned firm is making spaghetti in Idaho, it counts toward the GDP of the
United States.53 But, if an American-owned Starbucks sells lots of lattes in Shanghai, the sales
do not count toward United States GDP. They count toward China’s GDP.
Today, most economists use GDP, and not GNP, to measure the size of a country’s economy.
In the United States, the Bureau of Economic Analysis
is responsible for tabulating and reporting Gross
Domestic Product. The Bureau reports on GDP every
three months.
Bear in mind that GDP is only a measure of the final
value of goods and services. If GDP also included the
value of raw or intermediate goods, it would overstate
production. For example, if the value of the meat sold
by a producer was counted in GDP, and later, if every
DECADOG that contained the meat was also
counted, then the meat would be double-counted.
GDP would be overstated.
No single statistic can tell the whole story
Without a doubt, GDP is one of the most basic statistics in
analyzing economies. Unfortunately, it is also one of the
most widely misunderstood figures. GDP is an indicator of
the size of an economy, but it is often quoted as an
indicator of the health of an economy. The latter use is
inaccurate. Politicians will sometimes mention ‘‘an
increase in GDP’’ to suggest that they or their
administration have improved life for everyone. But GDP is
not a measure of economic well-being, nor was it ever
intended to be one. For example, an increase in GDP could
be the result of an increase in the production of gasguzzling vehicles, which emit more carbon dioxide than
their fuel-efficient counterparts. Has our quality of life
improved if we have larger, more comfortable cars? Or has
it diminished if the air we breathe has more pollutants?
There are two ways to avoid double counting. One is
to count only final consumer goods and services (excluding raw and intermediate goods). Alternatively,
GDP can be counted with a value-added method, in which a factor of production is followed through
the production process, adding value to GDP each time it changes form, until it finally becomes a
product. In the production of a milk chocolate bar, the value of the cacao is counted, then the value of
the milk and sugar added to it. Later, the value of the chocolate wrapper is added, too, but nothing is
included more than once.
Some economists criticize GDP for not representing all the activity in an economy. For example, GDP
does not include the value of used goods that are resold; these goods were counted the first time they
were on the market. This means that auction sites such as eBay add basically nothing to GDP. Nor does
GDP count the value of black market dealings54; in some countries, the underground economy is very
significant. Household activities, such as washing your own clothes instead of sending them out to the
dry cleaner, also go uncounted.
Methods of GDP Measurement
There are at least three ways of calculating GDP. In the income approach and the expenditures
approach, GDP is determined as the sum of the market value of final goods and services. The outcome
53
It also counts toward the GNP of China.
Demand and supply curves in black markets (as opposed to the corresponding curves in a legal market) can be affected by the additional
costs of dodging law enforcement while buying and selling.
54
approach employs the value-added method. The outcome of each approach should be the same, though
statistics being inexact, they rarely quite are.
The Expenditures Approach to GDP Measurement
The expenditures approach is the most frequently employed because it is the easiest to use. IT divides
all economic transactions into four categories: Consumption, Investment, Government Spending and
Net Exports. GDP is the sum of the categories.
The expenditures approach is described by the equation Y = C + I + G + X.
“Y” is GDP. In economic notation, “Y” always represents income.
“C” represents Consumption, the transaction category that involves households buying goods
and services from suppliers. Burgers, flights to China, laptops and haircuts are all examples of
consumption. In the United States, consumption is the largest share of GDP.
“I” represents Investment, including investments made by households and businesses, often
through financial intermediaries. Investment creates value in the future. Often, investment is
converted to capital, or man-made resources that produce more value. A firm’s purchase of a
factory is an example of investment, as is a household’s purchase of an actual house.
“G” represents Government spending. Government spends money on infrastructure, items such
as roads, bridges and dams. It also spends on services, such as public education and national
defense. The government can directly impact GDP by altering its fiscal policy. In theory, the
“G” component of GDP can increase whenever the government chooses to increase it, because
the government can borrow money to finance a budget deficit.
“G” does not include transfer payments. A transfer payment is a “payment” made by the
government to an individual for nothing in return. Welfare and social security are examples of
transfer payments. They are excluded from GDP because they are not transactions: they only
move money around, purchasing nothing. After receiving a transfer payment, a person will
spend or invest it; at that point, the spending is counted in GDP.
…“X” is Net Exports, or the difference between exports and imports. If there is a trade deficit
(in which imports exceed exports), net exports will be negative. By Net Exports, we mean the
value of all the exports a nation sells minus the value of all the imports it buys. An Americanmade television shipped to Paris adds to United States net exports because it was made in
America. It is subtracted from France’s GDP because, to France, it is an import. Currently, X is
very negative for the United States; we import much more than we export.
The Income Approach to GDP Measurement
National Income Accounting is a set of rules and definitions for measuring economic activity. It is
paraphrased as the income approach, and it adds together all wages, salaries, corporate profits, interest
payments, and rents. The income approach also subtracts indirect taxes and adds subsidies.




Wages and salaries are what people are paid for their labor.
Corporate profits are revenues to companies beyond the money they spend in production.
Interest payments are the payments made to those who gave out loans.
Rents are charges for borrowing other things of value, like an apartment or a car.


An indirect tax is a government tax on a product, such as gasoline or tobacco.
A subsidy is a government expenditure to lower the price of a good. Public television, state
university tuition, and agricultural goods are often subsidized.
GDP = Employee Compensation + Rents + Profits (- Indirect Taxes + Subsidies) + Interest
Suppose employee compensation one year were $4 trillion, rents $2 trillion, corporate profits $1 trillion,
and interest payments $3 trillion. Meanwhile, there were $1 trillion in indirect taxes and $1.5 trillion in
subsidies. That year, GDP would have been $10.5 trillion.
Calculating GDP with the Income Approach
Employee Compensation
$4 trillion
+
Rents
$2 trillion
+
Corporate Profits
$1 trillion
+
Interest Payments
$3 trillion
-
Indirect Taxes
$1 trillion
+
Subsidies
$1.5 trillion
GDP
$10.5 trillion
Other terms to remember are the net national product (NNP), national income (NI), personal income
(PI), and disposable income (DI).
Imagine a country generates $5 trillion in GDP using all its capital goods and a productively employed
labor force. Unfortunately, some of the country’s capital deteriorates from year to year. For example,
machinery in missile factories eventually breaks down. When you subtract the cost in any given year of
replacing such depreciated capital from GNP, you are left with Net National Product. If you are
starting with a country’s GDP, you need to adjust it to GNP first (by adding revenues by domestic
interests abroad and removing revenues by foreign interests in the country).
GNP minus depreciation = NNP
National income is defined as the total amount of income paid for a country’s resources. It can be
calculated by subtracting indirect taxes from NNP.
NI = NNP minus indirect taxes
Personal income is how much of this national income actually goes to individuals. It can be calculated
by taking national income, then subtracting corporate profits that do not get distributed to
stockholders, subtracting Social Security taxes, subtracting corporate taxes and subtracting payments on
the national debt.
PI = NI minus retained corporate earnings minus
Social Security taxes minus corporate taxes minus national debt payments
Disposable income is personal income minus income taxes but plus transfer payments (such as welfare
and social security checks.) It is the actual portion of GDP people have left in their pockets to spend or
save as they wish.
DI = PI minus income taxes plus transfer payments
Disposable income is the measurement most people “feel” on a day-to-day basis.
The Output (Value-Added) Approach to GDP Measurement
In the output approach, we gauge the value of everything produced in an economy by measuring the
value added at each step in the production process. These can include goods, services, and anything else
of value. The main problem with measuring GDP in this way is double counting.
A car stereo is an example of a good that can overstate GDP because it is prone to double counting in
the value-added method. Car manufacturers rarely produce their own stereos: they pay other firms to
make stereos for them. Each stereo is sold twice: first, when its producer sells it to the car manufacturer
and, later, when the dealer sells it—with a car attached. Each stereo is only created once, though, so it
should not be included twice in GDP. To prevent counting the same production twice, we include only
the value added by each transaction in a country’s GDP. Value added is defined as the difference
between the sale price of a product, and the materials and processes used to create that product. To
determine the value added by an automobile, economists determine the price paid by the dealer for
every part that goes into the car. They then subtract that total from the selling price of the car. The
difference is the car’s contribution to GDP.
Real GDP and Nominal GDP
We use the sale price of every good and service produced in an economy to determine Gross Domestic
Product. If the price of a good increases because the quality of the good has improved, we would expect
GDP to increase too: the economy is being more productive with the same amount of resources as it
had used before. But if the price of a good increases due to inflation, GDP will increase even though the
economy is no more productive than it was.
Because of inflation, we need two different definitions of GDP:
Nominal GDP is Gross Domestic Product expressed in terms of the current value of money. If the price
of a good increases, nominal GDP will increase, too, regardless of whether the price increase is the result
of improved quality. If nominal GDP increases from one year to the next, we have no way of knowing
whether the economy was actually more productive in the second year.
Real GDP is Gross Domestic Product with inflation factored out. When an economy is experiencing
inflation, the prices of most goods and services will rise. If we eliminate inflation from nominal GDP
for two consecutive years, then we can determine whether an economy was in fact more productive in
the second year. If real GDP increased from one year to the next, then the economy really grew.
Nominal GDP versus Real GDP
Demilon’s GDP in Year 1
After Demilon is founded, the country produces 2 widgets in its
first year. The widgets sell for three dollars each. There has
been no inflation (since Demilon has only been around for a
year), so nominal GDP and real GDP are both six dollars:
The following year, Demilon’s widget makers arbitrarily raise
their selling price to five dollars per widget and Demilon still
produces only 2 widges. Nominal GDP increases to 10 dollars,
even though Demilon is no more productive than it was the
previous year. Real GDP does not increase, however.
=
$$$
=
$$$
+
Nominal GDP and Real
GDP:
$$$ $$$
Demilon’s GDP after Inflation in Year 2
=
$$$$$
=
$$$$$
=
$$$$$
=
$$$$$
+
Nominal GDP:
+
$$$ $$$ $$$ $
Real GDP:
$$$ $$S
Suppose the selling price of a widget did not change in Demilon in Year 2, and Demilon produced two more widgets, for a total of
four. Both nominal GDP and real GDP increase to reflect the increase in productivity:
Demilon’s GDP after an Increase in Productivity in Year 2
=
$$$ $$$
=
$$$ $$$
=
$$$ $$$
=
$$$ $$$
+
Nominal GDP:
+
$$$ $$$ $$$ $$$
Real GDP:
$$$ $$$ $$$ $$$
The Circular Flow of the Economy
We can categorize economic activity as either productive or consumptive. Productive activity is what
producers do; consumptive activity is what consumers do.
To be more precise, we can say consumers consume what producers produce. Consumers get the cash
for the goods from the producers themselves, in the form
of wages and other payments made to them for resources
such as land—in other words, employment income.
This movement of goods, services, and money comprise
the circular flow of the economy. To the right, the inner
red arrow represents the money flow of the economy:
households make payments to firms, and firms buy labor
and other resources from households. The outer black
arrow represents the real flow of the economy, or the
movement of resources, goods, and services.
In the resource market, firms obtain labor and other resources from households. The resource market is
also called the factor market. In the goods and services market, households obtain goods and services
from firms.
In the circular flow model, money moves in the opposite direction of resources, goods, and services.
Enter the Government
No economy is as simple as the two-sector diagram. The
model is incomplete if we ignore the government that is busy
taxing both sectors while also buying their goods and services.
In a mixed economy, most economic activity takes place in
free markets, but the government has a role, too.
When the government collects income taxes and sales taxes,
money leaks from the circular flow. When the government
buys goods and services from firms, money is injected into
the circular flow. Money is also injected when the
government transfers money directly to people as welfare
payments or social security. These transfer payments do not
involve the exchange of goods or services.
Exports and Imports in the Circular Flow
If an American firm produces a good and exports it, the firm
receives money from abroad. The money is an injection into
the money flow, and a leakage from the real flow. If a firm
purchases a foreign good, the expenditure is a leakage from
the money flow, but an injection to the real flow.
Economic Growth
You’ve probably heard politicians talk about wanting
economic growth. They usually mean things like “more jobs”
or “improved standards of living.” For economists, economic
growth has a more precise definition. Economic growth is an
increase in an economy’s ability to produce.
Economic growth can be represented as an outward shift in
the production possibilities frontier. It’s not an increase in production; it’s an increase in productive
capacity. If an economy improves its technology, it will be able to produce more output for every
combination of capital and consumer goods. Potential GDP increases, and the PPF shifts outward.
Factors contributing to economic growth include, but are not limited to:




Increase in capital
Increase in resources
Trade
Improved human capital
An increase in GDP does not necessarily mean that economic growth has occurred. Existing resources
may just be coming into use. But if economic growth does occur, then GDP will most likely increase.
For this reason, and just because it’s easier, when you hear people talk about economic growth, they are
often talking about economic “downturns” and “upturns,” which are decreases and increases in business
activity. Changes in GDP reflect these upturns and downturns.
The Business Cycle
Every so often you hear the economy is
Debate it!
slipping into a recession, but economists
are usually calm about it55. They seem to Resolved: That governments should consider the economic benefits of
going to war when choosing whether to become involved in a conflict.
take for granted that the economy will
recover and expand again. They are often more concerned with minimizing a recession’s impact and
length than with asking, “How can we get rid of all recessions?”
This is because the economy naturally moves back and forth between periods of expansion and
contraction. This pattern is called the business cycle.56 Many American economics textbooks contain
graphs depicting the country’s GDP, or the rate of growth of real GDP or GDP per capita, over the
past century. Below is one such chart, based on data from the Department of Commerce. The points at
which the change in real GDP is positive correspond to times of prosperity, and the points at which it is
negative correspond to times of hardship.
Wars tend to stimulate an economy; this
Rate of Economic Growth in the United States
occurs because in wartime the
20.0
government must spend a lot on the
military. If “G” increases, then
15.0
“C+I+G+X” probably does, too. On the
10.0
graph, notice the growth around the
times of World War II (early 1940s), the
5.0
Korean War (early 1950s), and the
0.0
Vietnam War (late 1960s-early 1970s).
1930
1940
1950
1960
1970
1980
1990
2000
-5.0
This does not mean wars are “good” for
the economy. The extra spending keeps
-10.0
industry and labor busy, but bombs and
-15.0
planes do not directly provide utility to
anyone other than the military. But the
dollars spent making bombs and planes do flow to people and firms as wages and rent. Of course, if
everyone is making missiles, this new money may not find enough new consumer goods to buy. This is
why wars tend to coincide with inflation.
On the chart you can also see the recent United States “tech boom” of the 1990s, represented by a
steady positive growth rate, and, further back, the recessions of the early 1990s and late 1970s. The
most significant recession in the past century was the Great Depression, a period of hardship from the
late 1920s into the 1930s. The data only reaches back to 1930, but you can see how the curve begins
deep in the negative.
In the United States, the Great Depression followed a period of prosperity in the 1920s (often referred
to as the Roaring Twenties). When the economy is booming, people are quick to believe things will be
good forever. In the 1990s, books with titles like Dow 30,000 predicted the stock market would rise
forever. Caught up in the bandwagon—what Federal Reserve chairman Alan Greenspan labeled
55
56
Except in 2008, when the economy slipped off a cliff.
The business cycle follows no specific pattern. It’s hard to predict expansions and depressions.
“irrational exuberance”—many did not safeguard against the inevitable downturn when the “dotcom
boom” came to an end around 2000.
The stock market spent much of the next decade
lurching up and down without going decisively in
either direction—a classic “bear” market. Home values
soared, however57—as did consumer debt—creating
another unsustainably exuberant state of affairs. It came
to a crashing halt in September 2008, when the United
States suffered its greatest stock market decline since 911. The final section of this resource details this crash
and its causes and consequences.
The historical business cycle can be charted through
changes in real GDP, in the rate of economic growth,
or, less often, in the unemployment rate.
Any analysis of the business cycle reveals a number of
different points and periods.

Expansion occurs when business activity grows for at least two quarters (six months).

A peak occurs at the end of an expansion. It is the high point of the business cycle.

After a peak, business activity decreases. The start of this fall is an economic downturn.

By definition, a recession occurs when real GDP (i.e. domestic economic activity) decreases for
two consecutive quarters.

A depression is a severe recession. There is no actual textbook definition for the point at which a
recession becomes so severe that it can be called a depression.

A trough occurs at the end of a recession. It is the lowest point in the business cycle.

When a trough ends, a new economic upturn begins. Business activity begins to increase again,
and the economy enters a fresh period of expansion.
Economic Indicators
Leading indicators hint at where the business cycle is heading in the future. They measure things like
how many buildings are scheduled for construction (more is better) and how consumers are feeling
about the future. In the United States, they include:
Average workweek of manufacturing workers
Unemployment insurance claims
New orders for consumer goods and materials, adjusted for inflation
Vendor performance (how quickly are orders being filled?)
New orders for capital goods
New building permits issued
Index of stock prices
57
Many people used money they had earned in stock boom of the 1990s to buy real estate, driving prices upward.
Changes in the money supply (M2)
Difference between the 10-year Treasury bond rate and the Federal funds rate
Index of consumer expectations
Coincident economic indicators give a sense of the current economic situation. They tell us what things
are like now. They include:
Manufacturing and trade sales
Level of non-agricultural unemployment
Level of industrial production
Average personal income (minus transfer payments)
Lagging indicators measure past economic conditions, usually
from the last few months. They include:
Mean prime interest rate
Average span of unemployment
Ratio of inventories to sales
Changes in labor cost per unit of output
Number and size of commercial and industrial loans
Ratio of consumer debt to income
Change in consumer price index for services
Aggregate Demand
Aggregate demand is the demand for all domestic output at each
possible price level. It is the sum of the demand for all goods and
services produced domestically.
Earlier we saw how, when the price of a good or service increases,
people are willing and able to buy less of it, so the quantity demanded decreases. Aggregate demand
works the same way. When the price level is high—when everything seems more expensive than it used
to be—people will be willing and able to buy fewer goods and services.
One way of thinking about the aggregate demand curve is as the result of adding the demand curve for
every good and service produced within an economy. It is similar to the demand curve for an individual
good. The major difference is in the axes. The vertical y-axis on the graph for a single good has actual
numeric prices, like $5 or $10. But a single price would not make sense on the aggregate graph.
Instead, the y-axis is of the overall price level for an
economy. The actual price level does not matter, just
whether it increases or decreases. If goods and services
increase in price (inflation), the price level will go up.
The “price level” can refer to a specific industry, or to a
specific sector of an economy, or to the whole
economy. The horizontal x-axis is the quantity
demanded of an economy’s total output.
In the expenditures approach, we find GDP by
adding up how much society spends. The equation
for this method is Y = C + I + G + X. If there is a
change in consumption, investment, government
spending, or net exports, there must be a change in
aggregate demand, too.
The aggregate demand curve has a negative slope for two reasons.
First: as the price level decreases, goods become cheaper; in effect, consumers have more wealth, so are
willing to consume more real output. This is the wealth effect of changes in the price level.
Second: as the price level falls, domestic goods grow cheaper for consumers abroad. Exports increase
and imports decrease. This is the international, or exchange-rate, effect of changes in the price level.
Just as the demand curve for a single good can shift right or left, so can the aggregate demand curve.
To understand how the aggregate demand curve is affected by economic events, let’s revisit the
expenditures approach to GDP calculation. In it, we find GDP by adding up how much is spent in an
economy—that is, we look at the demand side of GDP. The equation for this approach is Y = C + I +
G + X. If consumption, investment, government spending, or net exports change, then you can expect
aggregate demand will, too, because those are the components of what is spent on aggregate output.
1. This brings us to the first factor affecting aggregate demand: a change in foreign income. Aggregate
demand is the total demand for U.S. goods—and, if foreign income falls, there will be less of a
demand for U.S. exports from buyers abroad. Net exports will decrease. In the equation Y = C + I +
G + X, a decrease in net exports is a decrease in “X.” On the other side of the equation, “Y” must
decrease, too; aggregate demand decreases and the aggregate demand curve shifts to the left.
A Change in Foreign Income
Y
=
C
+
I
+
G
+
X
Y
=
C
+
I
+
G
+
X
Price Level
A decrease in foreign income lowers the demand for exports,
resulting in a decrease in aggregate demand. The aggregate
demand curve shifts to the left.
AD2
AD1
Quantity of Output Demanded
2. If firms’ expectations of future income increase, they’ll be willing to invest in the present. “I”
increases so “Y” increases. Aggregate demand shifts to the right. If consumers have positive
expectations about their future incomes, they’ll be willing to buy more at each price level in the
present. The aggregate demand curve will shift to the right.
Positive expectations about future income convince firms and
private individuals to invest. The increase in investment results
in an increase in aggregate demand. The aggregate demand
curve shifts to the right.
Y
=
C
+
I
+
G
+
X
Price Level
A Change in Expectations about Future Income
AD1
Y
=
C
+
I
+
G
+
X
AD2
3. If firms’ and consumers’ expectations of future prices rise (that is, if they expect inflation will occur
in the future) then they will want to buy more in the present, while the price level is lower. When
consumers buy more, there is an increase in consumption, or “C” in the expenditures equation, so
there must be an equal increase in “Y.” The aggregate demand curve will shift to the right.
A Change in the Expected Future Price Level
Y
=
C
+
I
+
G
+
Price Level
The expectation of inflation motivates consumers to buy more
output in the present. The increase in consumption results in
an increase in aggregate demand. The aggregate demand
curve shifts to the right.
X
AD1
AD2
4. Exchange rates also affect aggregate demand. If the dollar loses value (depreciates) relative to other
currencies, domestic consumers will be less able to buy foreign goods. Foreigners will be more able
to buy suddenly “cheaper” American goods. Thus, when the dollar weakens, net exports increase.
An increase in “X” leads to an increase in “Y.” The aggregate demand curve shifts to the right.
An increase in the exchange rate makes U.S. goods cheaper to
foreigners, so the demand for net exports increases. The
increase in ‘‘X’’ results in an increase in aggregate demand, so
the curve shifts to the right.
Y
=
C
+
I
+
G
+
X
Price Level
A Change in the Exchange Rate
AD1
AD2
5. The distribution of income has an effect on aggregate demand. If distribution changes so lowerincome families receive a larger share of national income, aggregate demand will increase—because
lower-income families spend a more of their income on consumption than do higher-income
families. When “C” increases, “Y” increases, so the aggregate demand curve will shift to the right.
The Effect of Income Distribution
The redistribution of income puts more money in the hands of
the poor-----who spend more money on consumer goods than
the wealthy do. The increase in consumption results in an
increase in aggregate demand, so the curve shifts to the right.
Y
=
C
+
I
+
G
+
Price Level
X
AD1
AD2
6. Many government policies aim to shift the aggregate demand curve. If the government runs a
deficit, it must be spending that money somewhere. If government spending (“G”) increases, “Y”
must increase, too. The aggregate demand curve shifts to the right.
When the government runs a deficit, it does so to stimulate the
economy by spending money, and ultimately putting it in the
hands of consumers who spend it again. The increase in
government spending results in an increase in aggregate
demand. The aggregate demand curve shifts to the right.
Y
=
C
+
I
+
G
+
X
Price Level
A Change in Government Spending
AD1
AD2
Consumption and the Marginal Propensity to Consume
Suppose you were as a teacher earning a salary of $50,000. Of this, you might spend $40,000 on
consumption—paying for your house, your meals, your photocopies and your car—and you might save
$10,000 for the future.
Now suppose you received a raise to a yearly salary of $60,000. Will you spend all $10,000 of new
income on consumption goods? No. Will you put it all in the bank? No. You’ll probably spend some of
it and save the rest.
The marginal propensity to consume (MPC) refers to this phenomenon. People tend to consume a
certain percentage of new earnings and to save the remaining sum for future needs. If the MPC in an
economy is 0.8, then 80% of each additional dollar will be consumed and 20% saved. If the MPC is
0.9, then 90% of each additional dollar will be consumed and 10% saved.
The marginal propensity to save (MPS) is
the flip-side of the marginal propensity to
consume. If the MPS is 0.15, then 15% of
each additional dollar earned will be saved
and 85% consumed. Together, the MPS and
MPC always equal 1.
Displayed is a diagram that plots the amount
of money consumers in the United States use
on consumption against their total disposable
income. It is called a consumption function.
Connecting all of these points shows that the
data forms a nearly perfect straight line.
REAL CONSUMER SPENDING (IN TRILLIONS OF 1982 DOLLARS)
REAL DISPOSABLE U.S. INCOME THROUGH 1985
(IN TRILLIONS OF 1982 DOLLARS)
When points form a straight line, they imply
a definite relationship between the two variables. Here, consumption on the vertical axis is almost
always about 90% of disposable income. The data point for 1960 represents an income of about $1.1
trillion for all consumers and consumption of about $1.0 trillion. The point for 1985 represents $2.63
trillion in income and $2.35 trillion in consumption.
Each year, in other words, Americans consistently spent 90% of their incomes on goods and services;
the line thus has a slope of 0.9.
Keynes argued that the MPC remains fairly constant for a nation through time. Despite recessions,
depressions, economic recoveries, or alien invasion, consumers continue to spend about the same
fraction of their incomes on themselves. The data above indicates he was right. For decades, U.S.
consumers have continued to spend about 90% of their disposable incomes on consumption.
The Multiplier Effect
Suppose an elderly woman had $20,000 under her mattress, which
she finally decided to spend on her eightieth birthday. Her society
has a MPC of 0.8, meaning 80% of each dollar earned in
disposable income is spent on consumption.
1
Multiplier = 1  MPC
A
Total Increase = 1  MPC
When she spends her $20,000, the people who receive that sum—
travel agents, car salesmen, telemarketers, whoever—will in turn A = initial amount spent
spend 80% of it, or $16,000. The new holders of the $16,000 will MPC = marginal propensity to consume
also spend 80% of it, or $12,800, on their own chosen goods—gel
for their hair, cologne, anything at all. By now you follow the gist of this: the recipients of the $12,800
will spend 80% of it, or $10,240, and this in turn will be spent in the same ratio, on and on, until the
money is exhausted.
What matters most is the overall result. If you have a mathematical background in sequences and series,
you may recognize that we are looking at the sum of an infinite series with a factor of 0.8. The formula
for finding this sum is shown above.
The multiplier gives us a good sense of how many times each dollar will be spent. It can be found by
dividing the marginal propensity to save into 1, or (1-MPC) into 1, as shown to the right. In a society
with an MPC of 0.8, the multiplier is 5; if the MPC were .5, the multiplier would be only 2. The lower
the MPC, the less often money will be spent.
To find the total spending that the injection of a particular amount of money into the economy will
cause, we multiply that amount by the multiplier. If someone spends $15,000 in an economy with an
MPC of 0.8, it will then be spent 5 times—resulting in a final spending increase of $75,000.
‘‘Ideal’’ vs. ‘‘Real’’ Multipliers
What we have just calculated above is called the “ideal multiplier,” or the “oversimplified multiplier.”
Why the extra label? Because often a theory can be nice, but experimental evidence shows something
else. In real life, the multiplier is not as high as the calculated “ideal” multiplier. The reasons for this:



inflation tends to decrease the purchasing power of this new money to spend
some of the extra money is spent on imported goods (and, therefore, goes abroad)
taxes and other expenses take a portion of the money out of circulation each time it is spent.
Again, the MPC for the United States is close to 0.9—maybe a bit lower since the crash of 2008. This
gives us an ideal multiplier of around 10. Various studies have tended to show that for the United States
the real multiplier amounts only to about 2. Analysts admit there is no very accurate way to measure the
multiplier, since so many forces and confounding variables are involved.
Aggregate Supply and Economic Equilibrium
Aggregate supply is the quantity of domestic output suppliers
are willing to produce and sell at every possible price level. It is
the sum of the supply of every good or service produced in an
economy. Remember, as the price of a good or service increases,
the quantity supplied of the good or service increases, too. The
aggregate supply works roughly the same way. As the price level
rises, suppliers are willing to produce and sell more of their
goods and services.
Aggregate supply differs from the supply of a single good.
Generally, more of a single good or service can be produced by
allocating resources from the production of other goods and
services. But this is not possible in the aggregate because there is
ultimately a limited supply of resources.
Consider a comparison. Suppose you wanted to enlarge a room
in your house. We could expand any one room by borrowing
space from other rooms or from the yard. But we couldn’t expand the whole house beyond the plot of
land we own.58 When suppliers are producing at full capacity, the aggregate supply curve becomes
completely price-inelastic. Regardless of what consumers are willing to pay, we have reached the
maximum capacity of the economy (the edge of the production possibility frontier). Below full capacity,
the supply curve has a positive slope.
58
Assume we can’t build a second floor. There’s a floor ceiling.
In the long run, the supply curve is believed to be vertical. Someday, oil producers won’t be able to offer
more oil because there won’t be more to offer—no matter how much consumers are willing to pay.
Where the aggregate supply curve becomes vertical, the economy is at full employment; suppliers are
using all the resources available to them. In other words, the economy is producing at a point on its
production possibilities frontier. At any point below full employment, suppliers would be producing
below capacity, at a point within the PPF.
A shift to the left or right of the aggregate supply curve results from a change in potential output. The
same factors that shift the PPF, including the availability of resources, size of the labor force, capital,
entrepreneurship and technology, will cause changes in aggregate supply.
When the economy is in full employment equilibrium, the aggregate demand curve intersects the
aggregate supply curve exactly at full employment. If the economy is in recession equilibrium, the
aggregate demand curve will intersect the aggregate supply curve at a point below full employment. The
economy will be at a point inside its production possibilities frontier because suppliers will not be using
all the resources they have available to them.
The Labor Force
The labor force includes every civilian
Debate it!
over age 16 who either has a job—
full-time or part-time—or who is Resolved: That people of all ages, including children, should be allowed to
participate in the labor force.
actively seeking a job. We must be
very precise with this definition, so, here, we will explore the standard United
There is no such
States interpretation of it. Let’s break it down, bearing in mind that the details
thing as an
of the definition do vary between countries.
“…civilian…” Those who serve in the military are not counted in the labor
force. Civilians who work for the military, like a custodian at the Pentagon, are
not considered military personnel.
unemployed 14year-old.
“…over age 16…” Even if you have a job, you are
not counted as part of the labor force until you are
16. You can’t technically be unemployed if you’re
not in the labor force. This means there is no such
thing as an unemployed 14-year-old, even if he or she
is looking for a job.
“…has a job…” A person who has a job—and is over
16, of course—is part of the labor force.
“…full-time or part-time…” The CEO of Facebook
and the head fry cook at McDonald’s are both part of
the labor force, even if the cook works 60 hours per week and the CEO only 25.
“…actively seeking a job…” Even if a person has no job, he or she is part of the labor force as long as
he or she wants one and is looking for one. But take note: you are only “actively” job-seeking if you are
turning in applications and scheduling and attending interviews. If your slacker friend sits around
playing WoW while mumbling about how he’d like to have a job, he isn’t part of the labor force. Tobe
counted, he has to be off that couch, polishing his shoes, and shaking hands with middle managers.
The Labor Force Participation rate (LFP rate)59) is the percentage of the civilian population in the
labor force out of all the people who could be in it. In other words, it is the percentage of noninstitutionalized people over age 16 who are working or seeking work. Anyone over 16 who doesn’t
want to work, like a housewife or a full-time student, lowers the LFP rate. It is found as follows:
Labor Force =
Participation rate
# of people in the labor force
# of people over 16 in the civilian population
x 100
In the United States, the Bureau of Labor Statistics is responsible for tabulating how many people have
jobs, how many want jobs, how many have jobs they want, etc. Every month, it conducts a household
survey to determine the current unemployment rate.
According to the Bureau of Labor Statistics, the labor force consists of people who are employed and
people who are unemployed. A person who is employed is one who has a job, either full-time or parttime. A person who is unemployed is in the labor force but does not have a job.
To reiterate, someone who chooses to not work is not considered unemployed even though he is not
working—he is not part of the labor force.
Labor Force = Employed + Unemployed
The employment rate is the percentage of the labor force that is employed:
number of people who are employed
number of people who are in the labor force
Employment rate =
x 100
The unemployment rate is the percentage of the labor force that is unemployed:
number of people who are unemployed
number of people who are in the labor force
Unemployment rate =
x 100
A person in the labor force is either employed or unemployed. There is nothing in between. So the
employment rate plus the unemployment rate should always total 100 percent.
Unemployment Rate
+
Employment Rate
=
100 %
Categories of Unemployed Persons
Some people just lose their jobs. The Bureau of Labor Statistics calls these people “job-losers” (really).
Some job-losers are temporarily laid off, or furloughed, perhaps for a month or less. Some are laid off
for good. Some are strongly encouraged to resign or retire. And, of course, some people are fired. What
all job-losers have in common is that they leave their jobs against their will.
59
The United States Labor Force Participation rate hovers between 65 and 67 percent.
Job-leavers voluntarily leave their jobs. Some move on to better jobs right away, so are not part of the
unemployment problem. Others may leave a job without knowing what to do next—perhaps because
they are unhappy, sexually harassed, or facing pressure from their spouses.
New entrants are unemployed because they joined the labor force. They have never had jobs, so they
need to find employers who will hire them without experience.
Re-entrants left the labor force and are now returning to it. While out of the labor force, they are not
considered unemployed. But once they begin seeking jobs, they rejoin the labor force and drive up the
unemployment rate. Some people leave to raise children, to spend time with their families, or to travel
through rural Morocco. When they come back, they typically look for jobs similar to those they had
before they stopped working. Some leave the labor force to go to school. When they return, they often
want jobs in which they can employ their new training. They may or may not find them.
Kinds of Unemployment
Economists define four kinds of unemployment.
Frictional unemployment occurs when people are
Debate it!
between jobs for “normal” reasons. In the ordinary
Resolved: That the government should not help
course of business, people quit and are fired. Because
frictional unemployment is unavoidable, economists unemployed people who quit their jobs voluntarily.
tend not to worry much about it. Frictional unemployment is a large part of the reason the
unemployment rate is never 0%. Most economists think a rate of about 4% is normal and inevitable.
Structural unemployment happens when there are changes in demand for certain skills in an economy,
often due to technological change—for example, suppose postal workers were laid off because everyone
stopped sending real mail in favor of email. Structural unemployment is also often caused by
realignment of economic activities, such as the shift of manufacturing jobs from developed to
developing nations. Unlike those who are frictionally unemployed, those who are structurally
unemployed have a serious problem. They must often either take jobs with lower pay or switch into a
different field, perhaps after some retraining.
Cyclical unemployment results from fluctuations in the business cycle. The workers who are laid off
because of a recession are cyclically unemployed. Their skills are not obsolete, so most of them will
probably be working again when the economy recovers. The Employment Act of 1946 was aimed at
alleviating cyclical unemployment. Until it expired in 2000, it made the government responsible for
minimizing the volatility of the business cycle and for pursuing four percent unemployment.
Seasonal unemployment is the result of changes in the season during the year. Most ski instructors lose
employment in the summer, while swim teachers are out of jobs in the winter (except in places like
Hawaii and Cancun). Many agricultural jobs are also seasonal. Since we can’t do much to stop the
seasons from changing, we need to help employees to diversify their skills. If a ski instructor learns how
to teach swimming and rake leaves, he or she ought to have a job year-round.
Four Portraits of Unemployment
Mike leaves his job at K-Mart so he can move to a new home in another city. Once there, he begins
applying for positions at other discounters. Mike is unemployed.
Megan is a conductor of the pit orchestras that accompany operas on Broadway. Suddenly all Broadway
theaters decide to use the Internet to replace live human conductors with less expensive conductors from
abroad. Megan is unemployed.
Kim works in the furniture relocation industry. When a recession sets in, a quarter of the industry is
laid off, Kim included. She has to bide her time looking for work until another contractor finds value in
her services. Like Mike and Megan, Kim is unemployed.
Montgomery is a high school student who finds work at a pumpkin stand in October. In November,
Montgomery is laid off because no one is buying pumpkins.
Mike, Megan, Kim and Montgomery each typifies a different kind of unemployment.
Mike is frictionally unemployed. Friction is the force between two objects that are touching; we might
think of Mike as sandwiched between two jobs, the one he had the one he is looking for.
Megan is structurally unemployed. There has been a major shift in the economy, resulting in her
replacement by someone ten thousand miles away. Structural unemployment stems from changes in
what or how an economy produces.
Kim is cyclically unemployed. Her job depends on the condition of the economy. During recessions
and depressions, many workers are laid off. During a recovery, they are (hopefully) rehired.
As for Montgomery, he is seasonally unemployed. His employer is likely to rehire him the following
October, when pumpkins are in demand again. But for the moment, he’s not needed.
Money and Currency
Barter economies are inefficient. Remember from earlier in this resource that in order to barter people
must have a double coincidence of wants. This reduces the number of possible transactions.
To trade without bartering, an economy must have some form of money. We are all familiar with
money because we are all used to having it. But take a step back and consider what a strange thing
money is. In the United States, it comes in the form of pieces of mostly green paper with pictures of
dead presidents on them.60 In China, the colors are different and the pictures are all of Mao Zedong.
Everywhere, people sacrifice hours of their time in return for the promise of these pieces of paper.
But people won’t work for just any piece of paper—except maybe for certificates of achievement in the
World Scholar’s Cup. What is so special about United States dollars and other forms of currency that
makes people willing to work so hard for them?
The main answer should be pretty straightforward. Dollars let us buy goods and services. World
Scholar’s Cup certificates do not.61
Currency includes only paper money and coins, but check are written to represent some amount of
currency held elsewhere. Checks allow the pieces of paper to be shuffled offstage.
60
61
Except for Ben Franklin. He’s the only exception.
Don’t try it. You can’t even exchange them for alpacas.
There are two main kinds of money. Fiat money is money with no inherent value—it is money only
because the government declares it to be money and people believe the government. It has no real value
outside of being money. There aren’t many other things you could do with dollar bills. You could line a
bird cage with them, but a newspaper would work better. You could take notes on dollar bills, but
they’re hard to read: a pad of lined paper would probably be better. They also make very uncomfortable
toilet paper.62 For the most part, dollar bills are only useful if you’re spending them.
Unlike fiat money, commodity money has value besides its use as money. If chocolate were money, you
could choose to spend it or to eat it. If cigarettes were money, you could spend them or smoke them.
Both chocolates and cigarettes have often been used as money in prisons. Gold and silver are good
examples of more widely-used commodity money. They are both precious metals with market value, as
we all know from commercials urging us to invest in them, and the raw ingredients of jewelry and other
goods. Most currencies were historically made from precious metals—which led people to try and fake
the metals, or to mix them with less valuable metals without anyone noticing.
The term ‘commodity’ in commodity money refers to the fact
that anything used for money must be widely available,
standardized, and easy to value on the market. If it is not a
commodity but a more unique good, such as handmade hats,
then we are partly back to the original problem of bartering.
The Three Functions of Money
Money acts as a medium of exchange, which is why money is
more efficient than a barter system. If you can exchange money
for the things you need, then you need only to exchange the
things you have (such as your time and effort) for money.
Then you can exchange your money for the things you want.
Everyone must still provide goods and services that are wanted,
but they can be goods and services that are not necessarily
wanted by the people with products that you want.
Money acts as a unit of account. It measures the relative worth
of different goods and services and the relative wealth of
different people, organizations and nations. If you spend $5 on
a Happy Meal in San Francisco, you know you’re giving up a
$5 e-book or half a $10 t-shirt. It is harder to gauge value in a
barter system, because all products and services are worth
different amounts to different people.
MediumofExchange
• Youcanusemoneytobuy
productsfrompeoplewho
mightnotwanttobarter
withyouforyourused
socks,butarehappytotake
yourusedcash.
UnitofAccount
• Youcanmeasurethecostof
things‐‐likeheadphones,
Facebook,andCramKits‐‐in
termsofthemoneyitwould
taketobuythem.
StoreofValue
• Ifitisworth$50today,it
willbeworth$50nextyear.
Money also acts as a store of value. You can spend a fifty dollar bill, and in return, you’ll get a fire
extinguisher. However, you could also hang on to it. You could keep it in your pockets, under your
mattress or in your bank account. After a few weeks, you could still pick up a Happy Meal—several, in
fact. Money retains value. If yogurt were money, you would have to spend it before it went bad.63
62
63
Trust me on this.
Or, you could feed it to Michael Weston.
Types of Money and the Money Supply
The money supply is the total money in an economy. Currency—actual cash and coins—is only a small
part of this total. For every U.S. citizen, there are only about $1,500 of currency in circulation.
Economists measure the money supply in different ways. Each differs in the liquidity of the money it
counts, or how easily it can be converted to something you can spend at a store. If it takes a pawnshop
to convert something to cash, it isn’t very liquid—but it’s still more liquid than, say, your arm.
M1 is the most liquid definition of the money supply. It consists of currency, demand deposits (such as
your checking account) and travelers’ checks.64
M2 is less liquid than M1, but is still liquid enough that many economists consider it the most accurate
measure of the money supply. All of M1 is included in M2, as are savings accounts, certificates of
deposit65 (CDs) under $100,000, and money market and mutual fund (“retail money”) shares.
M3 takes M2 and adds large time
deposits, such as CDs worth more than
$100,000, along with Eurodollars
(American dollars held in banks abroad)
and money market funds that take a very
long time to return money to investors.
The United States Federal Reserve
stopped measuring M3 in 2006.
Definitions of the Money Supply
L. L stands for “liquid” and is not a
standard measure. It includes M3 and
some loans, such as treasury bonds and
commercial paper (loans to companies.)
When economists talk about the money
supply, they are usually referring to M2.
Inflation and Price Indices
U.S. Money Supply Since 1960
By the time we reach high school, we have
probably witnessed some inflation firsthand. Prices for most goods and services go up over time. In
1962, when the first Motel 6 opened in Santa Barbara, it charged $6 a night per room—that’s why they
called it Motel 6! By the 1980s, it charged over $40 a night. Today that same room will run you $99.66
When inflation is taking place, all prices are going up—and so, in theory, are wages and rents. You
might wonder, then, why inflation is such a big deal. If everything costs more, and everyone is being
paid more—nothing is really changing.
64
Traveler’s checks are falling out into disuse as more and more travelers carry credit cards—but your parents may have used
them when they went on European vacations after high school.
65
A CD is a time deposit: when you buy one, you deposit a certain amount in a bank and agree not to withdraw it for a
period of time. At the end, you get back your deposit, plus interest. The longer the period, the higher the interest rate.
66
But it comes with free wifi!
It is true that inflation does not directly
affect economic activity. If all prices are
going up, producers continue to produce
the same number of products—just at the
new nominal price. Economists credit this
behavior to what they call price
neutrality: markets, in other words, care
only about real prices. They are “neutral”
with regard to nominal prices.
However, inflation does have an effect on
both firms and households. Inflation is
good news for borrowers with a fixed
interest loan. Suppose someone has
borrowed $5,000 and promised to pay
back 5% a year. If inflation is suddenly
10% a year, the value of what they owe is
actually shrinking over time. The lender is
in the opposite situation—he or she loses
out.
U.S. Money Supply in October 2010
M1
Currency: $907.6
Traveler’s Checks: $4.8
Demand Deposits: $480.3
Other Checkable Deposits: $386.9
TOTAL: $1,779.6
M2
M1: $1779.6
Savings Deposits: $5298.4
Small Denomination Time deposits: $967.8
Retail Money Funds: $721.3
TOTAL: $8,767.1
Societies pursue price stability because inflation has some substantial economic costs:
 Inflation lowers the buying power of people living on fixed incomes, such as retirees and
welfare recipients. Some forms of fixed income do adjust for inflation over time, but not all
at once.
 People may find their savings are suddenly worth much less, especially if they were holding
them in cash, not in hard assets, such as gold, whose prices rise with inflation.
 The shoe leather cost of inflation is a metaphorical term for the costs of making frequent
trips to the bank to withdraw more cash. This metaphor is less relevant now, as lots of people
bank online67 and use credit cards.
 Financial markets cannot handle unpredictable inflation. Banks have trouble valuing loans
when it is unclear what they will be worth over time. Erratic inflation rates can lead to
diminished investment activity, which directly impacts economic growth.
 Another cost of inflation is the menu cost—because, in theory, restaurants have to keep
printing new menus to keep up with inflation. Some firms, such as gas stations, can easily
adjust prices every day, but others are not so flexible. If inflation is high or unpredictable,
firms have no choice but to change prices constantly.68
 Related to menu costs is the allocative cost. The relative prices of goods do not always adjust
at the same rate. Say oranges normally cost twice as much as memory sticks—but, while
67
Now it could be called carpal tunnel cost.
Some firms have long-term contracts with fixed prices. If inflation is higher or lower than expected, one party loses and
one gains. For a long time, Southwest Airlines was able to stay profitable despite rising oil prices because it had signed a longterm contract for fuel at lower prices.
68
orange farmers can raise prices quickly in an inflationary period, memory stick makers
cannot. They are locked in by published catalogue prices, etc. For a time, oranges will cost
three times as much as memory sticks. Consumers will favor memory sticks, which is difficult
on the orange growers.69 Goods will be allocated inefficiently.
 The planning cost of inflation refers to the fact that it takes a lot more time to plan budgets
and think about future earnings if there is high or unpredictable inflation.
 Even for those whose wages adjust to inflation, there is still a cost called the hidden tax:
Progressive tax brackets are usually defined nominally and not adjusted to inflation very
often. Thus, inflation pushes people into higher tax brackets for the same real income.
Demand-pull inflation occurs when aggregate demand increases, but supply is maxed out—at least in
the short run. When aggregate demand intersects aggregate supply at the full employment level of
output, any further increase in demand will push
up the price level without producing more output.
We can summarize demand-pull inflation as too
many dollars chasing too few goods. To stop it,
we must reduce aggregate demand.
Cost-push inflation occurs when the price of
goods and services increases because the prices of
inputs—such as oil—increase. Firms have to pay
more to produce, so aggregate supply shifts to the
left. The equilibrium price level rises even though
no more output is exchanged.
Cost-Push Inflation
Structural inflation is less common, caused by a
shift in demand from one type of good to another.
For example, many companies have moved from
glass to plastic containers.70 The change pushes the
demand curve for plastic outward, raising its price.
You might think the lower demand for glass
would reduce proportionally, but not necessarily. Prices increase far more easily than they decrease;
economists say prices are sticky in the downward direction. This is not always true, of course, especially
with high-tech products like hard drives, which tend to decline in price as production technology
improves—though manufacturers can keep prices on others high by releasing shiny new models.
To measure inflation, we must observe and measure any movement in the price level. From one quarter
to the next, prices may shift upward or downward.
The Consumer Price Index (CPI) is the standard tool for measuring inflation in the United States. The
Bureau of Labor Statistics calculates the Consumer Price Index. Each month, it measures what it costs
to purchase a fixed “market basket” of consumer goods and services. The market basket includes goods
that Americans buy frequently.71 The market basket does not include luxury items or financial
69
And might lead to scurvy, unless the memory sticks are vitamin-c-enhanced.
Examples include Voss water and Pom pomegranate juice (which I nearly called pomeranian juice.)
71
Thus, it includes breakfast cereal, but not congee.
70
instruments such as stocks and bonds. The CPI uses a fixed basket of goods so it can consistently
measure changing prices. However, this is also its weakness, as increasing prices of goods in the market
basket may drive consumers to lower-priced substitutes.
What goods and services does the CPI cover?
Food and Beverages
Housing
Apparel
Transportation
Medical Care
Recreation
Education and Communication
Other Goods And Services
breakfast cereal, milk, coffee, chicken, wine, service meals and snacks
rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture
men’s shirts and sweaters, women's dresses, jewelry
new vehicles, airline fares, gasoline, motor vehicle insurance
prescription drugs and medical supplies, doctors’ services, hospital services
televisions, pets and pet products, sports equipment, admissions
college tuition, postage, telephone services, software and PC accessories
tobacco and smoking products, haircuts and personal services, funeral expenses
The CPI is expressed as a percentage of a given earlier year. The earlier year is called the base year. For
example, if the CPI for a particular year is 163, then the price level that year is 63 percent higher than it
was in the base year. For simplicity, the base year is kept the same for several years at a time. That way,
we can more easily understand the movement of the price level.
Inflation is expressed as the percentage by which the current price level exceeds the prior price level.
This inflation rate is determined as follows:
price levelyear - price levelprevious year
price levelprevious year
Inflation rateyear =
x 100
Suppose for 1998 the price index is 163.0 and for 1997 it is 160.5. The inflation rate for 1998 is:
Inflation rate1998
Inflation rate1998
=
price index1998 - price index1997
price index1997
x 100%
=
163.0 - 160.5
160.5
x 100%
=
2.5
160.5
x 100%
=
1.6%
Economists use the CPI to measure inflation because the demand for consumer goods represents the
bulk of aggregate demand. If consumer prices are rising, we can assume other prices are rising, too.
Although price levels usually increase, they can
Watch it on YouTube
also decrease. This is called deflation.
History’s most notorious period of hyperinflation occurred in
Deflation is rare, in part because prices are
Germany in the 1920s. Watch this clip for a sense of what this
sticky in the upward direction: it is harder to
experience was like for the German people:
convince stores to raise prices than to lower
http://www.youtube.com/watch?v=MCU6Fcnc2H0
them. The most pronounced period of
deflation in American history occurred from 1928 to 1933, at the onset of the Great Depression—when
numerous banks shut down and people’s savings vanished, leaving less money in circulation. At a very
basic level, less money meant the remaining money was worth more.
Economists use a few other specialized terms to describe inflationary developments:
Hyperinflation means inflation is very high—for instance, 50% per month. When
countries go through hyperinflation, their governments tend to break down.
Disinflation72 means the rate of inflation is decreasing. When disinflation occurs,
inflation is still occurring—it is positive—but the rate of inflation in one year is lower
than in the previous year. If inflation in 2011 is four percent and in 2012 it is three
percent, then disinflation has occurred.
Constant inflation means the rate of inflation is not changing. Prices are increasing, so
there is inflation, but the inflation rate is not increasing. It stays 3% for several years at a
time. Constant inflation is not too problematic, as people can adjust their behavior
around predictable changes.
Accelerating inflation means the rate of inflation is increasing. If the inflation rate is 5%
one year and then 7% the following year, accelerating inflation is occurring. This is
more harmful, as no one knows how much the rate will increase.
Hyperinflation
Disinflation
a high rate of inflation -
a decreasing rate of inflation
“18%”
“5%, 4%, 3%…”
Accelerating Inflation
Constant Inflation
an increasing rate of inflation
a stable rate of inflation over time
“3%, 4%, 5%...”
“3%, 3%, 3%”
Another price index, the Producer Price Index (PPI) measures the prices of raw materials, and helps us
to determine when the prices of the factors of production are rising.
In the United States, the GDP Deflator is a more comprehensive price index meant to determine the
“real” value of GDP over time. It measures a broader array of prices than the CPI or the PPI. The GDP
deflator is determined by adding up a market basket of goods for each of two years. The baskets are
priced according to what each would have cost in the base year. The total price of each basket differs,
even though each is in base year dollars, because some of the goods in the current year either did not
exist or were less common consumer items in the base year.
With the GDP deflator, we measure inflation with a changing basket and fixed prices. We can calculate
the GDP deflator as follows:
GDP
Deflator
=
price of current basket base year prices - price of base year basket base year prices
price of base year basket base year prices
We use the GDP deflator to factor inflation out of nominal GDP:
72
Don’t mix disinflation with deflation. They are two different things.
x 100%
Real GDP =
Nominal GDP
GDP Deflator
Suppose GDP is $100 billion in 2084, and the deflator is 220. Real GDP is found as follows:
Real GDP2084
Real GDP2084
=
Nominal GDP2084
GDP deflator
=
$100 billion
220%
=
$100 billion
2.2
=
$45.5 billion
Interest Rates
One way banks earn profit is by
charging interest on loans. The
original loan amount is called the
principal balance. Interest is
added to the balance of the loan at
given intervals. Interest is
calculated on the entire balance:
the original principal combined
with any accumulated interest.
Islam, Interest Rates, and a Different Way of Banking
The topic is far too large to explore here, but it is worth noting that not all
banks follow the ‘‘charging interest’’ model. Islamic banks, due to religious
restrictions on interest, have had to find other ways to remain profitable. It is
hard to find unbiased articles on the subject, but, if interested (no pun
intended) in learning more, you might want to start here:
http://www.american.com/archive/2007/march-april-magazinecontents/islamic-banking-is-it-really-kosher/
For instance, say you originally borrowed $10,000. Since then, you have incurred $2,000 of interest.
Your next interest charge will be based on the entire balance of $12,000. The more frequent the interval
at which interest compounds, the faster the balance will grow. If you borrow at an interest rate of 5%
compounded yearly, then after a year you need to pay back the principal plus 5% interest. But if the
rate is 5% compounded daily, you will owe much more.
Financial institutions compound interest using different intervals. To make it easy to compare, most
state the total interest rate per year. This measure is called the annual percentage yield, or APY.
The nominal interest rate on a loan is the stated percentage rate of interest. If there were no inflation,
then banks would actually earn nominal interest. However, for the past century, the U.S. has
experienced varying degrees of inflation. The real interest rate is the value of the interest that banks
actually earn—and debtors actually pay—when there is inflation. It is the difference between the
nominal interest rate and the inflation rate.
Real Interest Rate = Nominal Interest Rate --- Inflation Rate
Many loans have flexible interest rates, which are determined by adding some arbitrary rate to the prime
interest rate. The prime interest rate is the rate that banks charge on short-term loans to their most
creditworthy corporate customers. The prime interest rate is published quarterly in the Wall Street
Journal. The documents for loans that have flexible interest rates will indicate that the rate is determined
by adding some percentage to “the prime interest rate, as published in the Wall Street Journal.” When
banks change the prime rate, they are adjusting for inflation.
Roles of the Government in a Market Economy
Even most free market economists agree there should be limits on what people should be able to do to
make money—for example, the enslavement of children. There is no such thing as a “pure” market
economy, or one that functions with zero government regulations and interventions.
In most modern countries, the government steps in when the market cannot fulfill important social
goals. (These goals vary by country; for example, some see health care as a right of all citizens, while
others do not.)
In the United States, most of us value breathing
clean air. We value knowing we would continue
to have some food and shelter, even in a severe
depression. We value knowing we have some
recourse if something happens to our property—
or if we become disabled. Government
intervention protects these values.
Taxation is a second vital government function.
To provide public goods and services, the
government needs funding—so it collects taxes.
Taxes affect the economy: they alter the prices of
goods and services, they reduce how much
people have to spend, and they result in
incentives that can change behavior—for
example, a tax deduction on mortgage interest
encourages people to take loans to buy homes,
and tax penalties on second children (best
exemplified by China) can increase the number
of single-child families.
Promoting competition among buyers and
sellers is a third government function. Laws
protect buyers and sellers against anticompetitive practices. Most governments
investigate and prosecute companies that commit
anti-competitive behavior. Even when a
company, such as Microsoft, escapes scrutiny in
the United States, it may still be penalized for
anti-competitive
behavior
elsewhere—for
example, by the more socially progressive
European Union.
73
Defense Against Aliens, and Other Public Goods
One of the most critical government functions in a market
economy is to provide and protect public goods. A public good
(or service) is one for which it is impossible to distinguish
private property rights. In other words, no one owns it-----and no
one can own it.
A pure public good is non-rivalrous and non-excludable.
Non-rivalrous means that if one person takes some of a good,
everyone else still has access to just as much of it. For example,
if I breathe air, there is still plenty of air left for other people to
breathe. (Unless we are stuck on a spacecraft.) If I download an
episode of Dexter from iTunes, that doesn’t decrease the
number of episodes you can download.
Non-excludable means there is no way to stop people from
taking or using a good or service. No one can be excluded from
it. Air is both non-rivalrous and non-excludable. You can’t stop
people from breathing it. But episodes of Dexter on iTunes are
excludable: Apple can charge for downloads, and exclude people
unwilling to pay.73
In fact, sometimes you can’t even exclude yourself from a public
good-----such as national defense. If hostile aliens were to land in
your town, the government would try to protect you-----even if
you insisted you hadn’t paid taxes and didn’t deserve protection.
The government may not provide us the air we breathe, but it
regulates air quality-----ensuring the air is clean. Even goods that
are not ‘‘pure’’ public goods-----such as national parks, which
exclude some visitors with small entrance fees and are not
completely non-rivalrous, since too many visitors at a time will
damage them-----may still require government protection.
Debate it!
Resolved: That private firms should be allowed to compete
without government regulation.
Of course, people can work around such constraints—using services such as BitTorrent. But, technically, they could steal
eggs from the market too; the eggs are still technically excludable.
Private property rights are another important government responsibility. As you have learned,
individuals must believe their rights to private property are being protected, or they will have no
incentive to invent, to invest, to innovate, or to take entrepreneurial risks. The government is
responsible for establishing and enforcing laws that protect private property.
Providing income security and redistribution is another role of the government in a market economy.
People cannot work forever or always; they grow old or they may lose their jobs. And some people can
never work enough to support themselves or their families. In the United States, the government
provides a modest Social Security income to the retired and the disabled by taxing those who work. It
also assists the temporarily unemployed. Without the government as an intermediary, many selfinterested, rational people would not freely pool a portion of their income to support complete
strangers. The government also provides aid to impoverished families with children (nicknamed
“welfare”) as a social service that softens the harshness of the market system.
To make all this possible, governments collect taxes from consumers and producers.
Sales, Value Added, and Excise Taxes
Some taxes are on the money people earn, others on the money that they spend. Sales, value added, and
excise taxes fall on the spending side, and are therefore known as consumption taxes.
Traditional sales taxes (still common in the United States) are levied on the final sale of most goods and
services. If there is a 10% sales tax in a city, people will pay $1 of tax on a $10 good—driving the total
price up to $11.74 Purchases for the purpose of resale—such as buying 100 DemiDec Cram Kits at
Barnes and Noble in order to resell them to 100 other students—are exempt from sales taxes.
A value added tax (VAT) is a nationwide sales tax (first introduced by the French in the 1950s) levied at
each step in the production process. DemiDec would pay a certain amount of tax on the paper used to
print the Cram Kits, Barnes and Noble would pay tax on the printed Cram Kits it bought from
DemiDec to stock at the bookstore, you would pay tax on the Cram Kits you bought from Barnes and
Noble to resell to your friends, and your friends would pay tax on the Cram Kits they bought from you.
Supporters of the value added tax believe it limits fraud; with a sales tax, companies and consumers
might try to pretend they plan to resell a product in order to avoid paying it, but with a value added tax
there is no incentive to lie. It also generates revenue for the government even in countries where many
people are unemployed or have low incomes, as long as they are consuming something.
An excise tax is a special tax applied to each unit sold of a specific good or service. A government usually
imposes excise taxes for one of two reasons.
First, it might want to discourage consumption of a good by making it more expensive. Such “sin taxes”
can apply to items such as alcohol and cigarettes that have negative externalities for consumer health—
or for society. We’ll come back to this topic later when we discuss Pigovian taxes.
Second, the government might be looking to generate revenue on items for which demand is priceinelastic. For example, travelers almost always need someplace to stay the night—so demand for hotels
is relatively inelastic. Local governments therefore impose steep taxes on hotels, rental cars, and airplane
74
Some goods—often including raw fruits and vegetables, but not processed snacks such as Doritos—can be excluded from
sales taxes if the government is trying to encourage people to buy them.
tickets, because their impact on the number of units sold is minimal—and because most of the burden
is felt by taxpayers from someplace else!
Sales Taxes and Deadweight Loss
The graph demonstrates the effect of a sales or excise tax on the
market for a good—say, DECABARS. When the government
enacts an excise tax of 20 cents, the cost of DECABARS rises by
that amount for every bar sold. Essentially, the supply curve shifts
to the left, from S1 to S2, 20 cents higher.
The new equilibrium price is higher than the original price—in
this example, it rises from $1.00 to $1.10.
But wait: the tax was 20 cents, and price only rose 10 cents. That
means producers are also absorbing some of the cost of the tax.
Since consumers are paying more than they
would be without the tax, and benefitting from a
smaller number of goods, they sustain a loss of
welfare, represented by the region B and C.
Watch it on YouTube
Deadweight loss is easiest to learn when you see it animated
on screen. Check out this video lecture on YouTube:
http://www.youtube.com/watch?v=9F6PSIOJQuU
Since producers are earning less than they would
be without the tax, they also sustain a loss of welfare, represented by the region D and E.
The government collects revenue—in this case, 20 cents per each of the 40 units sold. The
government’s revenue amounts to regions B and D.
What happens to regions C and E? They are simply lost: consumers and producers no longer benefit
from them, and the government doesn’t collect them. They are referred to as deadweight loss.
All taxes have a fundamentally similar effect on buyers and sellers. Taxes raise the amount consumers
pay and decrease the amount producers receive. They decrease the quantity exchanged, they generate
revenue for the government, and they create a deadweight loss for society.75
“Tax incidence” and “tax burden” refer to who bears the welfare loss that results from a sales or excise
tax. Tax incidence is usually shared between consumers and producers, but the degree to which it is
shared varies by how price-elastic demand is.
If demand is perfectly elastic, producers
bear the tax burden—since any price
increase will cause all consumers to
leave the market. If demand is perfectly
inelastic, consumers bear the whole tax
burden, since producers can raise
prices without affecting how much
consumers choose to buy.
75
The government can try to compensate for this deadweight loss by using tax revenue effectively.
Most goods lie between these extremes. The more price-elastic the demand, the more of a burden
producers will bear. Consider charts A and B. Demand in A is very price-elastic, so a 20 cent tax is
borne mostly by the producers—equilibrium price only rises 5 cents. Demand in B is relatively inelastic,
so more of the burden falls on consumers: price rises 15 cents.
Lump Sum and Property Taxes
A lump sum tax requires everyone to pay the same amount. For example, all businesses in a certain
region may be required to pay $150 in order to stay in operation—a so-called business license or
registration fee. It may not be called a tax, but it effectively is one.
In the United States, owners of land and buildings pay property tax, which is usually a fixed tax per
some amount (usually $100) of assessed property value. A property tax is a tax on wealth, not income or
spending. If you invest a million dollars in an apartment building, you will pay an annual property tax
plus income tax on any income from renting out the apartments. If you invest a million dollars in a
work of art, you will be charged a sales tax, but you won’t have to pay an art owner’s tax every year.
Property taxes can influence the real estate market. If a city significantly raises its property taxes, fewer
people will want to move there, and real estate prices will fall.
Income Taxes
The personal income tax is a tax on the money people earn as income each year. In the United States, it
is a progressive tax made legal by the 16th amendment in 1913. It is progressive because, as a person’s
income increases, he must pay a progressively larger percentage of his income in tax. To determine tax
liability, the United States government divides people into income brackets. The more income you
make, the higher your bracket, and the higher your marginal tax rate.
Suppose we had 4 hypothetical income tax brackets:
INCOME
$0-10,000
$10,001-$20,000
$20,001-$50,000
$50,001 and up
MARGINAL TAX RATE
0%
10%
20%
30%
Someone who made $10,000 would pay zero tax76.
Someone who made $15,000 would pay zero tax on the first $10,000 and 10 percent marginal tax on
the remaining $5,000, for a total tax of $500. He would keep $14,500.
Someone who made $25,000 would pay zero tax on the first $10,000, 10 percent on the next $10,000,
and 20 percent on the last $5,000—or $2,000 in all. He would keep $23,000.
Someone who made $100,000 would pay zero tax on the first $10,000, 10 percent on the next $10,000,
20 percent on the next $30,000, and 30 percent on the last $50,000—or $22,000 in all. He would keep
$78,000.
The actual tax brackets in the United States, as of 2010, were as follows:
76
This might upset certain presidential candidates.
Marginal Tax Rate
Single
10%
$0-$8,375
15%
$8,375-34,000
25%
$34,000-82,400
28%
$82,400-171,850
33%
$171,850-373,650
35%
$373,650+
Married Filing Jointly Married Filing Separately
$0-$16,750
$0-$8,375
$16,750 -68,000
$8,375-34,000
$68,000-137,300
$34,000-68,650
$137,300-209,250
$68,650-104,625
$209,250-336,550
$104,625-186,825
$373,650+
$186,825+
Technically, married couples combining incomes
confront higher tax rates than if filing separately.
This is sometimes criticized as a marriage tax.
Some critics of progressive tax systems argue all
people should be the taxed at the same
proportional or flat rate—say, 20%. The
drawback to this approach is that taking away
20% of a struggling person’s limited salary would
probably have a much greater impact on him or
her than taking away 20% of a wealthy person’s
enormous investment income. In this way, a flat
tax is actually regressive.
A regressive tax is one that costs those with fewer
resources a greater proportion of their income.
For example, if all people must pay $100 each to
vote for president, it costs poor citizens a
relatively greater portion of their resources to
vote. Your average Bill might only have a
thousand dollars in savings, while Bill Gates
might have five hundred million.
Promoting Competition
In the United States, the Constitution grants
Congress the power to regulate interstate and
international commerce: “to regulate commerce
with foreign nations, and among the several
states, and with the Indian tribes.” This portion
of the Constitution is referred to as the
“Commerce Clause.” Traditionally, Congress
and the Supreme Court have interpreted the
interstate commerce clause to allow wide-ranging
federal jurisdiction; after all, most large
transactions do involve more than one state.
Debate it!
Resolved: That all people should be taxed at the same rate.
Coase Theorem
Suppose you use high speed Internet to run an online poker
business in your bedroom-----and you use so much bandwidth
that you’re slowing down the Internet for your neighbor,
Susan. Susan wants to receive photos of her new grandson,
but they come in so slowly that she is more and more
frustrated. Worse, the slow Internet is making it hard for her
to research, write, and get paid for freelance magazine
articles. The traditional solution to a problem like this one-----a
negative externality-----would be for the government (or some
other party) to regulate Internet usage. You might be
forbidden from using more than 500 gigabytes of bandwidth
per day, or taxed $10 for every gigabyte you go beyond that.
The solution works-----but the economist Ronald Coase
realized there might be another way. What if your neighbor
paid you enough to make it worth your while to rent a server
somewhere else? For Susan, the loss of utility from receiving
photos of her grandson-----and the lost revenue from writing
magazine articles-----makes it totally worthwhile to hand you,
say, $100 per month to rent a remote server. And, for you,
the remote server would have no impact on revenue, so why
not accept the $100? Coase’s remarkable insight-----now
known as the Coase Theorem-----was that it didn’t matter
who owned what in the initial state-----as long as the parties
involved in a situation have clear property rights and can
negotiate easily and freely, with zero transaction costs, they
will reach an efficient solution.
Read more about the Coase theorem-----including its
implications for divorce law-----here:
http://www.econlib.org/library/Enc/bios/Coase.html
Unfortunately, most externalities are not so easily resolved.
Property rights are not always so explicit (who owns the air,
or the right to a climate-change-free world?), and
transactions and negotiations can be costly and complicated,
especially when many parties are involved.
Congressional power is necessary to curb the
power of monopolies because the government would be unable to enforce antitrust law if it did not have
jurisdiction. United States antitrust law was codified in the 1890 Sherman Antitrust Act and the 1914
Clayton Antitrust Act.
At first the Sherman Antitrust Act was used to restrain labor unions while monopolies ran free. More
recently, it has been used more effectively to restrict monopolies. Section 1 restricts collusive agreements
such as backroom deals to fix prices. Section 2 makes it illegal to monopolize a market.
The Clayton Antitrust Act was passed to protect labor unions while more directly targeting real
anticompetitive business behavior. The Clayton Act prohibits mergers that would substantially lessen
competition or create a monopoly. When two airlines try to merge, the government studies the market
very carefully to en sure the merger will not lessen competition and hurt consumers.
Similar laws exist in most economies. However, most constitutions grant their governments the power
to regulate all commerce, regardless of whether it is “interstate.” The United States is not the only
government with an emphasis on state’s rights (neighboring Mexico has a similar structure) but it is one
of the most extreme.
Positive and Negative Externalities of Public Policy
An externality occurs whenever an economic transaction has a side effect on someone other than the
buyer or seller—a side effect that neither party pays for. That side effect can be positive or negative.
The most common example of a negative externality is pollution. A power plant might expel poisonous
waste into a river, killing its fish and hurting the economy of a village downstream. When the plant
decides how much energy to produce, it only considers its own costs and revenues and does not consider
the cost of pollution to the village. The power plant staff underestimates the real cost of producing
power—and produces more than the socially ideal amount.
If you buy a hybrid Toyota Prius to save on fuel costs, it improves the quality of life for everyone else in
the form of cleaner air.77 If enough people in a community pay to be vaccinated for the flu, those who
didn’t pay for the vaccination also become less likely to catch it—because there are fewer people left
through whom the flu can spread. Or, consider my friend Craig’s purchase of a home in Boston. It was
in a less than prosperous neighborhood. A few years after he bought it, the Massachusetts Bay
Transportation Authority opened a new subway station nearby, making it possible to commute easily
into Central Boston. Home prices shot up and businesses saw a surge in customers. The opening of a
subway station had positive externalities for everyone already in the neighborhood—but they paid
nothing more for it than any other taxpayer in the state.
To combat negative externalities, or to encourage positive externalities, economists and policy-makers
devise market incentive programs. All power plants might be given a limited number of pollution
credits, with the ability to trade credits with other power plants. Cleaner power plants could make a
profit by selling their right to pollute to dirtier power plants. Such policies give producers an economic
incentive to pollute less.
The government may try to make decision-makers incorporate social costs into actual accounting costs,
“internalizing” them. Carbon dioxide contributes to global warming and is produced in many different
ways; some goods are associated with more carbon dioxide production, some with less. This is a cost
77
It would also lower gas prices for everyone (through decreased demand).
that most people do not consider when choosing what to buy. The government could implement a
carbon tax that would increase the cost of all products made in ways that contribute carbon dioxide to
the atmosphere. Non-polluting products which would ordinarily cost more than their polluting
counterparts would become a better value. Such behavior-modifying excise taxes are sometimes referred
to as Pigovian taxes.
When something has a positive externality, its benefits are undervalued, so the market produces less than
the socially optimal quantity. The government may choose to give subsidies or tax breaks to encourage
the production and consumption of such goods and services.
Social Security
The Social Security system began in the United States with the passage of the 1935 Social Security Act
as part of Franklin D. Roosevelt’s New Deal. The Social Security tax is a payroll tax; employers and the
employees both pay a percentage of the employee’s income into the Social Security program. The
system has worked relatively well, but now economists are predicting a problem.
When the program began, Americans did not live as long, and they had more babies—so the average
length of retirement was shorter, and there were more young people around working. The ratio of
workers to older beneficiaries was over 30 to 1. Right now, there are about 3.5 workers to every
beneficiary; in 2020 there will be about 2.5. Since the payments of current workers are transferred
immediately to current beneficiaries, it will be difficult for the proportionally shrinking pool of workers
15 years from now to keep financing all of Social Security.
Let’s go over one more time: current workers are transferring funds to the currently retired with their
current tax dollars. When a person pays taxes into Social Security, those taxes are used immediately. The
funds a person pays are not saved for his or her own retirement.
In some systems, such as in Chile, people have own government-allocated retirement accounts that pay
their own funds back to them when they retire—amounting to government-run investment accounts.
Critics note that, while this plan sounds good during boom times when the stock market is rising, at
other times it could lead to people losing their retirement savings to stock market declines.
In the United States, as the large baby-boomer generation continues to retire, there will most likely need
to be less paid out by Social Security (reduced benefits or increased age requirement) or more taken in
(higher taxes). Neither option has many champions; solutions remain elusive78.
The American Welfare System
The modern welfare system first took shape in the United States following the Great Depression. It was
intended to provide workers with money if they became unemployed. It was also designed, through
public works projects, to provide jobs in a faltering economy. By putting money into the hands of cashstrapped consumers, the government hoped to stimulate aggregate demand and boost production levels
for the economy. The theory was that the artificial stimulus would provide a needed jumpstart to the
economy, as if it were a car with a dead battery. Once revived, the economy—like the car—would
propel itself forward from there.
78
Former President Clinton recently noted on The Daily Show that this problem should ease as soon as people his age die
out, since Americans, especially recent immigrants, are actually having a fair number of babies again.
From the 1930s through the mid-1990s,
Debate it!
a program called Aid to Families with
Resolved: That the unemployed should not be permitted to have
Dependent Children (AFDC) assisted
additional children until they find jobs and can support them.
poor families in the United States. It had
few work requirements of those who received benefits, gave more money to families with more children,
and placed no time limits on benefits. This often meant benefits were collected indefinitely, since, as
critics observed, there was little incentive to start working for limited wages and thereby lose the
benefits. If a rational person could do nothing for $150 per week or work hard to receive $200 per week
while also paying for childcare, he or she would probably choose to do nothing. A rational person might
also have more children to increase welfare payments.
The 1996 Personal Responsibility and Work Opportunity
Reconciliation Act (PRWORA)—passed by President
Clinton—aimed to repair these misplaced incentives. It replaced
AFDC with Temporary Assistance for Needy Families (TANF),
which limits most welfare recipients to five years. TANF also has
higher work requirements, and it gave states more flexibility in
how to administer their welfare programs. President Obama
recently increased this flexibility for states, provided they
continue to show enough welfare recipients finding work.
The number of American families on welfare fell significantly from the all-time-high of 5.1 million in
1994 to about 2 million in 2000. Some economists believe the decline was less the result of welfare
reform than it was the happy byproduct of increased employment opportunities and higher minimum
wages during the boom times of the 1990s. More recently, TANF has been criticized for providing
benefits to only about 40% of eligible families, and during the recent global economic crisis it has come
under increased pressure to service the growing numbers of American families in need.
Unemployment Compensation
Unemployment compensation (also
Debate it!
known as unemployment insurance)
Resolved: That unemployment benefits should be limited to two years.
provides payments for a brief period to
workers who have been fired or laid off. Its purpose is to provide people with a financial base while they
try to find a new job. The economic argument for unemployment insurance is that it keeps people from
being desperate enough to apply for welfare or to take jobs that don’t suit them. Imagine an aerospace
engineer being fired and then taking a job picking grapes because she has to support her family—and
then being so busy picking grapes she can’t hunt for another engineering job. This poor allocation of
labor resources would leave the economy producing below the production possibilities frontier.
Unemployment compensation is intended to smooth the transition from job to job so that the economy
can fully employ all its scarce resources.
In the United States, unemployment compensation comes from a mix of federal and state programs. At
the federal level, it was first part of the Social Security Act of 1935. States also manage their own
unemployment programs. The specifics, such as who is eligible, how much recipients receive, and how
long they can qualify, are determined by both state and federal law.
Fiscal Policy
In a mixed market system, the federal government uses fiscal policy to influence economic activity.
Fiscal policy consists of government taxation and spending in order to influence aspects of the larger
economy, like productivity, inflation and unemployment. Income taxes, government expenditures,
transfer payments, and the size of the deficit are all part of fiscal policy.
In general, the goal of fiscal policy is economic stability. The government hopes to use its powers of
borrowing, spending, and collecting to soften the impact of the business cycle.
The government has two categories of fiscal policy tools.

Automatic stabilizers adjust on their own in response to changes in the business cycle. For
example, the personal income tax is an automatic stabilizer. In a recession, people earn less
income—so pay less in tax. A person whose annual income falls $10,000 will really only lose
$7,000 if that lost income would have been taxed at 30%. As we saw above, welfare systems that
deliver money to the unemployed also help keep people adding to economic activity.

Discretionary fiscal policy involves deliberate government efforts to influence economic activity
in a specific way—such as with a stimulus package to cut taxes and create more jobs.
The first major fiscal policy advocate was the economist
John Maynard Keynes. In fact, many people use the
terms “fiscal policy” and “Keynesian policy”
interchangeably. Keynes noted that, as part of the
natural business cycle, the economy does not always
reach full employment. If a recession worsens enough,
there will be many people who want jobs but cannot
find them. GDP will decrease, and, because overall
income will decline, consumers won’t have enough
money to start the cycle of increased spending that
could spiral the economy upward again. Recovery might
take a long time.
Classical economists believed the government should try
as much as possible to balance its own budget during a
recession, so as not to interfere with the “invisible hand”
working everything out. Keynes disagreed. He believed
there was an economic reason for intervening. A recession, he said, was caused by poor coordination
leading to non-optimal choices. How could it make sense to have so many factories and laborers idle?
Even if the invisible hand could work things out in the long run, Keynes famously pointed that “in the
long run, we’re all dead.” Why not act sooner?
Keynes theorized that if the government stepped in and injected extra spending into the circular flow,
this spending could jumpstart an upward spiral. As an economy recovered, the government could
gradually lower its spending and let private consumption lead the way. He argued that if the
government were well-informed it could even increase spending before a recession or depression ever
took hold—the fiscal equivalent of preventive medicine.
Expansionary fiscal policy is the use of government spending to stimulate aggregate demand and spark
an economic upturn. To expand economic activity, it can:

Increase Government Spending (G). This injects more money into the spending cycle,
increasing aggregate demand. As more goods and services are needed, more people are hired
to produce them. Unemployment falls, GDP rises, and the price level rises, too.

Lower Taxes. Lower taxes leave consumers with more disposable income. They spend more,
so aggregate demand shifts to the right. Unemployment falls; GDP rises.
Remember the multiplier effect. If the government
injects money into the system, be it by buying
airplanes or by hiring people to fix bridges and
schools, the increase in economic activity includes
not just the injection itself, but all the exchanges
based on the money it adds to the economy.
Contractionary fiscal policy refers to government
efforts to slow an economy, usually to fight
inflation, by cutting back aggregate demand. It can:

Decrease
Government Spending.
Lowering G removes money from the
spending cycle, thereby reducing
aggregate demand. Unemployment
rises; GDP falls.

Raise Taxes. Higher taxes mean consumers have less disposable income—so they spend less.
The aggregate demand curve shifts to the left. Unemployment rises; GDP falls.
Federal Taxes in the United States
This is a good time to step aside and consider government taxes and spending more carefully. Like
many policy choices, they vary among countries. Here, we consider the United States.
Tax revenues come from a variety of sources. Some revenues are pooled into a general fund, from which
the government spends money however it sees fit. Other collections are earmarked for certain uses; the
government cannot use earmarked funds for anything other than their intended purpose.
Sources of U.S. government revenue include:

Personal income taxes. As described earlier, the United States has a progressive income
tax, with higher income brackets charged higher rates. The chart shows the tax brackets
for 2010; brackets change regularly to account for inflation. Personal income taxes
account for about half of federal tax revenues.

Corporate income taxes. Just as individuals are obligated to pay taxes on personal
income, most corporations must pay taxes on profits.

Consumption taxes. As discussed earlier, consumption taxes—including sales taxes,
value added taxes, and excise taxes—are taxes on the purchase of goods.

Import taxes or “duties.” Duties are collected on the sale of certain imported goods.

Estate and gift taxes. These tax wealth that is inherited or given to another person.

Capital gains taxes. These tax the profits from the sale of investments such as stocks and
property. Some countries charge higher taxes on short-term capital gains—usually
defined as investments held for less than year—to help promote a stable investment
environment.
Some examples of earmarked taxes include:

Payroll taxes. Payroll taxes include Social Security and Medicare taxes. Both are
deducted from employee paychecks. All payroll tax collections are employer-matched;
that is, half of what is collected is deducted from employee pay and the other half is paid
by employers. Critics complain that this hurts the self-employed, who must pay it all
themselves. Payroll taxes do not enter the General Revenue Fund.

User fees. We pay fees for the use of airports, highways, national parks, etc. The fees we
pay are earmarked to be re-invested in those locations. The funds collected from user
fees do not enter the General Revenue Fund.
Shortcomings of Fiscal Policy
Some critics believe government spending “crowds out” private investment, limiting its effectiveness.
Others note that it takes a long time for fiscal policy to pass through the legislature and the bureaucracy.
By the time a measure is enacted, a crisis may already be over. Also, because fiscal policy is the domain
of elected politicians, it may suffer from or be accused of political bias.
For instance, in 2011, President Obama proposed the American Jobs Act, a fiscal policy package—
combining spending increases and tax cuts—meant to generate jobs in an economy on the precipice of a
second recession in as many years. “Pass this bill,” he declared over and over again in the weeks that
followed, but he probably knew it stood almost no chance of passing in a Republican-controlled House
of Representatives. Fiscal policy, whether good or bad, is easily politicized—and stalled.
Budget Deficit and National Debt
When expenditures exceed revenues—that is, when
outlays exceed receipts—there is a budget deficit. If To finance a budget deficit, the federal government
must issue and sell debt securities. National debt is
receipts exceed outlays, there is a budget surplus.
the accumulation of outstanding debt securities.
Generally, deficits and surpluses refer to a single year’s
finances. The United States federal government has run a deficit over most of the past fifty years. The
recent exception was the period from 1998 to 2001, when the government ran a surplus under
President Clinton. At its peak, the surplus was $236 billion in 2000. Afterward, the federal government
relapsed into deficits—spurred largely by significant tax cuts and increased military spending under
President Bush. The deficit was $412 billion in 2004 and a record $482 billion by the time President
Obama took office in 2008; it has continued to grow since.
Congress cannot pull money out of thin air. To run a deficit, the Treasury must take a loan: it issues
and sells bills, bonds, notes, and other securities. Some of the debt is sold to other government agencies
that are running surpluses. Some is bought by the Federal Reserve. Much is held by foreign nations.
The rest is bought and held by the American public.
Each time the United States federal government runs a budget deficit, the government issues and sells
long-term debt securities. When there is a surplus, it can be used to repay outstanding debt. But when
there is a deficit, it accumulates into the outstanding debt. The accumulation of all outstanding debt
securities is the national debt. By the end of fiscal year 2003, the national debt was around $6.78
trillion. On Thanksgiving Day 2010, it was $13.8 trillion.
In 2011, Congress hesitated before passing its usual law to raise the debt ceiling—the maximum
amount the United States government can borrow at any one time. The result was great political and
economic uncertainty, and a downgrading of United States credit.
The Federal Reserve System
The Money Panic of 1907 prompted Congress to consider creating a national banking system, which
the United States had lacked for seventy years. In response to the prodding of President Woodrow
Wilson, Congress finally passed the Federal Reserve Act of 1913. It was a compromise between those
who wanted centralized control of money and those who did not.
The resulting Federal Reserve System is not one bank, but is divided
into twelve districts, each with its own bank. There are also 25 smaller
branch banks. For the most part, “the Fed” operates independently of
other parts of government. By law, all national banks—banks
operating in more than one state—must belong to the Federal Reserve
System. State banks may elect to do so. Only about a third of
American banks belong to the Federal Reserve, though this number is
rising as more banks merge across state lines.
The Federal Reserve has six main functions:






Determine and conduct monetary policy
Supervise and regulate financial institutions
Lend to banks and other financial institutions
Serve as a bank for the U.S. Government
Issue cash (currency and coins)
Offer services, such as clearing checks, to financial institutions
The Federal Reserve System
Board
of
Governors
Federal
Open Market
Committee
Federal
Advisory
Council
12 Federal
Reserve District
Banks
25 Federal
Reserve Branch
Banks
Member
Banks
At the head of the Federal Reserve is seven-member group called the Board of Governors. Each member
is appointed to a 14-year term by the President, with one term ending every two years. To ensure
geographical representation, no two members can be from the same Federal Reserve District. The Board
of Governors supervises the banking system and money supply. It also rules on proposed bank mergers.
The President appoints the Chairman of the Federal Reserve. Bush appointee Ben Bernanke replaced
long-time chairman Alan Greenspan in 2006 and was confirmed to a second four-year term by
President Obama. Bernanke has had the hefty responsibility of steering the nation’s monetary policy
through the economic crisis that began in 2008.
The twelve district banks are a holdover from the fear of centralized banking power; today, instant
communication makes the existence of twelve separate banks less meaningful. They effectively act as a
single entity. The district banks are technically owned by their member banks; every commercial bank
in the Federal Reserve System must purchase shares of stock in its local Federal Reserve Bank.
The twelve-member Federal Open Market Committee meets monthly in Washington and manages the
purchase and sale of government bonds and securities on the open market. Seven of its members are
drawn from the Board of Governors for the entire Federal Reserve. The other five are presidents of
regional Federal Reserve Banks. The New York District Bank president is a permanent member.
The Federal Advisory Council is another committee of twelve, all prominent commercial bankers. Each
district chooses one person to represent it each year; representatives ordinarily serve three one-year terms
before stepping down. The Federal Advisory Council meets four times annually. Although the council
cannot set policy, it helps maintain communication between leaders charged with maintaining the
national money supply and profit-seeking bankers who operate under their policies.
Monetary Policy Goals and the Employment Act of 1946
The broad mission of the Federal Reserve is to pursue (through monetary policy) the economic goals of
the United States. These goals include price stability, full employment, and economic growth. The
Employment Act of 1946 and the Humphrey-Hawkins Act of 1978 helped define these goals.
The Employment Act of 1946 charged the government with the responsibility of creating and
maintaining full employment, a situation in which just about everyone who wants a job has one. The
act did not define a specific target employment rate, however. The 1978 Humphrey-Hawkins Act (also
known as the Full Employment and Balanced Growth Act) presented more concrete goals:

It defines four percent unemployment as the highest acceptable unemployment level.

If at all possible, the government should balance the federal budget.

The government should try to improve the balance of trade.

The Federal Reserve Board and Federal Open Market Committee are responsible for
maintaining economic growth.

At least once each year, the President is required to inform Congress of his economic
targets and his plans to implement them.

At least twice each year, the Chairman of the Federal Reserve Board must inform Congress
of his money supply targets and his plans to implement them.
The Humphrey-Hawkins Act expired in 2000, but many of its provisions have continued informally.
One that has not is the requirement that the Federal Reserve set targets for money supply growth. In
2000, the Federal Reserve announced that the money supply is no longer an accurate measure of
economic prosperity or, on its own, an effective guide for monetary policy.
Monetary Policy ----- History and Methods
Where the rest of the government uses fiscal policy to pursue economic goals, the Federal Reserve and
other central banks use monetary policy. Monetary policy describes any effort to increase or decrease
the money supply; by contrast, fiscal policy focuses on changing aggregate demand.) To understand its
place in the scheme of things, we need to consider the history of economic policy.
In the beginning, there was classical economics, sparked by Adam Smith and his “invisible hand”.
Classical economists urged governments to ignore the temptation to tamper with their economies;
laissez faire was the way to go. During a recession, classical economists argued, wages would fall, and
eventually businesses would hire workers again from the newly cheap labor pool, bringing down
unemployment and restarting the cycle of rising economic activity. Helpful business investments would
also tend to increase with falling interest rates.
That status quo mostly endured until the Great Depression. Then economies tumbled as governments
stood by with their invisible hands tied behind their backs—until John Keynes unshackled them with
proposals for active fiscal intervention. Governments upped their spending, hoping to restore aggregate
demand.
Keynesian economics dominated the world for decades. Then, in the 1960s, a new theory, monetarism,
challenged Keynesian wisdom. Milton Friedman, an economist at the University of Chicago, had
conducted research connecting the money supply to the health of the economy over a span of many
years. He found that periods of too little money in the economy correlated with recessions or
depressions. Periods of too much money correlated with inflation.
Friedman contended the ultimate cause of the Great Depression was the destruction of the money
supply. The combined effect of the stock market crash, panicked bank runs, and the closure of banks
was a drastic decrease in the nation’s money supply.79 Earlier, we showed how banks help to multiply
money and direct idle savings towards investments. To understand Friedman’s theory, which became
known as monetarism, imagine what would happen if many people suddenly withdrew their money
from banks and stuffed it in their pillows. The multiplier would take a severe hit.
Since monetarists believe a reduction in the money supply is the main cause of recession, they believe
the best way to restore a down economy is to expand the money supply. The reason fiscal policy seems
to work, they argue, is that it does expand the money supply. But it is inefficient because it relies on the
government to decide what to spend on and whom to reward with tax cuts. The infusion of money into
the economy may focus on government priorities instead of on what consumers and suppliers want—
and may overshoot its goal, leading to inflation.
According to Friedman, the best way to help the economy grow in a stable way is to maintain a slow,
steady increase in the money supply. Friedman suggested a two or three percent annual increase to allow
gradual economic growth while discouraging inflation. By the early 1970s, many economists had
accepted this theory and governments began to give more power to their central banks.80
Friedman’s most important contribution to economic policy was a simple equation of exchange that
relates the money supply, the velocity of money, GDP, and the overall level of prices in an economy:
(M)(V) = (P)(Q)
79
This was in the era before the Federal Deposit Insurance Corporation (FDIC) guaranteed a certain amount of every bank
account (currently $250,000). Similar organizations and guarantees now exist around the world.
80
This does not mean Keynesian theory has been forgotten, as recent stimulus packages in the United States have shown.
The velocity of money is how quickly it is spent. How many times in
the course of a year does the average dollar (or peso, or pound) change
hands? People and firms do not always spend their money immediately.
Suppose the average household or business holds a dollar for two
months. It would take about four months for each dollar to circulate
through the economy: two months held by consumers, two months
held by businesses. The result: a velocity of 3, since each dollar
circulates through the economy three times per year.
What if habits changed, and businesses and
households held onto a dollar for an average
of three months every time it was spent or
earned? Each dollar would complete a
circular flow every six months. The velocity
of money would be 2.
(M)(V) = (P)(Q)
M = Money Supply
V = Velocity of Money
P = general Price Level
Q = quantity of goods (GDP)
Velocity of Money (M2) in the United States
It is straightforward to calculate GDP once
you know the amount of money in an
economy and its velocity. Consider the
imaginary country of Bieber. There is only
$1000 in circulation in Bieber. If the velocity
of money in Bieber is 5, each of those dollars
will be spent on goods and services and reearned by workers five times each year.
$1,000 times 5 equals $5,000 of goods and
services bought in a year. GDP would be $5,000.
However, there is a third factor: the price level. If the money supply suddenly doubled to $2,000, the
velocity of 5 would then give us a GDP of $10,000, seemingly doubling the economic output of the
nation. But what if it turned out prices in Bieber had doubled, too? An item that cost two dollars last
year now costs four. Real GDP would have stayed the same even as GDP appeared to double.
Thus, the dollar amount of GDP is misleading. In our equation of exchange, P can rise instead of or
along with Q—producing some degree of inflation instead of just increased GDP.
Friedman’s research indicated the velocity of money tends to remain fairly constant. If you examine the
equation of exchange, you will see that if velocity doesn’t change, one needs only to change the money
supply to affect the nation’s GDP (provided that inflation is under control). If both the price level and
velocity are constant, increasing the money supply by five percent means GDP will rise by five percent,
too. Decreasing the money supply 10 percent decreases GDP 10 percent.
Nothing is that easy, however. History has shown us that velocity does change. Check out the chart.
During the recent economic crisis velocity slowed down significantly, as people held onto their money
in times of uncertainty—and it surged during the boom years of the Clinton presidency, when
Americans were spending more often on more things (including dot-com stocks!)
Also, inflation is almost always going to raise prices at least a bit each year, and increasing the money
supply too quickly will tend to increase prices more than it does GDP. But, according to Friedman, if a
country adheres to a policy of slow, steady increases in the money supply, it will tend to see equally
steady economic growth.
Monetary Policy Tools
Like its counterparts in other countries, the Federal Reserve has three main tools for implementing
monetary policy changes.
Open market operations refer to the buying and selling of government securities or bonds. They are so
named because the Federal Reserve buys and sells them on the open market. If the Federal Reserve
believes the money supply should be increased, it buys bonds, injecting money into the economy. If it
believes there is too much money in the economy, it sells bonds, taking money out of circulation. Open
market operations are the most commonly used monetary tool in the United States.
Purchasing bonds and securities—Money supply increases.
Selling bonds and securities—Money supply decreases.
The discount rate is the interest rate the Federal Reserve charges when it lends money to banks. By
lowering the discount rate, the Federal Reserve decreases banks’ costs of borrowing, thereby allowing
banks to lower the rates for their own loans to consumers and firms. As per the law of demand, this
causes a greater quantity of loans to be taken. If banks make more loans, then people have more money
in their hands to spend. Lowering the discount rate therefore increases the money supply.
The Federal Reserve also sets the Federal Funds Rate, which is the maximum rate of interest charged by
one commercial bank when lending to another commercial bank; changes in the Federal Funds Rate
tend to reflect those in the discount rate and have a similar effect.
Lowering the Discount or Federal Funds Rate—Money supply increases
Raising the Discount or Federal Funds Rate: Money supply decreases
The reserve requirement is the percentage of deposits a bank must keep on reserve. If the Federal
Reserve lowers this requirement, the money supply increases—since banks can loan out more funds.
Increasing the Reserve Requirement—Money supply decreases.
Decreasing the Reserve Requirement—Money supply increases.
Suppose a bank has 5 clients each with $10,000 deposited in a checking
account. It owes $10,000 to every depositor, so the bank has $50,000 in
liabilities. Any depositor can demand back all of his money at any time. Of
course, not everyone will (certainly not at the same time), so the bank does
not have to keep all of it on hand, or in reserve.
Money Multiplier
Multiplier
=
1/R
Total Increase
In Money Supply
=
A/R
R = Reserve Requirement
A = Initial Amount of Increase
At a minimum, a bank must have in reserve the percentage specified by the
reserve requirement. In our example, total deposits were $50,000. If the reserve requirement is 10%, the
bank must keep $5,000 on hand. It can lend out the other $45,000. If the bank lends all $45,000,
recipients of the loans now have an additional $45,000 in their hands to spend. Suppose the Federal
Reserve lowers the reserve requirement to 2%. The bank is only required to keep $1,000 cash on hand.
It can lend out another $4,000. This additional “new” money can be spent, too.
Bank loans can have an even broader effect on the money supply. Assume a reserve requirement of 20%.
A bank loans $100,000 of excess reserves to various people. These people probably took the loans in
order to spend them. When they purchase items, the recipients of the money will deposit it in their own
accounts. This means demand deposits at other banks increase by $100,000. These banks, in turn, can
loan out $80,000. The cycle repeats: the money is re-loaned, re-spent, then re-deposited at banks that
can loan out 80% of it. And so on. 81
We can develop a formula for this multiplier in the money supply: 1/r, where r is the required reserve
ratio. For the above example, the money multiplier is 1 divided by 0.2, which yields 5. The initial loan
of $100,000 will increase the volume of money in the economy by up to 5 times, or $500,000.
As with the spending multiplier, the real money multiplier is not quite as high as the formula implies.
Our calculation assumes all banks will loan out all the money they can. It also ignores taxes removing
some of the money at each exchange, and the fact that people might not spend the entirety of their
loans. But it gives us a sense of the impact a single change in the money supply can have.
Money, Supply and Demand
Just as with a product or service, the equilibrium price and quantity of money in the economy can be
found by looking at supply and demand.
To the right is a supply and demand diagram. This
time, the “good” is money itself. The vertical axis, as
usual, represents price. The price of money is the
interest rate you must pay to borrow it. The horizontal
axis represents the quantity of money in the economy.
Assume the current equilibrium of supply and demand
sets the money supply at M0. If the Federal Reserve
pursues policies to tighten, or decrease, the money
supply, the new supply curve will shift inward. In our
example, it will move from S0 to S2. Interest rates rise
(here, from 9% to 15%), and fewer people are willing to
borrow. If fewer people borrow, less money is created,
dropping the money supply from M0 to M2—and
thereby limiting economic activity.
If the Federal Reserve instead pursues a loose money
policy, something designed to increase the money supply, the supply curve for money would shift
outward, perhaps from M0 to M1. The new equilibrium would sport lower interest rates (here, 6%). If
interest rates drop, more people will borrow money, increasing the amount of money in circulation, and
augmenting economic activity.
Less Direct Controls over the Money Supply in the United States
The following Federal Reserve policies tend to have a less significant impact on money supply than the
above more directly quantitative techniques.
81
This should remind you of the spending multiplier (related to the marginal propensity to consume).

Setting the Margin Requirement for Stocks. When a person buys a share of stock worth $100, he
may not need to provide all the cash up front. He can also purchase the stock “on the margin”—
paying, say, $10 of the $100, and letting the stockbroker loan him the difference. The Federal
Reserve Board of Governors has the power to set the minimum percentage one must pay to
purchase stocks. Raising this margin requirement would lessen speculation in stocks, stabilizing the
money supply and the economy. A low margin requirement would encourage more speculation,
since little money would be required up front when buying stocks.

Setting Consumer and Real Estate Credit Standards. In rare times of emergency, Congress has
given the Board of Governors the power to set restraints on consumer credit, such as minimum
down payments on real estate loans and maximum length of repayment for loans. During World
War II, overall spending soared, but the number of consumer goods available declined because the
government channeled the majority of economic activity into weapons and war supplies. Civilian
consumers were still earning wages, but the government did not want the economy to shift back to
consumer goods. If the supply of consumer goods kept falling, the prices of everyday items would
rise sharply. By setting a higher required down payment on mortgages and requiring loans to be
paid off quickly, the Federal Reserve discouraged consumer borrowing.

Interest rate ceilings. Under Regulation Q, the Board of Governors can establish a ceiling on
interest rates commercial banks pay consumers on their time deposits. Usually, the ceiling is so high
the market rate set by banks is far below it. In other words, the ceiling seldom has any effect.

Moral suasion. Another unofficial method the Federal Reserve uses to implement its policies
involves “friendly persuasion” or “arm twisting”. This moral suasion may take the form of public
pronouncements, policy statements, and direct appeals. In the 1950s, for example, faced with the
Korean War, the Federal Reserve asked banks to limit non-war-related lending to consumers in
order to keep inflation down. Discussions between the Federal Reserve and specific banks may
resemble threats if the situation is serious. If banks oblige, they may be rewarded in the future.
Key Terms
“Loose Money”
“Easy Money”
“Expansionary Money Policy”
All of these refer to anything the Federal Reserve does to increase the money supply. The result
will tend to be an increase in economic activity. This is often accompanied by lower
unemployment, higher GDP, and higher inflation.
“Tight Money”
“Hard Money”
“Contractionary Money Policy”
All of these refer to anything the Federal Reserve does to decrease the money supply. The result
will tend to be a decrease in economic activity. This is often accompanied by higher
unemployment, lower GDP, and lower inflation.
Advantages of Monetary Policy

Swift enactment of policy. In the United States, changes in monetary policy can be implemented
immediately via the sale or purchase of securities and bonds. The Federal Reserve’s other tools, such
as changes in the discount rate, are also easy to implement during monthly meetings of the Board of
Governors. No complicated politics: just quick action. When you compare this to the obstacles
fiscal policy faces in Congress, the Federal Reserve’s advantage becomes very clear. Even when fiscal
policies have quick, dramatic effects, it can take a long time to legislate them.

Politically acceptable tight policies. If the best policy is to slow the economy down, what elected
politician will want to vote for a tax increase or a cut in spending? Politicians want to be reelected;
even necessary tax hikes or spending cuts are exploited by their opponents to make them look bad.
Monetary policy, set by the banking system, does not put a target on their backs.

Economic experts make the decisions. The average politician probably understands less economics
than someone who has read and understood this resource. Remember, the skills required to be
elected are different than the skills required to manage a large economy.

Easier to fine-tune policy. The Federal Reserve can change interest in rates in small increments,
allowing it to guide the economy to a “soft landing” or to accelerate it gradually. Typical fiscal
policy, such as tax cuts and spending increases, are more like hitting the problem with a hammer.
Their exact impact is difficult to predict or control.
Disadvantages of Monetary Policy

You can’t push on a string. Tight money policy works well. If banks make less money available,
fewer dollars exist, and economic activity slows down. Loose money policies are harder to execute.
They make more money available in the form of cheaper loans, but if a depressed public does not
want loans banks’ excess reserves just sit there. The money supply is unaffected. Fiscal policy, on the
other hand, can put money directly into the hands of consumers (through tax cuts and transfer
payments), and can directly add to consumption (through government purchases).

Commercial banks and private companies can offset monetary policies. The ownership and
purchasing of government bonds can lessen the effect of some monetary policies. For example, from
1955 to 1957, the Federal Reserve pursued a tight money policy. To maintain cash reserves, banks
and corporations sold some of their bonds, allowing them more money, especially for business
investment (I). When, in 1958, the Federal Reserve turned to a loose money policy, corporations
bought back the government securities, decreasing available money supply.

Changes in velocity. As discussed, consumer expectations can change velocity. If consumers expect
prosperous times, they tend not to worry about keeping as much cash on hand. It is spent more
quickly, raising V. If consumers expect a recession, they become more cautious, keeping more cash
on hand, and lowering V. Consumer confidence levels are surveyed to gauge this.

Non-bank financial institutions can lessen the effects of monetary policy. Savings and Loans,
credit unions, personal finance companies, and financial institutions abroad are not controlled by
the Federal Reserve. When the Federal Reserve pursues a tight money policy, these other institutions
will loan out more money, since they can make more profits at higher interest rates. This works
against the Federal Reserve’s policies to contract the money supply.

Difficulty controlling cost-push inflation. If inflation results from higher prices of inputs (such as
oil) controlling the money supply has little effect. Too much spending is not the problem.

Impact on investment not always clear. Individual consumption (C) is not affected much by
changes in the money supply. Investment (I) is, but there are also other factors that influence it. For
example, during a boom, the Federal Reserve will raise interest rates to slow down growth. But,
during a boom, business optimism is high, so investors may decide to take out loans even at higher
interest rates. Also, many corporations have enough market power (especially in monopolies and
oligopolies) that they can pass the cost of higher interest to their consumers.

Time for monetary policy to take effect. It takes time for changes in monetary policy to filter into
the economy. For expansions or contractions of the money supply to be felt, several cycles of loanmaking or paying off loans must take place. Fiscal policy’s effects are more immediate.
Other Notable Economists
Phillips Curve
In the 1950s, Kiwi82 economist William Phillips devoted himself to studying unemployment and wage
changes over the last century of British history. He quickly noticed an inverse correlation: when wages
were rising the most quickly, the rate of unemployment was lowest. It made sense: in a booming
economy, everyone would be looking to hire more workers; an increase in demand for labor would lead
to an increase in the wage rate.
Before long, economists took this relationship even
further. Wages weren’t the only thing rising in a
booming economy—so were prices in general,
pulled along by high demand. The lower the
unemployment rate, the higher the rate of
inflation.
The resulting Phillips Curve connecting
unemployment and inflation is an observation, not
a strict rule. Its key assumption is that there is a
natural rate of employment. At the natural rate,
the economy is neither depressed nor overheated.
Inflation is low, the economy is stable, and
children sing and dance. If unemployment is above
this natural rate, there is a lot of slack in the
economy, and inflation is low. If unemployment is
below this natural rate, the economy is
overheating, and inflation is high.
Data collected in the 1960s seemed to confirm the
Phillips Curve. However, the 1970s ushered in
both high inflation and high unemployment.
Economists concluded there was no single,
enduring natural rate of employment: the Phillips
Curve changes depending on the overall economic environment. The 1990s, for example, saw low
unemployment and low inflation, and today economists worry that efforts to jumpstart the economy
are sparking a surge in inflation without noticeably lowering unemployment.
82
He wasn’t a bird, he was a New Zealander.
Lorenz Curve
If all people in a country shared its income equally, any 1% of the population would receive 1% of the
income, any 5% would receive 5%, any 25% 25%, and so on. This is true nowhere on Earth.
The so-called Lorenz Curve illustrates the
inequality of real income distribution. The y-axis
Debate it!
of the Lorenz curve shows the total amount of Resolved: That inequality is important to economic growth.
income earned by the percent of people
represented by the x-axis. Look at the graph to the right. The bottom 50% of people earn roughly 20%
of total income, while the top 10% earn more than 30% of the total income.
The inequality is even starker when we measure accumulated wealth rather than income. The poor
spend just about all their income, whereas richer people are able to save and invest.
The Gini coefficient measures the difference between a line of perfect equality and the real Lorenz curve
in an economy. It can be measured as the area of the region titled A. The lower the coefficient, the more
equality in the economy. Gini coefficients generally range between about 0.24 in very equal countries
such as Denmark to about 0.71 in developing economies with great inequality. The United States is in
the middle, at about 0.41.
Laffer Curve
All else held equal, increasing taxes will result in somewhat less
economic activity, since taxes reduce the marginal benefit of
economic activity. But, at low tax rates, an increase will not
affect overall economic activity very much and will collect
significantly more revenue for the government. If doubling the
rate from 1% to 2% only slightly reduces the amount of
economic activity, overall tax revenue collected will still be
much greater. At some point, too high a tax rate is too high, it
stifles the economy, and increasing it further leads to a drop in
tax revenue. The Laffer Curve shows this relationship between
tax rate and total tax revenue collected. It illustrates three
important theoretical points.

At 0% taxation, no tax revenue is collected.

At 100% taxation, no tax revenue is collected.
No economic activity takes place; there is no
incentive to work.

There is some tax rate—at the top of the
curve—that maximizes revenue. No one
knows what this rate is, and it probably varies
by country and by culture.
Learn More Online
It’s easy to complain about taxes, but it’s worth considering
where your country stands relative to the rest of the world.
Check out this list of the six countries with the highest and
the six countries with the lowest tax rates. Such lists vary
by how you measure tax rates, but, in general, you’ll find
that the United States has among the world’s lowest tax
rates, and the Nordic welfare states, such as Norway, have
among the highest: http://tinyurl.com/lowtaxcountries.
Unlike a firm seeking profits, maximizing tax
revenue is not the typical goal of a government. Most governments balance keeping taxes low enough to
encourage economic activity and high enough to fund important programs—such as education.
Say’s Law
A factory hires workers and pays them wages. The wages allow the workers to demand and buy other
goods.83 Without the factory, the workers would have no money with which to buy things.
The French economist Jean Baptiste-Say (1767-1832) first noticed this relationship and stated it as
what we now call Say’s Law: that supply creates its own demand. That is, the revenues earned by those
producing goods and services are used to buy goods and services—including those they just produced!84
Because of its emphasis on supply as the only real form of wealth, Say’s Law goes against the notion that
a recession can be cured by pumping more money into the hands of consumers to stimulate aggregate
demand. Say can be thought of as one of the first critics of Keynesian economics85. But Say was not a
monetarist either. He believed in monetary neutrality—that the size of the money supply has no effect
on an economy and only real wealth, composed of goods and services, matters.
Think of Say’s Law as trying to answer the economic chicken-and-egg problem: does demand spur
supply or does supply spur demand? Say’s Law implies that employers and entrepreneurs are more
important to economic prosperity than typical workers—because they pay out the wages workers need
to demand anything at all. They also help control what consumers demand in the first place. Steve Job’s
creativity and Apple engineers supplied the iPhone, which people then demanded.
One movement associated with Say’s Law is supply-side economics, famously championed by President
Ronald Reagan in the 1980s. Reagan, as a champion of the Republican Party, favored tax cuts for
businesses, shareholders and investors. His economic team believed these parties would use the tax
savings to hire more workers and increase output. Its critics call this approach trickle-down economics,
arguing it takes a long time for the benefits to “trickle down” from those enjoying the tax cuts to the
average person in the economy.
Take note: just as President Jimmy Carter never gave a speech in which he declared America to be in an
economic malaise, President Ronald Reagan never referred to his tax policy as trickle-down. These
memorable labels were crafted by their opponents. Recently, President Obama began referring to his
administration’s health care reform law as “Obamacare”—in so doing, he was owning the derogatory
term originally used for it by his political adversaries.
83
Henry Ford followed this principle: he paid his workers enough so they could afford to buy their own Fords.
This process is sometimes helped along with employee discounts.
85
He had to have been one of the first, since he died in 1832, 51 years before Keynes was born.
84
V. Trade and Globalization
The world used to be a larger place. When your classmates left to
study abroad, that was pretty much the last you heard from them
until they came home. Maybe they would send a letter, or make
an expensive phone call to a significant other, but mostly, they
were gone. There was no e-mail, no Twitter, no sharing of photos
on Facebook.
Now, people who go abroad can stay in touch very easily. Internet cafes
abound. Skype has made phone calls cheap. Men stand on the street corners of La Paz renting cell
phones by the minute to anyone who doesn’t already have one. If you ever need to go home in a hurry,
you can buy a ticket online and be nearly anywhere within 24 hours.86
In short, distance isn’t what it used to be. Global transportation, communication, and financial
interactions are within reach of most middle-class people anywhere on the planet. A Chinese immigrant
in New York can order illegal pharmaceuticals from India and have them arrive in a few days. A South
African track star in Beijing can have lunch at Burger King and then stroll down to the Gucci shop for a
new (increasingly obsolete) timepiece. The world is becoming, in the words of New York Times
columnist Thomas Friedman, increasingly flat (and hot and crowded).
With this bridging of distance, the role of each country in the global economy is ever more important—
and the flow of information, including culture, has come to matter as much as the transport of goods.
We will begin this chapter by analyzing why trade is almost always beneficial to countries. We will then
move on to questions of development—why countries have turned out the way they have. The two
areas combine in a brief look at the economics of imperialism.
Relative Price and Comparative Advantage
Economists tend to object to trade barriers. Most advocate
free trade, trade without barriers, because, in theory, letting
the markets freely work their magic should increase the
consumption possibilities for everyone.
To understand why trade is so beneficial, you must first
understand the law of comparative advantage—which
hinges on the concept of relative price.
To determine which goods to produce and which goods to
import, a country has to examine its production possibilities
and determine which goods it can produce at the lowest
opportunity cost. The relative price of a good is the cost of
producing it, expressed in terms of an alternative good. In
86
Unless you’ve been arrested by the Iranian government.
other words, the relative price of a good is the opportunity cost of producing one more unit of it—
expressed in terms of the alternative good.
To determine a country’s relative price for one good, we divide the total number of units of the other
good the country can produce with a given amount of resources by the total number of units of the first
good that can be produced with the same resources.
Relative Price of Good A
=
Total Possible Units of Good B
Total Possible Units of Good A
Relative Price of Good B
=
Total Possible Units of Good A
Total Possible Units of Good B
The relative price of good X, relative to Y, is expressed in the form of “units of Y per unit of X.” For
instance: “three bushels of wheat per pair of shoes.”
Suppose we can somehow combine all the resources available in a country (land, labor, capital, and
entrepreneurship) into generic “units” of resources. In the country of Decalon, one of these units can
produce 10 missiles. It can also produce 20 gallons of milk (but no missiles). And of course, one unit
could be used to produce some mix of missiles and milk. To produce a missile, Decalon must give up
two gallons of milk. The relative price of one missile is 2 gallons of milk—and the relative price of milk
is ½ missiles per gallon. To produce another gallon of milk, the country must trade off half a missile.
Relative Price of a Missile
=
20 Gallons of Milk
10 Missiles
=
2 Gallons per Missile
Relative Price of a Gallon of Milk
=
10 Missiles
20 Gallons of Milk
=
½ Missile per Gallon
The Production Possibilities Frontier earlier in this guide
represented this trade-off between two goods. The PPF for
Decalon can help us to visualize the relative prices of milk and
missiles. The relative price of a missile is two gallons of milk,
so if Decalon wants one more missile, it must sacrifice two
gallons of milk. It must move along the frontier. If Decalon
wants to produce one more gallon of milk, then it must be
willing to sacrifice half a missile—another movement along
the frontier. The relative price of a good is important when
we compare it with the relative price of the same good in
another country. From one country to the next, the relative
price of a good will differ—since each has different resources.
When the relative price of a good is different in two
countries, they should probably be trading.
If a country can produce a good for a lower relative price than
another country, it has a comparative advantage in the production of that good. The law of comparative
advantage holds that whenever two countries can produce the same goods at different relative prices,
the two countries can benefit from trade—each trading the good for which it has a lower relative price.
This law was first devised by the economist David Ricardo.
We can use this approach to expand on the example of Decalon. This time we add a second country,
Demilon, to see how each country can leverage its comparative advantage to determine how to trade.
The table below provides information about the production possibilities in each country:
Production Possibilities in Demilon and Decalon
Country Missiles Produced with Gallons of Milk Produced with
One Unit of Resources
One Unit of Resources
Decalon
10
20
Demilon
20
200
From the data, we can find the relative prices of a missile and a gallon of milk in each country.
Relative Prices Of Missiles and Milk in Demilon and Decalon
Country
Relative Price of One Missile
Relative Price of One Gallon of Milk
Decalon
2 Gallons of Milk
1/2 Missile
Demilon
10 Gallons of Milk
1/10 Missile
It would seem Demilon has no need to trade; it can produce milk and missiles more efficiently than
Decalon. But Decalon can produce missiles for the lower relative price: two gallons of milk. Demilon
can produce a gallon of milk for the lower relative price: one tenth of a missile. According to the law of
comparative advantage, this means Decalon should produce and export missiles and Demilon should
produce and export milk.
Suppose Decalon produces
The Effect Of Trade in Demilon and Decalon (Hypothetical)
only missiles, all 10 of them.
In turn, Demilon produces Country Production Possibility Before Trade Consumption Possibility After Trade
200 gallons of milk, and the Decalon
5 Missiles and 10 Gallons of Milk
two countries agree to trade Demilon 5 Missiles and 150 Gallons of Milk
milk for missiles at a rate of 8
gallons per missile (or 1/4 missile per gallon). If Decalon traded all 10 of its missiles, it could buy 80
gallons of milk from Demilon. If Demilon traded all 200 of its gallons, it could buy 25 missiles, in
theory, but Decalon cannot quite produce that many. Suppose Demilon trades only 40 of its gallons of
milk. The country buys 5 missiles and keeps 160 gallons of milk. Decalon sells 5 missiles for 40 gallons,
and keeps the other 5 missiles. Without trade, Demilon could only have had 5 missiles and 150 gallons
of milk, and Decalon 5 missiles and 10 gallons of milk. With trade, Demilon gains 10 more gallons of
milk and Decalon 30 more gallons.
Absolute Advantage
As we saw with the farmwives’ cooperative on the prairie, some people are just plain better at making
certain things than other people are. This is true of whole countries, too. Some are more efficient at
producing cars. Others are better at making cheese. When one country can produce more of a particular
good than another country, it has an absolute advantage in its production. In other words, if one
country can produce a good with fewer resources than it takes another country to produce the same
good, it has an absolute advantage in the production of that good. (Remember that it may not have a
comparative advantage even if it has an absolute advantage.)
Below, you’ll see hypothetical data about the production possibilities in two countries. Given 100 hours
of labor, France can produce 20 quarts of ice cream or 20 boxes of waffle cones. Using the same 100
hours of labor, England can produce 33 quarts of ice cream or 10 boxes of waffle cones. England has an
absolute advantage in the production of ice cream because the country can produce ice cream more
efficiently than France. On the other hand, France can produce more waffle cones in the same 100
hours; France thus has an absolute advantage at waffle-cone-making.
Production Possibilities in France and England
One View of Absolute Advantage
Country Quarts of Ice Cream Produced Boxes of Waffle Cones Produced
with 100 Labor Hours
with 100 Labor Hours
France
20
20
England
33
10
In the next table, we will see the same data differently. The table below indicates how many hours of
labor are needed to produce a quart of ice cream or a box of waffle cones in either country. Again, we
see that England has an absolute advantage over France in making ice cream because it can produce a
quart of ice cream in fewer labor hours than France. Meanwhile, France has an absolute advantage in
making waffle cones because it can produce a box of waffle cones in fewer labor hours than England.
Production Possibilities in France and England
Country Hours Needed to Produce a Hours Needed to Produce a
Quart of Ice Cream
Box of Waffle Cones
France
5
5
England
3
10
Regardless of how you choose to see it, an absolute advantage means one country is more efficient than
another in the production of a particular good. You can say that, given the same amount of resources, a
country can produce more of one good than another so it is more efficient. Alternatively, you can say a
country is more efficient because it uses fewer resources to produce a particular good.
An absolute advantage is not a sufficient reason to trade. A country should only trade when it has a
comparative advantage in the production of a good. In fact, we can build on the law of comparative
advantage now. Regardless of its absolute advantages or disadvantages, if a country has a comparative
advantage in the production of some good, the country should produce and export that good.
Exchange Rates
An exchange rate is the price of the currency in one country, expressed in terms of the currency in
another country. If you need two dollars to buy one euro, then the exchange rate of the dollar against
the euro is two dollars per euro, or one-half euro per dollar.
We use exchange rates to determine
Debate it!
the price of goods in terms of foreign
Resolved: That currencies should have fixed exchange rates.
currency. Suppose a pair of French
shoes costs €50 and one euro is worth two U.S. dollars. An American would need $100 to buy that pair
of shoes. Now suppose the exchange rate changed: now it takes $2.50 to buy one euro. An American
would need $125 to buy the same pair of shoes. Even though the quality of the shoes has not improved,
and nothing has happened to the supply of shoes, an American has to pay more for the same pair of
shoes simply because the exchange rate has changed.
When the price of one country’s currency increases relative to the price of another country’s currency,
the first country’s currency is said to appreciate against the currency of the second. When the price of
one country’s currency decreases, relative to the price of another country’s currency, the first country’s
currency is said to depreciate against the currency in the second. Holding all else constant, an
appreciation of one country’s currency will make its goods more expensive to foreigners.
Today, most exchange rates are allowed to float: they change based on market forces. A few are still
pegged, or fixed at certain values relative to another currency. For many years, the value of one Chinese
yuan was pegged at .132 United States dollars—a ratio that kept Chinese goods artificially “cheap” in
dollar terms and helped lead to a continuing trade imbalance. In 2005, bowing to international
pressure, the Chinese government allowed the yuan to begin floating, but it has limited the range of
possible values. At the time of writing, the exchange rate is 0.143 yuan to the dollar.
Economic Development Thresholds and Trends
We can divide countries into developed
Debate it!
countries, developing countries, and lessResolved: That only less developed countries willing to limit
developed
countries
(LDCs).
These
population growth should receive international aid.
classifications typically use GDP per capita.
Countries in which GDP per capita is under $3,000 are “less-developed”; countries in which it ranges
from $3,000 and $10,000 are “developing”; and countries in which it is above $10,000 are “developed.”
There are drawbacks to such arbitrary classifications. GDP per capita is just average GDP per person, so
it reveals nothing about income distribution. Poor countries often have a privileged few who are very
wealthy; those few might make enough to overstate “average” wealth. The Gini coefficient of a country
can help make sense of this.
GDP per capita
Status
Population
Examples
< $3,000
Less-developed
country (LDC)
‘‘Third World’’
High growth rate due to high
fertility. Many young people.
Pakistan, Guatemala, India, many African nations
such as Nigeria, Egypt and Uganda
$3,000-$10,000
Developing country
Varies greatly.
Many Latin American nations, Asian countries
such as Thailand and China, some former Soviet
republics
> $10,000
Developed country
‘‘First World’’
Low or slightly negative growth
rate.
U.S., Taiwan, Canada, Australia, United Arab
Emirates, Japan, South Korea, most of Europe
Why is this Country Different from All Other Countries?
Walk the streets of Brisbane and you may find yourself mesmerized by the clean lines and prosperous
look of the city and its inhabitants. Hike the outskirts of Kathmandu and hungry, undressed children
will run after you pleading for spare change—and then return to crooked houses with broken roofs.
Most of the world’s developed countries are in North America, Europe, Asia, and Australia. Its less
developed countries are clustered in Asia and Africa. Researchers have spent considerable effort trying to
decipher why some countries have developed more than others. Some factors may simply be an accident
of history: if Haiti, for example, had not been turned into a slave colony, perhaps it would have found
greater success in the global economy. Others may be a function of climate and geography: it is simply
harder to build a thriving civilization in the swamp, or when a third of the population is always sick
with malaria.
Developed countries tend to be industrialized and rely less on agriculture and basic manufacturing. In
other words, Singapore makes motherboards—and Thailand makes textiles. They also depend less on
foreign aid and investment. Their people enjoy better health; they tend to have more education, lower
birth rates, and longer life expectancies. Most developed countries have older populations that are
growing less quickly, or even shrinking87—while less developed countries have high population growth
rates despite higher shorter life expectancies and greater infant mortality.
Nations vary in their average labor productivity—how each person in their workforce contributes to
GDP. The average worker in more developed countries tends to be more productive than the average
worker in less developed countries. This difference results from a number of factors; studying them can
help less developed countries determine how to focus their economic development.
More developed countries tend to have more physical capital: better roads, newer factories, more
computers, faster Internet, etc. They also benefit
The Bretton Woods system
from superior human capital: a healthier and
Named for the New Hampshire town where world
more educated workforce. They often have more
leaders met to plan the world’s economic future in
natural resources—such as forests, mines, oil
1944, the Bretton Woods system aimed to prevent a
reserves, and natural harbors. Their workforce
repeat of the financial chaos of the Great Depression
also has access to better technology—from
by ensuring, among other things, that all countries
fixed the value of their currencies to the price of
vaccines to high speed Internet. Institutions also
gold. In return, participating countries could enjoy
make a tremendous difference. In countries with
funding from the IMF in times of crisis or economic
effective courts and rule of law—where banks
shortfall. Bretton Woods was widely accepted in the
function predictably and the police are there to
West until 1971, when U.S. President Nixon suddenly
announced the United States would no longer tie the
protect you, not demand bribes—business and
value of its currency to gold. The system collapsed.
entrepreneurship can flourish, maximizing
everyone’s productive potential.
Economic Development Organizations
The period immediately following World War II was a busy time for economic planners—as war-torn
Europe sought to rebuild and governments lingered over the lessons of the Great Depression. In
general, the Western powers (excluding the Soviet Union) believed in a post-war world driven by
capitalist markets. But their experience with the Great Depression also led them to support government
intervention and international cooperation to prevent undue hardship and instability.
In July 1944, as World War II was ending, economists and diplomats from 44 nations met in Bretton
Woods, a town in New Hampshire. Their mission was to plan the post-war economy. One notable
participant was John Maynard Keynes. Though most famous for his theories on fiscal policy and deficit
spending, Keynes first gained notoriety when he wrote a book criticizing the terms of the Versailles
87
In fact, the population of the United States would be declining if not for immigration.
Treaty that ended World War I. He had served as a (largely unheeded) participant at the talks that
designed that treaty—and here he had another chance to shape a post-war world.
Among other things, the Conference designed two institutions: the International Monetary Fund
(IMF) and the International Bank for Reconstruction and Development (IBRD). The IBRD later
evolved into the World Bank.
The IMF and the World Bank are administered in similar ways. Both are associated with the United
Nations, but each is self-governed. Both currently have 185 member states. Both are funded by their
member states and based in Washington, DC. The IMF levies a set quota from each member state,
while the World Bank sells subscriptions. These contributions are roughly proportional to the size of a
nation’s economy. As the largest shareholders of both organizations, the United States and European
countries have the most say in their policies.
By unwritten convention, the president of the World Bank is always an American and the managing
director of the IMF a European.
International Monetary Fund (IMF)
The IMF was founded to help restore and maintain the stability of the international monetary system,
helping its member states at times of economic instability. Its stated goals are to achieve “global
prosperity” through:




the balanced expansion of world trade
stability of exchange rates
avoidance of competitive devaluations
correction of balance of payments issues
To fulfill these goals, the IMF monitors the world economy and the economies of individual member
countries. It provides advice and warnings. It also lends to members facing balance of payment
problems. These are nations that face a shortage of reserves to pay their international obligations. Think
of it as the global equivalent of the stern parents coming in to rescue a child from credit card debt. The
parents might help to pay off the debt, but will probably make their child adopt different habits, submit
future credit card statements to them for examination, and pay them back over time. The IMF does
something similar on a national and international level.
The conditions imposed by the IMF are often structural adjustments that include reforms to economic
and political structures. These may include anti-corruption measures and deregulation of the banking
sector. The IMF also often recommends currency devaluation, since many balance of payment problems
are caused by overvalued currency.
The IMF also provides technical assistance to the governments and central banks of its member
countries. This often includes sending experts to work on projects related to a member’s economy.
The IMF’s performance has historically been mixed; it has critics on all sides of the political spectrum.
Many complaints center on its austerity programs, which it imposes on nations in financial distress.
These programs try to improve the budget situation by raising taxes and reducing government spending.
This can lead, short-term, to a worsening of the economy for consumers. IMF supporters point out the
IMF can only respond to problems, not prevent them. Thus, the IMF often comes into a situation after
a long period of pre-existing mismanagement, and there are no easy fixes.
The World Bank
The World Bank is similar to any other bank.88 It loans money to development projects around the
world at low rates of interest. For the most part, it collects on those loans. When it was first created, its
primary mission was financing the reconstruction of war-torn Europe. Today, its primary goal is poverty
alleviation and development projects, mostly in the Third World.
Like a brick and mortar bank89, the World Bank Group is owned by someone. Its shares are held by its
member nations, which provide the funds to sponsor the bank’s activities. The World Bank is not
meant as a giveaway fund. Most of its disbursements are loans that need to be repaid. In this way, the
World Bank is largely self-financed. However, it does also give grants that do not have to be repaid.90
The most typical criticism of the World Bank is that it promotes policies that benefit the wealthy
nations that control it. It is true that many of its loans come with strings attached, such as requiring the
structural adjustments also pursued by the IMF—and that many of these structural adjustments include
deregulation, which may help Western multinational corporations enter new markets.
These criticisms often go hand-in-hand with criticisms of unfettered free trade. Some allege, for
instance, that World Bank funds are spent to bail out private investors—mostly wealthy individuals
from wealthy countries—from bad loans that they should never have given.
The Gold Standard
Bretton Woods also laid out the rules for a
Debate it!
new, more stable world monetary system
Resolved: That currencies should have fixed exchange rates.
centered on the United States dollar. Most
major currencies were more or less pegged to the dollar. For its part, the dollar was backed up by the
United States’ gold reserves at a fixed exchange rate of 35 dollars per ounce of gold. (One dollar was
worth one-thirty-fifth of an ounce of gold.)
For a while, the system worked well, since most of the other wealthy nations of the world were indebted
to the United States after the war. The United States had become the wealthiest and most productive
nation in the world by far. It had the majority of the world’s gold reserves and produced most of the
world’s coal, oil and industrial goods. It was also the world’s largest creditor.
The system broke down in later years. The global economy’s rapid growth outpaced the United States’
reserve of gold and the United States became a debtor nation as its trade surplus turned into a trade
deficit and its government spending soared. In 1971, President Richard Nixon pulled the United States
off the gold standard, formally ending the original Bretton Woods system. The Bretton Woods
institutions, however, are still alive and strong, and worldwide faith in the stability of the United
States91 maintains the value of the dollar.92
88
In the United States, that now implies it gives bad mortgage loans and could shut down at any time.
But without free online checking.
90
Think of it as a college financial aid office for the world.
91
This faith took a hit in 2008, however, and has not quite recovered.
92
Tell that to the next American who visits London and discovers a latte costs $7.
89
Selected International Organizations
Organization
Description
HQ and Head
Members
World Bank
(formerly the International
Bank for Reconstruction and
Development)
Conceived at Bretton Woods. Made first loan in
1947 to France for post-war reconstruction.
Currently makes loans to LDCs for economic
development.
Washington D.C.
President Robert B.
Zoellick (U.S.)
184. All UN members participate in
some way except North Korea, Cuba,
Monaco, Tuvalu, Liechtenstein,
Andorra, and Nauru
International Monetary Fund
(IMF)
Conceived at Bretton Woods. Protects
international monetary stability by giving
advice and making loans to governments with
currency and debt crisis.
Washington D.C.
Managing Director
Dominique StraussKahn (France)
184 (same members as World Bank)
Bank for International
Settlements (BIS)
1930: Founded with Hague agreements. Its
mission is to work with central banks to foster
monetary and accounting stability.
Basel, Switzerland
General Manager
Jaime Caruana (Spain)
55 member central banks
G20 (recently assumed most
of the G8’s responsibilities)
Holds annual summits among leading
policymakers (often heads of states).
World Scholar’s Cup (WSC)
Promotes alpacas as the international animal of
learning. Holds tournaments for students from
around the world.
United States
Daniel Berdichevsky
About 30 countries, and increasing
each year.
Organization for Economic
Cooperation and Development
(OECD)
Established in 1948 to help administer the
Marshall Plan in post-war Europe. Provides data
and a forum to promote free markets.
Paris
Secretary-General
Jose Angel Gurría
(Mexico)
30-----all members are industrialized,
wealthy countries with representative
governments and market-driven
economies
Includes 20 leading economies. The
European Union counts as one
economy.
The Rise of GATT and the WTO
At the start of the Great Depression, Americans began to worry about imports taking American jobs. In
response, despite the cautions of countless economists, Congress passed the Smoot-Hawley Tariff of
1930. It dramatically raised import duties. Other countries reciprocated.
Like the individual decisions to withdraw bank savings following the stock market crash, raising tariffs
was the sort of reaction that seemed to make sense for each country on its own. But when everyone did
it, disaster followed. Soon international trade had plummeted by 58 percent. The decline did not help
already hurting economies worldwide.
The General Agreement on Tariffs and Trade (GATT) was launched in 1947 to prevent these sorts of
reckless and uncoordinated trade restrictions. GATT was a regular conference of countries meeting to
discuss and work together to reduce barriers on trade. It helped shape and coordinate the rules. It could
not, however, enforce them.
Increased trade creates enormously complicated issues of legality and fairness. When products and
capital can travel around the world, any country in which they make a pit stop is affected by them. Is it
acceptable for a country to charge any sort of fee on goods that cross its borders? Do the laws of one
country always apply to goods imported from another? Can items be manufactured in countries without
strong labor and safety regulations, then sold to more-regulated countries?
These questions were generally settled by treaties between individual countries; after 1947, GATT
brought many of these countries together in collective treaties, but no single organization had the power
to enforce trade rules globally. Hence the creation of the World Trade Organization (or WTO), an
international governing body that manages the rules and practices of world trade.
Based in Geneva, the WTO grew out of GATT in the early 1990s. In addition to providing a GATTlike forum for the development of trade policy, the WTO has another important function: it settles
disputes. When two or more countries disagree over a trade issue, the arguments can be extraordinarily
bitter, since the issue often has profound implications for each country’s economic health. Sometimes
these debates can even lead to war. The WTO thus has sweeping powers to judge these arguments on
their merits and issue decisions.
Disputes brought before the WTO are administered by the Dispute Settlement Body (DSB), which has
the power to investigate problems, issue reports and judgments, and then monitor compliance with its
rulings. Rulings can be appealed to an Appellate Body, a three-person panel chosen from a pool of
seven. When necessary, the WTO’s decisions can be enforced through the temporary raising of tariff
barriers or the imposition of other penalties (although some powerful economies, such as the United
States or European Union, have at times simply ignored WTO decisions against them).
The idea at the heart of the WTO is that nations and businesses are best served when they can freely
trade goods and services. The WTO enforces a policy called the Most Favored Nation (MFN) rule: it
requires any WTO member to treat all its trading partners (or at least those which have MFN status, as
determined by the WTO) the same way it treats its best trading partner. In other words, the United
States could not offer a sweetheart deal on lumber imports to its neighbor Canada without offering the
same terms on lumber to every other “most favored” trading partner. (Developing countries are exempt
from the MFN rule.)
Not everyone agrees with the WTO’s mission, or with the idea that free trade helps reduce poverty and
promotes healthy economic growth. A few economists and many activists link rising inequality around
the world to free trade, arguing that the unfettered flow of resources out of developing countries tends
to bleed those countries dry while enriching the wealthy few who operate international businesses.
Others blame free trade for the loss of good jobs in developed countries and the persistence of low wages
and poor working conditions in developing countries. Since free trade allows multinational businesses
to produce goods anywhere, they naturally move production to countries where production is
cheapest—even if this means hiring workers for very little pay or endangering the environment. Labor
activists call this phenomenon the race to the bottom.
But the WTO is not going away any time soon. The vast majority of economists agree that free trade, in
the long term, is good for everyone. The developed countries, where most multinational corporations
are based, certainly have no incentive to pull out. Today’s globalized economy depends in numerous
ways on free trade continuing to flow, for better or worse.
WTO members must commit to
Debate it!
follow its policies, which are agreed on
Free trade should be limited in order to safeguard different cultures.
at in-depth, multi-year meetings called
“rounds.” The first formative talks for the WTO were the Uruguay Round in 1993. Most GATT and
WTO rounds have concluded by lowering or eliminating tariffs on specific goods; the current Doha
round (named for its location in Qatar93) has been ongoing since 2001 and is mired in controversy over
a number of issues. For example, negotiations broke off at one point because the United States, India
and China could not agree on special tariffs to protect poor farmers.
93
Which is, incidentally, where I am editing this guide.
As of 2010, the WTO had 153 members. The largest economy not in the WTO (yet) is Russia.
Trade Blocs and Free Trade Associations
A trade bloc is a group of nations that has a special trade
agreement. A free trade association (FTA) is a trade bloc94 with
free internal trade that may enact barriers against trade with
non-members.
Debate it!
Resolved: That countries should only be
allowed to join one free trade zone.
Europe has the world’s single most powerful trade bloc, the European Union (EU)—formed by the
1992 Maastricht Treaty. More than a free trade association, the European Union is a step along the
path toward the political and economic unification of Europe. It now includes 27 member countries.
Because of the lack of trade barriers and its unified currency, the euro, the EU is now seen as a single
economy roughly on par with the American economy.
The EU’s political power has grown over the years, to a wary reception among many Europeans. It now
has a presidency rotated among its member states, carries out foreign relations, and has a court of
human rights whose decisions are binding on member states. It is based on Brussels, Belgium, where the
EU parliament meets. It has also been expanding into the former Communist countries of Eastern
Europe and the Balkans. All EU member states must meet certain political, economic, and human
rights standards, and any new members must be approved by all existing members.
In 1992, the United States, Canada and Mexico signed the North American Free Trade Agreement
(NAFTA). NAFTA went into effect on January 1st, 1994. Although all barriers to trade are not yet gone
among the three NAFTA countries, they are being gradually reduced.
The Free Trade Area of the Americas (FTAA) was an agreement to build a free trade zone among all
the countries of North and South America except Cuba. It was scheduled to be enacted by 2005 but is
now in limbo.
In South America, a number of nations have united in a free-trade zone called Mercosur. Full members
are Brazil, Paraguay, Uruguay and Argentina; neighboring Chile and Bolivia are associate members. The
Andean Community of Nations (formerly the Andean Pact) is a parallel free trade area between the
mountainous countries of Bolivia, Colombia, Ecuador, Peru, and Venezuela.
In Africa, the Common Market for Southern and Eastern Africa (COMESA) has brought together 21
nations to create a free trade area; like the FTAA, it is still in the process of development.
In Asia, Brunei, Indonesia, Malaysia, Singapore, Thailand, Cambodia, Laos, Myanmar, Vietnam, and
the Philippines are part of ASEAN: the Association of Southeast Asian Nations.
The island nations of the South Pacific, the Cook Islands, Fiji, Kiribati, Nauru, Niue, Palau, Papua
New Guinea, Samoa95, Solomon Islands, Tonga, Tuvalu, and Vanuatu, have formed PICTA: the Pacific
Island Countries Trade Agreement. You won’t be tested on this, but it can be fun to learn these country
names and mention them randomly at parties.
94
Interesting how trade blocs ware made to stop trade blocks.
A friend of mine nearly died of eating rotten ketchup in Samoa. This problem arises when restaurants use glass bottles,
because no one wants to eat the ketchup at the bottom; it just sits there menacingly.
95
Opposition to Globalization and Free Trade
Some people are very opposed to globalization and free
trade. They do not like the dominance of global (often
American) products, ideas, popular culture and
business practices. Others worry about low quality
goods infiltrating their economies from countries with
less quality control. For example, Chinese toys,
kimchi, and milk have all been, at times, found to be
dangerous, as has American beef. Proponents want free
trade to be safe trade, but with such a large global
economy, some problems do slip through the cracks.96
Why is this news? Because the last time Korea imported
A frequent complaint is that free trade agreements
kimchi from China, it turned out to be infested with parasites.
favor businesses and production at the expense of
human rights, equality, and the environment. Critics argue that, around the world, family-owned
businesses, small farms, and local firms are being driven out by giant chains (such as Wal-Mart and
Carrefour) and corporations. These businesses have fewer ties to communities and, it can be argued,
view the world as a large market from which to make profit.
Driving free trade are leaders of countries and
companies who want a flexible world in which
they can optimize production by marshaling
resources more freely—and consumers who
want high quality products and services at the
lowest possible prices. Companies scour the
world for the lowest production costs, starting
a factory in one country only to shut it down
after finding even cheaper production
elsewhere. Workers in developed countries may
feel betrayed when investors and business
leaders move their jobs abroad. In developed
countries, wages in industries such as
manufacturing are converging towards global
standards (usually lower). Meanwhile, wages in
developing countries are also converging
toward those standards—making, for example,
call centers in India less cost-effective for American companies than they were ten years ago.
A 1999 WTO summit in Seattle met with over 30,000 protesters, and a 2003 meeting in Cancun
collapsed when developing countries objected to subsidies for farmers in the developed world.
In the United States, the most memorable political showdown over free trade occurred in the 1992
presidential election, when third-party candidate Ross Perot took a hard line against NAFTA. He
claimed it would lead to a “giant sucking sound” as American companies opened up factories in Mexico,
96
Even the mechanisms of trade are subject to concern. For example, truck drivers from Mexico are seen as a threat on
America highways because their vehicles do not meet certain standards.
where they could pay lower wages.97 In recent years, the narrow passage of a free trade agreement with
Korea in the United States Congress, chaos in the Eurozone, and the election of nationalist leaders in
Venezuela and Bolivia have all suggested unease with both economic and cultural globalization.
Trade Sanctions
Trade sanctions are tariffs, quotas or other
Debate it!
administrative rules imposed as punishment
Resolved: That dumping can be an appropriate business practice.
or retaliation against another nation for
some behavior that offends the implementing nation. Trade sanctions are often narrow and used only
for commercial disputes. Economic sanctions, on the other hand, are imposed for political reasons, such
as by the United Nations against Iraq under Saddam Hussein.
In 2002, the United States implemented tariffs on imported steel to protect domestic manufacturers
from what it claimed to be foreign dumping practices. Dumping occurs when firms sell a lot of a good
or service at below market prices, taking a temporary loss to drive competitors out of business. The
European Union brought charges against the United States to the WTO, claiming the tariffs were not
allowed. In 2003, the WTO ruled in the EU’s favor, and President Bush rescinded the tariffs.
More recently, Japan, the EU and Canada implemented tariffs against the United States in retaliation
for an American law that gives proceeds of anti-dumping fines to American firms in an impacted
industry. The WTO ruled the law to be illegal and the United States promised to repeal it.
For its part, the United States has threatened trade sanctions against countries, such as Japan, that
routinely ban American beef following discoveries of mad cow disease in North America. The European
Union has also banned many genetically modified agricultural products, as well as threatened sanctions
over the use of the pesticide DDT. Brazil recently mulled sanctions against the United States for its
subsidies to cotton farmers, and it and other Latin American countries are also considering sanctions
against China for dumping cheap textiles on them.
Important Trade Blocs and Free Trade Agreements
Name
Dates
Countries
The EU (European Union)
The Maastricht Treaty (signed 1992—effective 1993) created the
euro and the modern European Union. Member states must be
democratic, respectful of human rights, open to the free market, and
willing to follow European Union laws and regulations.
Currently 28 members, including nearly all of
Western Europe and expanding into Eastern
Europe. Notable nonmembers are Norway,
Switzerland, Serbia and Russia.
NAFTA (North American Free
Trade Agreement)
Signed 1992-----effective Jan 1, 1994, with an environment and labor
side agreement negotiated in 1993
United States, Canada, Mexico
ASEAN Free Trade Area
(Association of Southeast
Asian Nations)
Set up by the Singapore Declaration in 1992, specifying tariff
reductions through 2008. Came into full effect early, in 2003.
Brunei, Vietnam, Indonesia, Malaysia, Philippines,
Laos, Singapore, Thailand, Cambodia, Myanmar
FTAA (Free Trade Area of the
Americas)
Talks began in 1994, but progress has stalled.
All American countries except Cuba
Mercosur
Began with Treaty of Asunción (signed Mar 26, 1991) and updated by
Treaty of Ouro Preto (signed Dec 17, 1994)
Argentina, Brazil, Paraguay, Uruguay
97
NAFTA’s impact has been tremendous. Mexican exports jumped from under US$40 billion in 1991 to US$158 billion in
2002 and nearly US$200 million in 2006. Likewise, imports from the United States went from pre-NAFTA levels of US$37
billion in 1991 to US$128 billion in 2000 and US$134 billion in 2006.
Andean Community of
Nations (CAN)
Began with Cartagena Agreement in 1969. Free trade area took effect
in 1993. Amended by later agreements. In 2003, CAN and Mercosur
officials discussed plans for free trade between the two trade blocs.
Bolivia, Colombia, Ecuador, Peru, Venezuela
DR-CAFTA (Dominican
Republic-Central American
Free Trade Agreement)
All parties ratified except Costa Rica.
Passed US Senate 6/30/2005, passed US House in 7/28/2005.
Dominican Republic, Costa Rica, El Salvador,
Guatemala, Honduras, Nicaragua (NOT: Haiti,
Panama, Belize, Cuba)
GATT (obsolete)
1948 Geneva Round: GATT launched
1993 Uruguay Round: Last round of GATT, ushered in the WTO
Many countries
WTO
Jan 1, 1995: Officially replaced GATT
153 countries as of 2010, including China but not
Russia
formerly the Andean Pact
V. The Global Economic Crisis
On September 15, 2008, India was celebrating Engineer’s
Day98, Prince Harry turned a swoon-worthy 24, and Barack
Obama was 50 days from being elected president of the United
States. It was an active day in the markets, but not an unusual
one. Then the roof caved in. That morning99, the fourth largest
investment bank in the United States—Lehman Brothers—filed
for bankruptcy. It was the largest bankruptcy in American
history, and it helped trigger a global economic crisis.
Four years later, that crisis continues. In Europe,
one country after another has teetered on the brink
of financial collapse. The European Central Bank
has taken emergency measures to prevent member
states of the European Union—and their banks—
from defaulting on their debts. Analysts worry that
more prosperous countries may begin to abandon
the Eurozone rather than risk their own economies
to help those countries in worse shape.
In the United States, the unemployment rate has
been so high for so long that some experts wonder
if it reflects a “new normal”— if higher
unemployment is here to stay. It peaked at 10% in
October 2009, a year after the crisis unfolded, and
remains above 8% today. In 2011 one major credit
agency downgraded the United States’ debt,
meaning it has begun to question whether the
United States will ever be able to pay back all the
money it has borrowed.
You may be studying the Russia economy this year,
but you cannot understand where that economy is
today without understanding its larger global
context since 2008: a context in crisis.
The Economy Takes a Bubble Bath
Bubbles burst. You know this if you’ve ever
blown a bubble, taken a bubble bath, or
popped a painful blister101. You would also
98
Vocabulary and Explanation
Twenty-seven European countries belong to the European
Union (EU); seventeen belong to the Eurozone, meaning they
use the Euro as their currency. The European Central Bank
coordinates the monetary policy of all EU members.
An investment bank is not the sort of bank you would visit to
use an ATM100. Investment banks raise and manage enormous
sums of money on behalf of individuals, companies, and
governments. They are also actively involved in many other
financial transactions, including mergers and acquisitions.
To default on a debt is to admit you will never pay it back.
Imagine: if you borrowed $100 from your friend and never
gave it back to him, no one else would want to loan you
anything at all, not even a hat.
In some countries, when a company realizes it will not be able
to pay its debts, it can file for bankruptcy. A bankrupt
company doesn’t always go out of business; sometimes it can
rework its finances, figure out a way to pay some of its debts,
and ‘‘emerge’’ from bankruptcy still operational.
The unemployment rate tells us what percentage of the
people in a country who are looking for a job can’t find one.
A credit agency is an organization that measures how likely
someone or something is to pay back its loans. Suppose your
school library charged for borrowing books-----and could
charge different people different prices. If a credit agency
says you are likely to return books on time, the library will
probably lend one to you very cheaply, for a few cents a day.
But if the agency says you are likely to lose books, the library
will probably only lend one to you if you agree to pay a lot for
it each day-----so that, if you don’t return it, the library can buy
a new copy. The same applies to loans. The better your credit
rating, the more cheaply you can borrow money. The price of
borrowing money is its interest rate-----if you borrow $100 at a
5% annual interest rate, you will owe $105 after a year.
Sadly, it wasn’t Investor’s Day. That kind of irony would be too good to be true, which is why it’s not.
At 2 am. Nothing good ever happens at 2 am.
100
Unless you were a country looking to withdraw billions of dollars.
101
Not recommended.
99
know this if you had been a flower investor in Holland in the 1630s—specifically, a speculator
in tulips. Seventeenth century tulips may not seem particularly current as affairs go102, but
learning how bubbles work is important to understanding the roots103 of the global economic
crisis. Few bubbles were as intense or instructive as the so-called tulipmania of Holland.
The first tulips arrived in Holland under the care of the botanist Carolus Clusius in 1593. He planted
them in his private garden. His neighbors, however, were struck by their beauty, and at least one stole a
bulb so that he could grow his own.
The great beauty and diversity of tulips soon inspired the
attention—and obsession—of all classes of society104. One
tulip was especially coveted: the Semper Augustus, named for
a Roman emperor and just as grand. As one historian put it:
“Both more prosaic and more sublime than any stock or
bond, it was a tulip of extraordinary beauty, its midnightblue petals topped by a band of pure white and accented
with crimson flares.”
Smart merchants realized there would be high demand for
tulips, but limited supply; it can take seven years for a tulip
flower to grow from a seed, and bulbs, which sprout more
quickly, are hard to produce. These tulip speculators stocked
up on tulip bulbs because they believed prices would soar. In
1624, one speculator was offered the equivalent of about
$60,000 in today’s dollars for a single tulip bulb—and turned
it down to wait for a better offer. Ten years later,
another man traded his entire farmhouse for three
A speculator buys something in order to sell it later at a
tulip bulbs. These transactions were not
higher price. Speculating is risky, but can be extremely
extraordinary. Savvy investors hoped to resell bulbs
profitable at the beginning of a bubble.
for even more outrageous sums of money than they
A bulb is a mini-plant-----almost a pod-----that will grow a
new plant and flower immediately. A bulb can split a few
were spending on them.
times, cloning itself to produce more bulbs, but then is
unable to split any further. This makes bulbs highly
Then, in the balmy spring of 1637, someone who
desirable.
had bought a tulip bulb decided he didn’t really
want it after all. He didn’t show up to pay for his tulip105. That one failed transaction punctured the
bubble. Maybe tulips weren’t worth whole houses after all. Within days the price of tulips had
collapsed. Everyone was selling them; no one was buying them. People who had spent princely sums on
tulip bulbs were left with no way to salvage their investments.
All bubbles follow the same pattern. Smart investors spot an emerging opportunity. They buy up as
much as they can. Media, public hysteria, and the arrival of more investors drive the price up and up.
102
Except for landscape artists, gardeners, and confused boyfriends on Valentine’s Day.
This is a very weak pun. Call it a punt.
104
Before Angry Birds, there was a lot less to get excited about.
105
This is the sort of thing that happens on eBay all the time.
103
Then, something happens that makes someone realize there is
no real basis for the high prices—and the market collapses.
Bubbles are most common in periods of rapid innovation,
when new technologies stun us with their new possibilities106.
According to The Wall Street Journal, they “may leave us
vulnerable to accepting the bizarre rationalizations that often
accompany financial speculation.” In other words, new
technologies can make us all a little gullible. Consider: when
radiation was first discovered, people were so convinced it
could cure disease that hundreds of thousands of people
bought devices called Revigators to make sure their water was
sufficiently radioactive.
In the same way, during the dot-com boom of the
1990s, investors were so infatuated with any
company related to the shiny new Internet that just
adding “.com” to the end of a company’s name
could triple its stock price107. Later, as soon as
Facebook became popular, investors poured money
into other new social networking sites—social
networks for dieters108, social networks for car
enthusiasts, social networks for pet owners, etc.
Most fizzled quickly; it turned out that people
didn’t really want to set up ten different profiles109.
You’d think we would learn, but bubbles keep
happening, from nanotechnology stocks110 to
Beanie Babies111. They keep happening because
they make economic sense for investors who can
“get out” before the market collapses. It is actually
in their best interest for a bubble to rise as high as
possible. It’s all a matter of timing: buy low, sell
high, and watch other people lose their shirts.
Someone gullible easily falls for things that aren’t true. Try
telling someone that alpacas are related to elephants. A
gullible person will believe you; a non-gullible person will not.
The dot-com boom was a period in the 1990s when Internetrelated companies soared in value. It was not uncommon for
a company’s stock to shoot up in value from $15 to $150 per
share in a matter of days.
A mortgage is a loan ‘‘secured’’ by a piece of property, often a
house, called the collateral. That is, if you take a loan from a
bank to buy a house, you guarantee that you will pay back the
loan-----or else the bank gets your house.
A subprime mortgage is one given to a person with bad
credit. A subprime mortgage usually charges much higher
interest than a normal mortgage. During boom times, banks
justify giving these loans for two reasons: because people
might have a better chance at paying them back, and because
they might be able to ‘‘sell’’ such mortgages to large
institutions and investors, handing the risk off at a profit.
Collections of mortgages sold by banks are known as
mortgage-backed securities.
Many economists trace the current global economic crisis to the bursting of the housing bubble in
2006. The bubble had two layers: actual house prices, and the mortgages used to buy those houses.
Home prices in the early 2000s were rising across the United States and around the world. Many
homeowners discovered they were much better off than they had ever imagined, based just on the
106
This explains apps that allow to use your iPhone as a flashlight and as a voodoo doll.
This tactic no longer works, or we’d be the World Scholar’s Cup.Com Foundation.
108
Could social networks for dictators be far behind?
109
Except, presumably, for those with multiple personality disorder.
110
The company Nanometrics, which had nothing to do with nanotechnology, saw its stock price shoot up when eager
investors bought up shares by mistake—seduced by their stock symbol, NANO.
111
At one point during the Beanie Baby bubble, some buyers were convinced that they could later resell their Beanie Baby
toys for enough money to pay for their children’s college.
107
increased value of their homes. This new “paper wealth” had a number of consequences, including
people spending beyond their means and buying houses they could not afford, on the expectation that
they could resell them for more later. Flipping houses—buying houses, remodeling them, and then
reselling them for a profit—became so popular that producers even made television shows about it.
The house bubble, though, was only part of the
real housing bubble. The goods most likely to
inspire bubbles are easily tradable, so that they can
be passed along from one buyer to the next at
higher and higher prices. Stocks, representing
partial ownership of a company, are the ultimate
example of this: you never hold an actual stock in
your hand. Tulips and Tickle-Me Elmos aren’t far
behind112. Houses are different. They are big,
heavy, and hard to trade113—so investors found a
workaround. To take advantage of rising home
prices, they began to trade in mortgage-backed
securities—essentially, collections of mortgages
bundled and sold together. The housing bubble
extended beyond the houses themselves to include
these much more tradable securities.
There are several reasons this led to an economic
disaster—simplified and summarized below.
Alpaca Farms & Subprime Mortgages
Suppose a bank lends you $1,000,000 in a subprime mortgage
to help you buy an alpaca farm in the midst of a major alpaca
bubble. After two years of paying $500 a month toward the
interest on the loan-----$12,000 in all-----you run out of money.
‘‘Sorry,’’ you tell the bank, ‘‘I’m foreclosing the farm.’’
The bank now owns the farm. ‘‘All right,’’ says the bank, ‘‘I’ll
just sell it to get back the $988,000 you still owe me.’’
If the alpaca bubble were alive and well, with alpaca farm
prices on the rise, the bank could probably sell the farm for
$1,100,000. But if the alpaca bubble had burst, the bank might
find no one willing to buy the alpaca farm at anything near the
original $1,000,000 price. It may end up selling the farm for
$600,000-----losing almost half the original loan.
Imagine this happening across many loans and many banks,
and you’ll understand why the banking sector suffered so
much after the housing bubble burst.
Worse yet: suppose that instead of keeping the mortgage and
taking your payments, the bank had sold the loan to a larger
investor. Over 30 years, counting all the interest, you would
have paid $2,000,000 for that $1,000,000 loan. Instead of
waiting 30 years, however, the bank could sell it for
$1,100,000 to someone else. Then, that someone else would
collect a profit of $900,000 over 30 years-----but the bank
could enjoy $100,000 of profit right away. That larger investor
would suffer the consequences if the bubble burst.
(1) Like tulip prices, house prices would not
go up forever. Someone was eventually
going to buy a house that then went down
in value. People who ended up owing
more for their houses than they were worth were said
to be underwater; underwater homeowners were the
most likely to give up and default, but so might any
homeowner who could no longer afford monthly
payments on his loan.
(2) Banks offered subprime mortgages to buyers with
poor credit. Some were designed so buyers could take
them out114 with no money upfront and with very low
payments for the first few years—a very tempting
proposition! When someone is unable to pay a
mortgage, ownership of the house goes to the bank—a
process called foreclosure. Banks assumed subprime
mortgages were a win-win situation. Either new
homeowners would make their payments or they
112
I never want to hold a Beanie Baby in my hand.
It can take months to find someone who likes the way you turned the master bedroom into a movie theater.
114
The phrase “take out” is used to describe getting a mortgage. In life you “take out” dinner, dates, and home loans.
113
would hand over their houses, which, thanks to rising home prices, the banks could then sell for
more money than the lost loan. When the housing bubble burst, however, banks were left with
foreclosed homes worth less than the original loan.
(3) Many banks sold their mortgages to larger
institutional investors, bundling them
(including the subprime ones) in so-called
collateralized debt obligations (CDOs). A
form of mortgage-backed securities, CDOs
were grouped from least risky to most risky.
The different groups were called tranches.
(4) Many of the CDOs were still rated by
credit agencies, but for their average level of
risk. A bundle containing a few very risky
subprime mortgages and several less risky
mortgages would look like a safe
investment—until the subprime mortgages
abruptly foreclosed.
Over time, mortgage-backed securities were sliced
up, traded, and valued in ever more complex ways.
As hedge fund strategist David Goodman put it:
Institutionalizing the Economy
The institutional investors that bought up mortgage-based
securities were not just other banks. They included pension
funds-----which hold the money that groups of workers are
saving for retirement-----and even government-backed
agencies, like the strangely-named Fannie Mae. All these
institutional investors were at gigantic risk when the
bubble burst and the subprime mortgages followed.
‘‘With increasing demand from Wall Street to
buy subprime mortgages, banks became
motivated to place ever more subprime loans
(since they were no longer at risk, should the
loans fail), and began to push messages like,
‘‘refinance your home, unlock all that equity, pay
off your credit card debt, and go on vacation.’’
Blogger Matt Henderson
In September 2008, no one really knew what the liabilities
of the system were, or what the value of any of the CDO
tranches might be, for there was no market. All the
participants in the structured credit market had done their
best to hide the degree of leverage in the system … And
that is why everything nearly came down. No-one really
knew what any of the assets would bring, and who was on
the hook for what.
Lehman Brothers was one of the most innovative packagers of
mortgage-based securities. It even created synthetic CDOs
that invested in other CDOs, and guaranteed that if the value
of an investment fell more than 20%, it would make up the
difference to investors. “This was an act of genius on the part
of an obscure profit center in the bowels of the bank,”
observes Goodman. Problem was: the damage could not be
isolated. The moment one group of CDOs fell more than
20%, so would all the others.
When that moment came, institutions and banks began pulling out in a mad rush—and Lehman
Brothers fell like a house of cards. Within weeks, the world had lost 50 trillion dollars in value. People’s
retirement savings were wiped out; so were entire banks.
It was an unprecedented global economic catastrophe—yet it would all have felt very familiar to tulip
investors in Holland.
The Great Recession
“Let Detroit go bankrupt,” a New York Times editorial
advised in November 2008, two months after the
government allowed Lehman Brothers to fail. Now the
country’s automobile industry was on the edge of collapse. It
had long been a symbol of American national pride—but
also of inefficiency and mismanagement. Both Presidents
Bush and Obama would soon face a choice: allow the car
companies to fail, or lend them taxpayer money to keep
them in business.
The Great Recession115 and Europe’s sovereign debt crisis in
Europe have come back again and again to this question:
when should governments “bail out” people, companies, and
even other governments in need? Mitt Romney is far from
the only person to have come out against bailouts. “Should
the EU just let Greece fail?” asked David Indiviglio of The
Atlantic in 2011. Many answered with an emphatic yes. A
German legislator compared Greece to “an alcoholic that you
urge to stop drinking and you simultaneously treat to a case
of schnapps116.”
Opponents of bailouts in the United States use equally
passionate language. It’s “time to let underwater
homeowners drown,” said investor Marty Boardman in
January 2012, criticizing a White House plan to offer those
underwater homeowners emergency loans at very low interest
rates. When the Bush Administration decided to bail out
other struggling banks after the fall of Lehman Brothers, one
Congressman, Ron Paul, warned, “What we’re doing today
is going to make things much worse.” Like many critics, he
argued the free market should be allowed to repair itself—
the invisible hand allowed to do its thing. Critics frequently
argue that bailouts are unfair to those who have behaved
responsibly. Why, they ask, should governments give special
help to those who have made bad choices?
Defenders of bailouts point out that those receiving them are
never given “blank checks” to use however they like. Bailouts
come with strict conditions meant to help recipients get their
financial houses in order. When President Obama agreed to loan funds to the auto manufacturers, he
required they first prove themselves to be on a path to viability. They had to pledge to cut unprofitable
115
116
Many economists began calling it this by 2009, probably because “the Second-Greatest Depression” is difficult to say.
Schnapps is an alcoholic beverage popular in Germany.
car models, trim jobs, sell off subsidiaries, and close inefficient
factories. When the European Union and International
Monetary Fund offered emergency aid to Greece, they insisted
the Greek government reduce spending on social programs and
pass other austerity measures—measures so draconian117 that
they inspired mass protests118.
Bailout supporters also argue that they are meant to prevent
widespread economic suffering. If a giant bank fails, as Lehman
Brothers did, the consequences can affect far more than the
owners of that one bank. In the same way, if a single European
country were to default on its debt, the financial consequences
could spread across Europe and beyond.
The Recession in America
Opening the TARP Door
Four years later, Forbes editor Robert Lenzner still wishes the
United States government had bailed out Lehman Brothers.
“There still would have been negative ramifications in global
markets,” he writes, “but maybe not the near collapse of the
system. You can relive that near-collapse in this timeline:
http://cnnmon.ie/Mw0Db
Just one day after the Lehman bankruptcy, the government
decided to bail out the giant insurance corporation AIG.
Perhaps it had concluded that the collapse of AIG would be
too much for the economy to handle.
A bailout is a package of aid-----often a mix of
loans and grants-----offered to a failing company
or organization.
The less a government participates119 in an
economy, the more it is a free market. No
country has a completely free market; different
governments participate in their economies in
different ways and to different degrees.
Something viable is able to survive. You’ll see the
term used not just for companies-----‘‘Are its
finances viable?’’-----but for plans-----‘‘Is his plan to
attend the World Scholar’s Cup viable?’’-----and
even political candidates-----‘‘Is the senator’s
campaign still viable after his loss in Ohio?’’
When a government severely cuts spending120 to
try and get its finances under control, it is
undertaking austerity measures. Typical
austerity measures include cutting back on social
services such as libraries, public education,
health care, and welfare. British Prime Minister
David Cameron recently declared the United
Kingdom must enter an ‘‘age of austerity’’-----in
other words, less government spending.
Even with AIG on life support, the stock market fell
dramatically—and rose—and fell again. It was a period of
great volatility. No banks were giving loans, not to
individuals and not to one another; the economy was too
uncertain. The crisis expanded. By September 25, a nine-day
bank run had driven to failure the sixth-largest bank in the United States, Washington Mutual. It was
the largest bank failure in American history.
Watching all this unfold, Treasury Secretary Henry Paulson championed a massive bailout package: the
Troubled Assets Relief Program, or TARP. “The financial security of all Americans ... depends on our
ability to restore our financial institutions to a sound footing,” he said. Congress, which had to approve
of the plan, was not as convinced. TARP failed the first time it went up for a vote. The Dow Jones, a
117
Draconian is a lovely word for “unusually severe or cruel”. I wouldn’t normally use it, except to give you new insight into
the character of Draco Malfoy.
118
It is the music of a people who want their unemployment benefits back.
119
Word choice is so important. I could have written “interferes” here—but it has a less neutral tone than “participates”.
120
In a severely conservative way, of course.
measure of the American stock market, immediately suffered the largest one-day drop ever. On its
second try, a Congress passed the law, designating $700 billion for the bailout. One purpose of all that
money: for the government to buy back high-risk mortgages and mortgage-backed securities, taking
them out of the banking system.
Discuss with your team: was TARP a good plan?
What measures did it take? How much did it end up
costing American taxpayers?
“If they’re too big to fail, they’re too big.”
Former Federal Reserve Chairman Alan Greenspan
Unpaid in America
Unemployment is often the most visible sign of an economic
recession. When people lose their jobs, they may not be able
to pay for their homes or support their families—and they
often turn to the government for help.
By 2008, when Lehman Brothers collapsed, unemployment in
the United States was already increasing. After taking office in
early 2009, President Obama championed a stimulus bill to
help improve the economy. The $800 billion “recovery
package” included:




Over $120 billion for repairing and building new
roads, bridges, railroads, and other forms of
infrastructure
A stimulus bill is a law intended to increase economic
Over $100 billion for education
growth.
It usually involves either cutting taxes or creating
Over $200 billion in tax cuts
more jobs-----both intended to put more money in the hands
Over $250 billion in direct help to the poor of consumers. The more money consumers have, the more
and unemployed, including food stamps
they will buy, and the more they will buy, the more the
A nonpartisan agency of the United States
government, the Congressional Budget Office,
estimates the stimulus bill helped create or save as
many as 2.9 million jobs. Many conservative critics
disagree. They argue it cost too much and achieved
too little—in other words, that it was inefficient.
Critics from the other side of the aisle, such as
Princeton economics professor Paul Krugman, have
the opposite complaint: that the stimulus was too
small to make an impact.
economy will grow.
Someone or something nonpartisan is not politically biased.
A non-partisan committee in a country with two political
parties might have three members from either party, so
that neither side has a majority (over half).
Someone on the other side of the aisle has an opposing
political view. In many governments, including the United
States, different political parties sit in different areas----meaning that there are aisles between their seats.
Infrastructure refers to ‘‘stitching’’ that holds an economy
together. It includes items such as power lines, highways,
train tracks, and, increasingly, high speed Internet.
Food stamps are coupons that people can use to buy food.
From earlier in this guide, you should recognize that
stimulus bills are an example of fiscal policy, in which governments adjust spending or taxes in order to
affect the economy. Remember, governments can also implement monetary policy, focused on the
money supply. A central bank, such as the Federal Reserve in the United States, can inject more money
into the economy or lower interest rates (making it cheaper for people to borrow money from banks). If
people borrow more money, they spend more money—and the more they spend, the more the economy
grows.
In September 2012, the Federal Reserve announced it would be doing all it could to encourage
domestic economic activity—a policy referred to as quantitative easing. Critics have assailed this action
as opening the door to inflation.
Political Consequences
At first, many Americans blamed President Bush, a
Republican, for policies—such as less regulation on
banks—that critics claimed helped lead to the
recession. As a Democrat, Obama won his election
easily; his opponent, Republican war hero John
McCain, was widely ridiculed for claiming that “the
fundamentals of our economy are strong.”121 Voters
disagreed.
After President Obama took office, his support of
the stimulus and of a controversial health care reform
bill122 inspired a political backlash in the United
States: the tea party movement123. The tea party
helped power Obama’s Republican opponents to a
major victory in the 2010 midterm elections.
In the United States, presidents are elected every four
years, but national elections are held every two years----which means that, half the time, national elections happen
midway through a president’s term. These midway
elections are called midterm elections.
The tea party is a political movement in the United States
that claims to represent the original philosophy of the
country’s founders. (American revolutionaries once had a
‘‘tea party’’ in Boston Harbor, throwing British tea into the
water to protest British taxation.) Members are generally
against taxation, a strong central government, and
government spending. Their concern over the national
debt-----how much money the government owes-----has
become a main topic in American politics.
Less regulation for investment banks (and other Wall
Street firms) meant that the government allowed banks to
take greater risks with their investments-----leading to both
great profits and great danger.
Public discourse is what people-----the news media,
politicians, and other opinion leaders-----are discussing.
Sometimes, an important issue is simply not talked about
until someone introduces it to the public discourse.
Just as the tea party drew attention to the national
debt in 2010, a new movement in 2011 tried to
refocus the public discourse on inequality. The top
1% of society, it claimed, was wealthier than ever—
but the other 99% was worse off. Calling themselves
Occupy Wall Street, members of the movement
literally camped out in financial centers all over the globe. “We are the 99%!” became one of their most
famous chants. They complained that recent American presidents had favored investors and the alreadywealthy over opportunities for the middle and lower classes.
As we go to print, Obama is now running for a second term. No American president since World War
II has been reelected when the country’s unemployment rate was above 7.2%; Obama is running with
an unemployment rate of 8.1%124. Will he defy history?125 By the time you attend competition, you will
know the answer to that question—and the next chapter in American economic history will have begun.
121
In his defense, he went on to acknowledge “tremendous turmoil in our financial markets and Wall Street.”
Among other things, it required all Americans to purchase health insurance to cover their expenses in the event of illness
or injury. Opponents claimed this mandate was unconstitutional, but the Supreme Court approved it in 2012 as a function
of the government’s power to tax. The law remains controversial, however, and relatively unpopular.
123
The tea party was also very critical of TARP, but it had been passed under a Republican president.
124
As of September 2012.
125
Arguably, every election defies history in some way or another.
122
The European Sovereign Debt Crisis
Even the Great Depression of the 1930s—which we
Americans tend to remember as our own dismal historical
episode—had global reach. This new global financial crisis has
emerged in an even more interconnected world, and its
consequences have touched every continent. Europe, in
particular, has been hit hard—and Russia with it.
By 2009, several countries in the European Union had levels
of debt that deeply worried investors. Credit rating agencies
cut their ratings on their national bonds—suggesting they no
longer trusted that they would ever be repaid.
The Crisis Unfolds
Economists are split on why these debts reached a breaking
point. Some countries, such as Ireland, were devastated by the
end of the housing bubble. As in the United States, many
Irish homeowners ended up underwater and the government
had to bail out several of its banks. The bank rescue
Definitions and Explanations
was expensive; it led to Ireland requiring a $113
The Eurozone countries with the shakiest economies are
million bailout of its own from the European Union
generally seen as Portugal, Ireland, Italy, Greece, and
127
in 2010 . Ireland’s unemployment rate remains
Spain-----PIIGS for short.
over 14% in early 2012.
Other countries were less affected by the bursting of
the housing bubble. The economy of Greece, the
poster child for the sovereign debt crisis, was doing
well in the early 2000s—but behind the scenes the
government was running up a deficit on defense and
domestic spending. Its tax revenue was also impacted
by tax evasion: it was losing as much $40 billion each
year to unreported transactions. Worse, when the
global economy collapsed, two important parts of the
Greek economy, tourism and shipping, suffered
badly. Government tax revenues declined sharply,
and, since spending did not decline at the same rate,
debt levels surged.
A poster child is the perfect example of something.
Jeremy Lin is the poster child for underappreciated, hardworking athletes turning out to be stars in hiding.
If a government spends more than it earns, it is running up
a deficit.
If someone pays you $1,000 in cash to clean his house126,
and you don’t tell the government about it, you are
engaging in an unreported transaction. If you reported it,
you would have to pay taxes on it.
“The choice is simple: Either we press ahead
with the road of change, a road that is
difficult, or we choose catastrophe.”
Greek Prime Minister George Papandreou
Imagine if you owed $100,000 on a college loan. If you made $250,000 a year as an investment banker,
that wouldn’t be so bad. But if you only made $50,000 as a teacher, you couldn’t pay off the loan in a
single year even if you put all your earnings toward it. Worse, you couldn’t do that anyway: you would
need some of the $50,000 to pay for housing, food, and iTunes downloads. You’d be in trouble—just
like Greece.
126
127
Presumably a very large house.
Bailout begets bailout: hello, domino effect.
In 2010 and 2012, Greece turned to the European Union for
help. It received bailout packages on the condition it
implement austerity measures, including higher taxes and less
spending on social services such as health care and benefits for
the unemployed. As in Ireland, those measures were unpopular,
inspiring protests—some of them drawing over 100,000
demonstrators. By taking money out of the economy, the
austerity measures also worsened the recession. Greece is now
entering its fifth year with unemployment rates above 25%.
As part of the most recent bailout, even private investors in
Greek bonds have agreed to give the government’s debt to them
a haircut. “If you go in there with the thought of what's fair
and what's not fair, it's going to be tough to get things done,”
says investor Hans Humes, whose hedge fund agreed to accept
back just 24% of what it was owed—a massive 76% haircut. “This is a situation where there was far too
much debt for the Greek economy to support. I think within the context, we ended up getting a deal
that is workable.”
Some policy makers are urging Greece and other
troubled countries to leave the Eurozone and
reintroduce its own currencies, which would give
them more ways to deal with their debt. For
example, if Greece had its own currency, the
drachma, it could just print enough money to pay off
the debt129. But many analysts call that strategy
unwise. The investment bank UBS warns it could
lead to "hyperinflation, military coups and possible
civil war.”
Definitions and Explanations
When those who hold a country’s debt agree to devalue
it-----to accept back less than they are owed-----they are said
to give the loan a haircut. The idea is to make it easier for
the country to pay back what it can; better that, the theory
goes, than for it to collapse entirely and pay back none of
it. The recent European bailout packages have included
haircuts.
When those who hold a debt agree to erase it from the
books completely-----that is, never to collect it at all-----they
are said to have forgiven the loan128.
When an economy experiences hyperinflation, money
becomes almost worthless-----what you can buy with $1
today might require $100 next week and $10,000 by the
end of the month.
During recessions, people make less money—which
means that even with higher tax rates a government
brings in less revenue130, making it harder to pay
down debt. Remember from earlier in this guide that
John Maynard Keynes urged governments to spend more to stimulate economies in recession, even if it
means going into debt. Many countries, including the United States, followed his advice during the
Great Depression, when it seemed the free market could not recover on its own. As Time magazine put
it, “His radical idea that governments should spend money they don't have may have saved capitalism.”
During the current economic crisis, some countries have implemented Keynesian policies, but others
have avoided them because they tend to require the government to borrow money to pay for them—
and the interest on the resulting debt could cripple an economy in the future.
128
To err is human; to forgive is expensive.
This sounds good until you realize it means that everyone’s money will be worth a lot less.
130
In nearby Italy, the government is trying to increase its tax revenues by requiring consumers to use credit cards instead of
cash—since cash income can be more easily hidden from the government.
129
All for On€
By 2011, it was clear that certain European countries would
require ongoing financial assistance. The 27 members of the
European Union collectively formed the European Financial
Stabilisation Mechanism (EFSM), an emergency funding
institution that could borrow money against a very stable
form of collateral: the budget of the European Union itself. In
other words, anyone lending money to the EFSM would
either get it back or have a claim on the budget of the
European Union. In the last year, the EFSM has raised and
distributed over 26 billion euros to member countries.
Political Consequences
In several Eurozone countries, including Portugal, Greece,
Spain, and Italy, anger over the bailouts, austerity measures,
and stubborn unemployment has led to dramatic elections
and changes of leadership. In Italy, Giorgio Napolitano replaced the beleaguered131 Silvio Berlusconi as
Prime Minister; in Spain, the more centrist People’s Party took power from the liberal Socialist
Workers’ Party. In general, whichever party was in office when the crisis began was likely to lose
support. Even outside the Eurozone, in the United Kingdom, David Cameron’s Conservative Party
drove Gordon Brown’s Labour Party out of power and implement a more austerity-focused agenda.
The crisis has also helped drive people out of countries
altogether. In Greece, a government program to help citizens
move to Australia had only 42 sign-ups in 2010—but over
12,000 in 2011. Families that can afford it are sending their
children to study abroad, where they are more likely to find
jobs. Long term, the loss of young talent will harm all the
countries affected by the sovereign debt crisis.
The crisis has also affected the balance of political power
within the Eurozone. Countries whose economies and credit
ratings have remained strong, such as Finland, have gained
new influence. (Finland was even able to demand nearly a
billion euros in collateral from Greece before agreeing to its most recent bailout132.)
The Crisis Elsewhere
The consequences of the 2008 downturn stretched from abandoned construction sites in Dubai to
warehouses in China filling with exports no one abroad could afford to buy.
In the face of rising unemployment and failing factories, China passed its own nearly $600 billion
stimulus package in November 2008. The Keynesian-style stimulus launched massive infrastructure
projects—new roads, high speed trains, and more—that would generate jobs and limit damage from
131
132
Someone beleaguered is being criticized a lot. The word rhymes nicely with leader: be a leader, be beleaguered.
Leading to the new saying, you’re not finished without the Finnish.
lost trade. The stimulus cut taxes and spent money on other priorities, such as education and housing.
All in all, China’s growth has slowed since 2008, but continued to hover around 9% per year. By
comparison, as the global recession took hold, most of the world’s developed economies actually shrank.
In Dubai, the collapse of the real estate market hit hard. A massive wave of construction during peak
economic times had left empty homes and offices surrounding the city. Dubai’s dependence on global
trade also meant that, as the world economy ground to a halt, so did Dubai’s opportunity to play a role
on it. Before long, Dubai needed its own $20 billion bailout from the neighboring emirate Abu Dhabi.
Foreign workers fled for home, and many extravagant projects—such as a giant glow-in-the-dark
pyramid to mirror those in Egypt—were set aside.
In regions that depended heavily on manufactured exports, such as Southeast Asia, the downturn
increased unemployment and slowed growth. The more connected a country to the global economy,
the more it was affected.
In Russia, the crisis meant more than a collapse in the price of oil on which the Russian economy vitally
depended. In the words of one expert, Stephen Sestanovich of the Council on Foreign Relations:
“Russia is confronting virtually all the negatives at once--sharply declining export earnings from energy
and metals, over-leveraged corporate balance sheets and a chorus of bailout appeals, a credit crunch and
banking failures, a bursting real-estate bubble and mortgage defaults, accelerating capital flight, and
unavoidable pressures for devaluation.”
By November 2008, Sestanovich had correctly predicted that the expanding crisis in Russia would boost
Vladimir Putin’s chances of returning to the presidency—with increased authoritarian trappings and
with a growing degree of anti-Western rhetoric133. Just as physics informs the messier natural sciences of
chemistry and biology, economics can inform the messiest social science of all: politics.
133
A cynic might observe that a country in trouble needs a strong leader and scapegoats to blame, or it tends to fall apart.
Conclusion: Act V
New York Times columnist David Brooks suggests the history
of economics as a field of study has had four acts. Act I was the
rise of basic economic theory, in which the first economists built
models based on predictable human behavior. In Act II their
successors complicated those models with more sophisticated
ideas—such as the reality that people don’t always behave
predictably. Act III, he believes, was the climax: the global
economic crisis of 2008 and 2009 that economists completely
failed to predict.
Now, he suggests, we live in the aftermath: an Act IV in which
those same economists are still trying to figure what happened,
why it happened, and how to stop it from happening again. For
the first time, many are looking at psychology, neuroscience
(the study of the brain), and sociology (the study of society), to
understand why human beings make the decisions they do.
Why do so many people—and governments—spend more than
they earn on things they don’t need? Why do people vote for
policies that harm them, or complain about cheap foreign labor
even as they buy its products?
In short, why are people inconsistent, and why do they make so
many mistakes? Brooks suggests the future of economics, if it
answers those questions, may not look like economics today:
“Economists will be able to describe how some people acted
in some specific contexts. They will be able to draw out some
suggestive lessons to keep in mind while thinking about
other people and other contexts—just as historians, psychologists and novelists do. At the end of Act V,
economics will be realistic, but it will be an art, not a science.”
Not all economists are as pessimistic about the future of their field. But the growing complexity of the
world is ever harder to analyze and predict. Faced with the same sort of economic crisis, the United
States chose to spend more, the United Kingdom less. Neither strategy has been a clear success. Though
the United States may be recovering sooner, it is, some would say, doing so at a greater cost.
Economies are emerging from the Great Recession—or plunging deeper into it—only to discover that
nothing is the same anymore. Some analysts believe China is on the verge of becoming the world’s
leading economic superpower, eclipsing the United States and Europe; others argue that beneath its
glittering new facade it is racing toward recession and collapse. Once a superpower in its own right,
Russia is on the move, strengthening ties with allies in Central Asia and the Middle East, such as Iran
and Syria—but will the return of Vladimir Putin as president spark a rebellion from within? Greece may
yet fall; Italy may leave the Eurozone.
The fragile economic recovery may be especially jeopardized by rising oil prices, even if they benefit
certain countries, such as Russia. “If the world wants to make the region insecure, we will make the
world insecure,” an Iranian government official has stated, warning that Iran could close the Strait of
Hormuz—instantly cutting off 30% of the world’s oil supply. Israel may or may not take military
action against Iran, which may or may not be developing nuclear weapons; the United States may or
may not support it if it does.
Rising oil prices, the Eurozone crisis, global climate change, growing food shortages, unpredictable
geopolitical tension, stubborn unemployment—the world economy has a fragile back and is dodging a
hundred straws.
Analyze those straws using what you’ve learned in this guide. Put yourself in the shoes of today’s global
leaders and ask, “How did this happen? Where do we want to go? And how do we get there?”
In a few years, those leaders will be you134, and Act V yours.
134
That, or you will be one of their powerful economic advisors, as Jeffrey Sachs was to Boris Yeltsin.
About the Authors
Daniel Berdichevsky likes to accumulate frequent flier
miles in order to visit freezing cold countries in the middle
of winter. As a senior, Daniel led the Taft Academic
Decathlon team to its second national championship; a
jaywalking ticket then turned him into a factor of
production. Since then, he has founded DemiDec and the
World Scholar’s Cup, managed a venture fund, worked as
a busboy, bookseller, and ghostwriter (just once, for the
Secretary-General), dropped out of three universities, and
acted in a Taiwanese film about Santa Claus.
Randy Xu likes to think he puts the con in economist. He has opened and
closed credit card accounts just to accumulate introductory miles—and
that was before he discovered hotel points. He also routinely deposits
promotional 0% APR balance transfers into interest-bearing certificates of
deposits. After graduating from Harvard, Randy designed energy trading
software in New York before deciding to go into law after being arrested
and detained for two days by the NYPD. He figured it would be cheaper
in the long-run than hiring a lawyer. In 2000, Randy led the Simi Valley
Academic Decathlon team to their first victory at the California state
competition. Twenty years from now, Randy is sure he will be in prison,
but is unsure if it will be for environmental activism, tax fraud, insider
trading, or anti-trust violations.
Tania Asnes lives in New York City, where she knows both Occupy Wall
Street protestors and Wall Street bankers. She finds they understand each
other more than the media lets on. Her preferred method of stimulating the
United States economy is to purchase movie tickets.135 She also stimulates
the economy of South America by purchasing too much yerba mate tea.
135
This may also double as her way of learning the nooks and crannies of the film industry, which she plans to infiltrate.

DemiDec Fundamental Economics Resource

Transcription

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