Econ Fundamentals Resource

A World Transformed2 0 1 1

ECONOMICS

WorldScholar’sCup

ECONOMICSTHE FUNDAMENTALS

EDITORSTania AsnesDaniel Berdichevsky

®

the World Scholar’s Cup®

YEARS

5CELEBRATING 5 PWAA-TASTIC YEARS!

ECONONOMICS RESOURCE | 1

ECONOMICS: FUNDAMENTALS Understanding the New Economy

Table of Contents

Preface ........................................................................................................................ 4 I. Think Like an Economist ........................................................................................ 6

The Basic Economic Problem—Scarcity ....................................................................................... 7 Production of Goods and Services ................................................................................................. 8 Increasing Costs .......................................................................................................................... 10 Distribution and Pareto Efficiency .............................................................................................. 11 The Factors of Production .......................................................................................................... 11 Cost-Benefit Analysis—Marginal Decision-Making .................................................................... 12 Marginal Utility and Waffles ....................................................................................................... 14 More on Marginal Utility and the Effect of Prices ....................................................................... 15 Individual and Social Goals ......................................................................................................... 16 Positive and Normative Economics ............................................................................................. 16 Economic Systems and Their Characteristics .............................................................................. 17 The Basic Economic Questions ................................................................................................... 17

What and how much to produce? ............................................................................................ 17 How to produce? ...................................................................................................................... 18 Who receives the benefits of production? ................................................................................. 18

Responses to Positive and Negative Incentives ............................................................................ 19 Characteristics of a Mixed Market Economy ............................................................................... 20 Voluntary Exchange .................................................................................................................... 20 Specialization and Division of Labor ........................................................................................... 21 The Basics of Trade ..................................................................................................................... 23

III. Microeconomics ................................................................................................. 24 Markets ....................................................................................................................................... 24 Prices .......................................................................................................................................... 24 Demand ...................................................................................................................................... 25

Demand vs. Quantity Demanded ............................................................................................ 25 Changes in Consumer Income ................................................................................................. 26 Changes in the Number of Consumers .................................................................................... 27 Changes in Consumer Expectations ......................................................................................... 27 Changes in Prices of Substitutes and Complements ................................................................. 27 Changes in Consumer Tastes and Preferences .......................................................................... 29 Seasonal Changes ..................................................................................................................... 29

Supply ......................................................................................................................................... 29 Supply vs. Quantity Supplied ................................................................................................... 30 Changes in the Factors of Production ...................................................................................... 30 Changes in Technology ............................................................................................................ 31


Expectation of a Price Change .................................................................................................. 31 Number of Suppliers ................................................................................................................ 32

Market Equilibrium .................................................................................................................... 32 Summarizing Equilibrium Changes .......................................................................................... 33

Consumer and Producer Surplus ................................................................................................. 33 Price and Wage Controls ............................................................................................................ 34 Utility and Income ...................................................................................................................... 35 Elasticity ..................................................................................................................................... 37 Market Structures ....................................................................................................................... 39

Perfect Competition ................................................................................................................. 39 Monopolistic Competition ....................................................................................................... 40 Oligopoly ................................................................................................................................. 40 Monopoly ................................................................................................................................ 41

The Production Decision ............................................................................................................ 43 Price Discrimination ................................................................................................................... 44 The Institutions of a Market Economy ....................................................................................... 44

Financial Intermediaries ........................................................................................................... 44 Labor Unions ........................................................................................................................... 45 Property Rights ........................................................................................................................ 45

Types and Nature of Income ....................................................................................................... 45 Factor Markets and Derived Demand ......................................................................................... 46 The Labor Market ....................................................................................................................... 47

The Hiring Decision ................................................................................................................ 48 Human Capital Development and Labor Productivity ............................................................. 48 Investments in Education ......................................................................................................... 48 Other Factors That Influence Income ...................................................................................... 49

Investment and Economic Growth ............................................................................................. 49 Entrepreneurs .............................................................................................................................. 50

IV. Macroeconomics ................................................................................................. 52 Gross Domestic Product and National Income ........................................................................... 52

Methods of GDP Measurement ............................................................................................... 53 The Expenditures Approach to GDP Measurement ................................................................. 53 The Income Approach to GDP Measurement .......................................................................... 54 The Output (Value-Added) Approach to GDP Measurement .................................................. 54 Real GDP and Nominal GDP ................................................................................................. 54 The Lorenz Curve and the Gini Coefficient ............................................................................. 55

The Circular Flow of the Economy ............................................................................................. 55 Exports and Imports in the Circular Flow ................................................................................ 56

Economic Growth....................................................................................................................... 56 The Business Cycle ..................................................................................................................... 57 Aggregate Demand ...................................................................................................................... 58 Consumption and the Marginal Propensity to Consume ............................................................ 60

The Multiplier Effect ............................................................................................................... 61 “Ideal” vs. “Real” Multipliers ................................................................................................... 61

Aggregate Supply and Economic Equilibrium ............................................................................. 62 The Labor Force ......................................................................................................................... 63

Categories of Unemployed Persons .......................................................................................... 63 Kinds of Unemployment .......................................................................................................... 63 Four Portraits of Unemployment ............................................................................................. 64


Money and Currency .................................................................................................................. 65 The Three Functions of Money ............................................................................................... 65 The Money Supply .................................................................................................................. 66 Inflation and Price Indices ....................................................................................................... 66 Interest Rates ........................................................................................................................... 68

Roles of the Government in a Market Economy ......................................................................... 68 Sales, Value Added, and Excise Taxes ....................................................................................... 69 Excise Taxes and Deadweight Loss ........................................................................................... 70 Lump Sum and Property Taxes ................................................................................................ 71 Income Taxes ........................................................................................................................... 71 Laffer Curve ............................................................................................................................. 71

Public Policy and Positive and Negative Externalities .................................................................. 72 Fiscal Policy ................................................................................................................................ 73 Budget Deficits and National Debt ............................................................................................. 74 Central Banking Systems ............................................................................................................. 75 Price Stability .............................................................................................................................. 75 Monetary Policy .......................................................................................................................... 77

Tools of Monetary Policy ......................................................................................................... 78 Money, Supply and Demand ................................................................................................... 79 Advantages of Monetary Policy ................................................................................................ 80 Disadvantages of Monetary Policy ............................................................................................ 80

Linking Unemployment and Inflation ........................................................................................ 81 Say’s Law and the Supply-Side Approach .................................................................................... 81

About the Authors .................................................................................................... 83 About the Illustrator ................................................................................................. 83

by Daniel Berdichevsky

Harvard University M.P.P. Stanford University B.A. & M.A.

and Randy Xu

Harvard University B.A. ‘05

with illustrations by Vicky Ge

Harvard University B.A. ‘12


Preface You don’t have to be reading this. You could be somewhere else instead. You could be with your best friend watching the latest

Harry Potter movie, 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 choice 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 Egypt will try to slow down inflation—which is when the same amount of money buys 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.

In this resource, we’ll first consider the fundamentals of economics. We’ll think more about trade-offs and consider what consumption and production 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

1 The correct answer is not “snogging”. 2 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. 4 I will never buy less tea.

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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.

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 the Great Depression, 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

5 At least until there are no more newspapers.


I. Think Like an Economist 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 tries to make a model out of markets and monetary movements. A model describes how things normally behave and lets us make predictions about them. 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 take away your videogames. This model helps you decide whether to study for your next test.

In economics, models help predict what will happen to the economy. If terrorists release smallpox in New York City and millions of Americans 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 can grow 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 a butterfly7 flapping its wings in Tokyo. This seems like a small thing,8 but weather is so complicated that some scientists believe it could start a storm in Florida—8,000 miles away.

In economics, you can never know every factor that will affect people. Maybe on Wednesday, 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?”10

Economics assumes people are rational—that they weigh costs and benefits and decide what is best for them. If you’ve ever had too much dessert, or procrastinated on a paper, you know this isn’t always true. But, for argument’s sake, economists pretend we always make our best possible choices.

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

6 My high school classmate Kevin did, filling them with dry ice and launching them at the gym. 7 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. 10 On the other hand, how many of your friends’ birthdays would you actually remember if Facebook didn’t remind you?

Debate it! Resolved: That economic models mislead lawmakers.


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 or no less comfortable, and Harry Potter is still determined to defeat Voldemort.11 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.12 You could have all the iPhone apps and fluffy alpaca hats in the world for free.13 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 humans have unlimited wants and that the world 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.14 He 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.15

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

11 Even if it means some whining in the forest along the way. 12 Horticulture, however, would become rather fashionable. 13 This assumes a very strange tree. 14 Unless she owns a military jet and can travel at Mach 5. 15 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?

Debate it! Resolved: That people do not really have unlimited wants.

http://www.youtube.com/watch?v=ZsN8FUV9nS4


quality standards. If factories release too much smoke, they are punished. As citizens, we pay taxes to fund 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 about opportunity cost. We deal with opportunity cost whenever we make choices. Suppose on Sunday, you can work at Caribou Coffee 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 Jason Mraz. The opportunity cost of going to college may be the lost salary from the job you could have had selling cars instead.16

Economists care about both kinds of costs. For most of their analysis, they measure economic cost, which includes both accounting and opportunity cost, plus other costs we will discuss later—such as external costs to the environment.

The economic cost of the lava lamp includes its accounting cost, the time and money spent driving to and from the store, the environmental impact of the materials used to create the lamp, and the social stigma you will experience when your friends see the thing in your room.

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 for orange trees, you can harvest 1,000 oranges per year. If you use all the land for blueberry bushes, you can harvest 10,000 blueberries per year.

The table displays your production possibilities. You can choose from different 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. 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” 16 My cousin tried this, and reports the opportunity cost is not very high.

PRODUCTION POSSIBILITIES

Oranges Blueberries

0 10,000

100 9,000

200 8,000

300 7,000

380 6,000

400 5,000

450 4,000

600 3,000

700 2,000

800 1,000

1,000 0


some land that is better for blueberries. If you produce mostly blueberries, you will make poor use of land perfect for oranges.

We can display all possible combinations of oranges and blueberries on a Production Possibilities Frontier (PPF). A PPF is one of the most important diagrams in economic decision-making. It shows all combinations of two goods that a producer or country can output at a given time.

The first graph highlights some of the combinations in which you might produce oranges and blueberries. If you choose 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 inwards and outwards. 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 would grow only 200 oranges and 800 blueberries. You might have your own reasons for producing at this point, but you would frustrate an economist. Producing at X is inefficient because it fails to employ all available resources. To produce at Y, or any other point on the frontier, would be efficient—employing all available resources.

Suppose you decided to produce 5,300 blueberries and 2,300 oranges. Point Z represents this ambitious combination. Because Z is outside the frontier, it is unattainable (except through trade). You don’t have the land or technology to produce that much fruit.

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 trade-off of 400 oranges for 4,000 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, 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

Some PPFs involve two similar goods. In the next PPF, a manufacturer compares the production possibilities for black and brown shoes. Since the cost and materials involved in producing black and brown shoes are basically the same, the greatest number of shoes that can be manufactured 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 80. At point D, 60 black shoes and 20 brown shoes are made—again, a total of 80.

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, the opportunity cost of any change in production must be 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. The real cost of making a black shoe is a brown shoe. ,

Most PPFs pair more different goods. Often, PPFs are used to represent a nation’s trade-off between military goods (“guns”) and civilian goods (“butter”). Another key trade-off is between capital goods, like factories, and consumer goods, like iPads and tofu.

In this guide, we use “milk or missiles”, but the specific items don’t matter much. What matters is that, like milk and missiles, they are very different.

A typical PPF is not a straight line—it is bowed outward from the origin. At either end, the trade-offs are greater because opportunity costs are greater.

Suppose the government of Alpacaland decides to move from A to B on the PPF to the right. This means Alpacaland will give up only 50 billion quarts of milk to produce its first 100 missiles. The more Alpacaland concentrates on missiles, the greater the trade-off becomes. If Alpacaland moves from C to D, it gains 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 its opportunity cost becomes.

The “law” is not always true, but it usually holds for two reasons. First, resources grow scarcer. We may need to dig deeper in mines to find metal for more 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 are even claustrophobic. As we make more missiles, we are forced to assign resources to mining—such as farmers and cows—that would have been much better at producing milk. Consider point D. Here, even if Alpacaland were to sacrifice all its remaining milk—320 billion quarts—it could only eke out another 50 missiles.

Debate it! Resolved: That a country should favor capital goods

over consumer goods.


PPFs never indicate which point is best. They can only tell us the possibilities and their opportunity costs. Yes, many resources great for making milk will be used inefficiently if Alpacaland moves from D to E—but if Alpacaland is at war, those extra 50 missiles could make the difference between victory and defeat. If zombies are taking over the planet, Alpacaland might choose to produce only milk, to hold one last ice cream party prior to extermination.17

Distribution and 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 brew cups of tea, pet my puppy, and check the Internet for political news—but, for the purposes of this guide, we will focus on one specific kind of efficiency: Pareto efficiency.18

If you can’t make anyone better off without making someone worse off, you’ve achieved Pareto efficiency.

Suppose a town in Alpacaland, Llamapolis, produces 1,000 bottles of milk. There are exactly 100 people in Llamapolis. As mayor, you hire a crew to deliver milk all across town. You give them the key to the milk warehouse. Soon, everyone, including you, has received 9 bottles of milk.

“We’re done delivering milk,” the chief deliveryman reports. “Everyone has more than enough. We’re going to watch the Clippers game. That Blake Griffin is a nasty dunker.”

“But wait,” you say. “There are 100 bottles of milk still sitting in the warehouse. You’ve only delivered 900 bottles of milk!”

The deliveryman groans. He realizes what you’re about to tell him: this distribution of milk is not Pareto efficient. He could deliver more milk without taking milk away from anyone. Then he has a sudden thought—and smiles wickedly. “Okay,” he says. “I’m on it.”

He takes the 100 remaining bottles of milk, hands them to you19, and says, “You now have 109 bottles of milk. There are none left in the warehouse. The situation is Pareto efficient. I’m leaving now.”

You want to stop him, but you realize he’s outsmarted you: he can’t deliver any more milk to anyone else without taking some from you. In any given situation, there can be many Pareto efficient outcomes, and not all are 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 considering 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 making milk and nuclear missiles. Trees would demand humans to collect fruit, just as cows would need humans (or robots) to milk them. For nuclear missiles, we would need factories to produce the metal casing; missiles don’t just grow on trees20.

Let’s classify these resources. Economists divide them into four categories of factors of production.

17 Producers of The Walking Dead, take note. 18 Named for the Italian economist Vilfredo Federico Damaso Pareto (1848-1923). It would have been inefficient to call it Vilfredo Frederio Damaso Pareto Efficiency. 19 Assume you both have very big hands. 20 We now know two things that do not grow on trees: iPhone apps and nuclear missiles.


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 all natural resources as land. This can be confusing, since rivers and trees are considered 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, mainframe computers, 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 extracted coal is an intermediate good, or capital. Producers pay interest for the use of capital.

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, producers 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 start businesses, improve processes, and invent products. Entrepreneurs figure out what to do with land, labor and capital. When a student drops out of Harvard to start Facebook, he is an entrepreneur. So is someone who opens an octopus burger stand outside an SAT school in Seoul, betting students will be hungry when they leave class at 2 am.

This word—betting—is the key. 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 greatly valued; in others, parents prefer their children find stable, secure jobs as soon as possible.

Cost-Benefit 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 cost-benefit analysis. A rational person or firm decides to do something when its benefits outweigh its costs.

Consider Anirudh, a young alpaca farmer pursuing his sworn enemy, Kosta, through the badlands of Texas. Anirudh plans to kill Kosta. Anirudh finally catches up to Kosta in front of a Krispy Kreme—but three police officers are lingering out front. Anirudh pauses to weigh the costs and benefits of killing Kosta on the spot. The benefit is obvious: his sworn enemy will be dead. The costs are uncertain, but significant. In Texas, murder carries the death penalty. The police will witness his crime; he will end up imprisoned or executed.21

21 Unless he hires a very good criminal lawyer. Maybe even a criminal lawyer.

Debate it! Resolved: That all young people should be encouraged

to be entrepreneurs.

If Anirudh has studied economics, we can assume he will conduct a cost-benefit analysis before he decides

whether to kill Kosta.


If Anirudh decides that Kosta being dead is more valuable than the years of his life he will waste behind bars, he will kill Kosta. However, if he decides that a dead Kosta is no good to him if he loses his freedom, he will probably let Kosta go—for now. We cannot make the decision for Anirudh, 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 Anirudh is rational, he will conduct a cost-benefit 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).

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 Anirudh, the distance he ran before catching Kosta is a sunk cost. As he hyperventilates, he might think, “I’ve already run two miles to catch Kosta. That counts for something—I should kill him and be done with it.” Maybe so—but, to an economist, those two miles count for nothing. He can never get back the time and energy he spent running them. Perhaps the future benefit of having Kosta dead would outweigh the past cost of running two miles—but Anirudh should kill Kosta only if the future benefits of having Kosta dead outweigh the future costs of killing him.

Of course, real economic decisions rarely involve murder; most are more mundane. From month to month, a firm might decide whether to increase or decrease production of a good—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. The firm would not consider past costs—such as leasing a donut factory or of training the donut makers—when deciding on this last donut.

Marginal decision-making is the act of weighing the benefits of an incremental change against its costs. The marginal benefit of increasing production is the added revenue from the sale of one more unit. The marginal cost is the cost—including labor and materials—of producing one more unit.

Suppose Sue’s Spaghetti Company grows pasta on Noodlebushes. Sue is deciding how many Noodlebushes to plant. First she must evaluate her marginal benefits and costs. For Sue, the marginal benefit of another Noodlebush is the money she will earn from selling the noodles that grow on it. The marginal cost is the cost of cultivating another Noodlebush, including labor, time, and land.

Examine the table of marginal costs and benefits for each Noodlebush. Then, decide: how many should Sue plant?

Take one marginal decision at a time. Each Noodlebush yields one box of spaghetti. Since each box sells for $7, the marginal benefit of each Noodlebush is $7. The cost of producing the first box of spaghetti is $2, so Sue plants the first bush: she earns more than $2 from it. She also plants the second, because the $3 cost is still less than the $7 sale. The same goes for the third bush. But, for the fourth bush, $8 of cost would exceed $7 of benefit. Using marginal decision-making, Sue stops at three bushes.

Two caveats: marginal benefit is not always this constant, and very few bushes grow spaghetti.

Noodlebush # Marginal Cost Marginal Benefit 1 2 7 2 3 7 3 5 7 4 8 7 5 12 7 6 17 7


Marginal Utility and Waffles

If we have unlimited wants, how is it that we ever have enough of something? Blame the law of diminishing marginal utility: as we obtain more of a good or service, we tend to derive less value from each additional unit of it.

Consider haircuts. If your hair is long and unkempt, a haircut would probably be very useful to you. But a second haircut right after the first one would not be too useful unless the first haircut was very bad. If you got a third haircut, you might end up bald.

Let’s define a few terms. Utility is the satisfaction a person obtains from consuming a good or service. Marginal utility (MU) is the satisfaction obtained from one more of that good or service. Total utility is the sum of all the satisfaction someone obtains from however many of that good or service he consumes.

Economists express utility in imaginary units: utils. If a meat-lover gains 10 utils from a burger and 1 util from a slice of tofu, we can quantify how much more utility the burger gives him. (Bear in mind that utils are not the same as units of happiness—economists can’t measure happiness directly.22)

Consider a man I knew in college, Steve. Steve ran track, and has a runner’s metabolism. He eats twice as much as I do, but never gains weight. He is also always hungry. Steve claims to have been full only once—when he decided one morning to see how much his stomach could hold. He sat down with a toaster, syrup, and several boxes of frozen waffles.23

Steve was (of course) hungry, so the first waffles tasted delicious. He wolfed them down as fast as the toaster popped them out. His marginal utility for each waffle was very high.

By the 12th waffle, they were starting to taste like cardboard. Since Steve wasn’t full, he kept eating anyways. The waffles’ marginal utility was rapidly falling, but still somewhat positive because at least they were still reducing his hunger.

By number 25, Steve hated waffles. His jaws were sore—but he still wasn’t full, and Steve was a stubborn guy. That stubbornness was enough to keep his marginal utility just a tiny bit positive.

22 Only Disneyland has a handle on that science. 23 I prefer mine with peanut butter, cream cheese and fresh blueberries.


After 36 waffles, Steve finally felt full.24 A 37th waffle would have caused more trouble than it was worth—stomach sickness, a migraine, maybe death.25 Because its marginal utility would have been negative, he decided not to eat it.

Note that total utility continues to increase as long as marginal utility is positive, even if marginal utility is falling. The graph shows that Steve’s total utility increased all the way to waffle 36. Only after that point would the negative marginal utility of more waffles have decreased his total utility.26

More on Marginal Utility and the Effect of Prices

Imagine you crawl out of the desert and find an abandoned pawnshop filled with water bottles and diamond rings. All are free. What would you do, assuming your MU for each product is as shown?

You’re literally dying of thirst, so it’s not a tough decision. The MU of the first water bottle is far greater than that of the first ring. It doesn’t matter whether it’s from Fiji or from Aquafina’s sewage purification plant. You start with the water.

Next, you weigh the MU of the second bottle (2,000 utils) against the MU of your first ring (1,500 utils). Thirst still wins out, so you grab another bottle. By now you feel less thirsty—in fact, you need a toilet—so when the third round of consumption comes around, the ring is worth 1,500 utils to you and the water only 50. You grab the ring.

You can see where this is going. It’s doubtful you’ll take any more water for a long, long while.

Let’s add prices. The pawnshop isn’t abandoned—a Halliburton employee is running it. He insists you buy the water at $20 per bottle. He also charges $750 per diamond ring. You have a lot of money, but your mom taught you never to spend wastefully. What to do?

The answer is in the ratio of marginal utility to price: MU/P. MU/P is the utility something brings you per dollar; it is a measure of “bang for the buck.” As a rational27 economic actor, you will spend each dollar where it will do you the most good.

The marginal utility of the first water bottle (MUW) is 1,000,000. The price of a bottle (PW) is $20. Thus, the marginal utility to price ratio, MUW/PW, is 1,000,000/20, or 50,000.

The marginal utility (MUR) of the first ring is 1,500. The price of a ring (PR) is $750. The marginal utility to price ratio, MUR/PR, is 1,500/750, or 2.

You can use the same approach to complete the table.

24 Steve should probably go into hot dog eating contests 25 When I asked him if he ever wanted to try it again, he said no way. Even feeling full suffers from diminishing returns. 26 How might we have convinced Steve to keep eating past waffle 36? We could have told him he would win a giant cash prize, or perhaps recognition in the Guinness Book of World Records. A sufficiently tempting incentive would have made his marginal utility positive again (at least until he died). 27 Rational people calculate ratios.

Quantity MU of a Bottle of Water MU of a Diamond Ring 1 1,000,000 1,500 2 2,000 1,200 3 50 1000 4 30 900 5 10 850 6 20 800 7 10 750 8 5 700

Water Rings Quantity MU MU/P MU MU/P

1 1,000,000 50,000 1,500 2 2 2,000 100 1,200 1.6 3 50 2.5 1000 1.3 4 30 1.5 900 1.2 5 25 1.25 850 1.13 6 15 .75 800 1.07 7 10 .5 700 .93 8 5 .25 600 .8


You will buy goods in the order of their ratio of marginal utility per dollar, starting with the highest (50,000 for the first water bottle). From there, you will buy two more bottles with ratios of 100 and 2.5, followed by two rings with ratios of 2 and 1.6. Next, you will want another bottle (your fourth) at 1.5, a ring (your third) at 1.3, another bottle (your fifth) at 1.25, and three more rings at ratios of 1.2, 1.13, and 1.07. Eventually, your dollars will stop working very hard for you, and you will choose to keep the money for future consumption rather than buy either a ring or more water.

Individual and Social Goals

When a person makes decisions out of rational self-interest, he optimizes by maximizing his own utility. What happens when a group of people tries to make a decision together? 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 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 contributes a bit less. This behavior is called shirking, or social loafing. Like nearly everything in economics, it results from rational self-interest. Shirking reduces the productivity of the group. Shirking can also be seen in a game of tug-of-war. If there are many people tugging a rope together, each person might give less effort, hoping the rest of his or her team will pick up the slack.28

Groups aren’t always less productive than individuals; having different perspectives can be crucial to good decision-making. But even diverse groups with good intentions can backfire. Social psychologist Irving Janis researched various government fiascos and coined the term groupthink to describe a condition in which everyone agrees to a bad decision because they are blinded by its popularity.

In the United States, many critics have argued that the 2003 invasion of Iraq was partly the result of groupthink. Intelligence services backed up the president’s statements about the threat of Iraqi weapons of mass destruction; military officers underestimated the difficulty of achieving peace in Iraq after an invasion. The militant atmosphere in Washington kept most people—especially people in positions of influence—from voicing any opposition to 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 one that can be proven or disproven with facts. It 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.

Like scientific theories, economic theories are stated positively. Theories are stated without bias, 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.

28 How many of you have done a group project and didn’t give it your all, hoping someone else would get the job done?

Discuss it! Are you familiar with examples of groupthink in your

own country or in your own experience?

Watch it on YouTube In 1961, President Kennedy authorized one of the

greatest disasters of his presidency-----the invasion of Cuba by a CIA-trained group of Cuban exiles. The

operation failed spectacularly. The lead-up to this Bay of Pigs disaster is a classic example of groupthink.

Learn more at bit.ly/2nUT9Y

NORMATIVE ECONOMICS opinionated,

subjective economics

POSITIVE ECONOMICS factual economics, unbiased

statements of theory

http://bit.ly/2nUT9Y


A normative economic statement is a judgment, a statement of opinion. It may interpret facts, but it can neither be 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 helping the people of Greece in 2012” is a normative statement.

To make a positive economics statement, you might say, “If we raise the tax on tobacco, then people will buy fewer cigarettes.” You could also say, “They raised the tax on tobacco last week.” To make a normative statement, you might say, “We should raise the tax on tobacco to punish smokers.”

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 world economy. Examples can be found in parts of Bhutan, Brazil, and Burkina Faso. Even in developed countries, remote areas may maintain aspects of traditional economies.

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, such as in North Korea, all land is publicly owned. A single central authority 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. Real economies mix different systems. The United States has such a mixed market economy. It promotes private enterprise, but the government

intervenes to help achieve certain goals (such as lowering unemployment). 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 battle scarcity. 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 determines what to produce. Suppliers produce what consumers want to buy—because that way they can make money selling it.

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 ostensibly holds 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: youtube.com/watch?v=FJ6E3cShcVU

Discuss it! Some people suggest that the economy should be overseen by

experts without political ideologies. Do such experts exist?

http://www.youtube.com/watch?v=FJ6E3cShcVU


In a command (or planned) society, a central authority decides what to produce. Often it enacts long-term plans—such as the China’s infamous Five Year Plans. They may not work perfectly, since it is hard to dictate factors like climate and worker productivity, but they still help to steer the economy.

The United States relies mostly on the market to decide what and how much to produce. However, the government also uses regulations and tax incentives to encourage firms to produce—or not produce—certain goods. For example, it requires a certain percentage of a manufacturer’s new cars produce zero emissions, and, in San Francisco, it has outlawed McDonald’s Happy Meals. It also directly produces many goods and services, from army rations to postage stamps.

How to produce?

This is a question of how to use scarce resources to produce the goods and services we want. Should we subsidize farmers who farm organically? Should companies in the United Kingdom outsource all customer support to call centers in India—or, as Indian wages 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 leads to the most profit.

In a planned economy, the government or a central authority decides how to produce. This has resulted in some success stories but also some disasters, such as Mao Zedong’s decision to have steel produced in rural Chinese villages. The resulting steel was useless; desperate farmers even melted their tools to meet Mao’s demands, helping lead to a famine that killed millions.

In a mixed market system, this question of how to produce is answered by both the market and the government. Firms try to produce in ways that maximize profit. The government may subsidize less efficient industries to ensure they can compete or deliver needed services. For example, the United States government subsidizes Amtrak (its national train service) because, if it were fully private, it would probably also be fully bankrupt.

The government also imposes regulations. For example, in most developed countries, firms can’t set up sweatshops to produce goods—though they can usually still import goods from sweatshops abroad. Governments dictate pollution limits, safety standards, and consumer rights.

Who receives the benefits of production?

While the first two questions were mainly questions of efficiency, the third is mainly a question of equity, or fairness. 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?

A major advantage of a communist planned economy, in theory, 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 promise is what drew people to design such economies in the first place. But the central authority may be corrupt or overwhelmed—or it may value equity at the expense of opportunity.

In mixed market economies, the question of who receives the benefits of production is answered by

Running (a long way between) the tables When I ate at a restaurant in Batumi, Georgia in 2000, I saw plenty of evidence of the country’s

recent communist past. A few small tables dotted a large room, ten waiters were standing around, 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 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.


both the market and the government. Public education is usually offered to everyone—often, health care too—and there are many programs that transfer money directly to those in need. All residents benefit from highways, trash collection, and water projects, but not all can drive fancy cars or eat sushi every night. Market forces decide who will receive those more elite benefits.

We can differentiate economic systems by comparing who answers the basic economic questions:

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 that actors29 respond predictably to incentives. A self-interested individual or firm will consider all benefits and costs when making a decision. By introducing new benefits and costs into a situation, incentives can be used to motivate people to make decisions in a desirable way.

A positive incentive is a reward for behavior meant to encourage that behavior. If my kitten decides to use the litter box, I reward her with a tasty hummingbird. This positive incentive encourages her to use the litter box consistently—and reduces the chance of her peeing on my carpet. An airline will give out frequent flyer miles to people who fly it often. The goal is to give people a reason to keep flying that airline, by promising that the points will lead to special privileges—such as upgrades.

A negative incentive is a punishment for an undesirable behavior. If my kitten pees on the carpet, I sternly scold her, and maybe refuse to let her sleep on the human bed. This negative incentive discourages her from peeing on the carpet again. In a similar way, police departments issue fines to discourage speeding. These fines are not just meant to punish speeders; the fear of them is meant to keep us from speeding in the first place.

Assume Jonathan is a typical student. If you offer him $50 to bring you a nearby yogurt, it is easy to predict he will do it. If you ball up a fist and threaten to break his jaw unless he brings you the yogurt, he will probably do it, too.30 To Jonathan, the $50 is a positive incentive for bringing you the yogurt, and being punched is a negative incentive for not bringing it. That you might be expelled for punching him in the jaw is probably irrelevant to his decision-making. He wants not to be hurt more than he wants you to be kicked out of school.

Jonathan’s responses are predictable because he responds in the way that maximizes his total utility.

Then again, $50 might not be enough of a positive incentive to someone else. Jonathan’s classmate Jacqueline might be so offended at the idea of taking your orders that the negative utility of obeying you would outweigh a $50 gain. (Of course, it might not outweigh a broken jaw.) 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 it as a negative incentive, we can predict she will avoid it. Both are maximizing utility.

Economists assume people behave according to rational self-interest. The study of economics does not treat people as good or evil, just as logical, well-informed, and self-motivated. Recent research

29 Not the Hollywood sort. These actors are more like you, me, Rwanda, and the Microsoft Corporation. 30 Unless he’s Chuck Norris, in which case he’ll find a way to knock you unconscious with the yogurt.

Debate it! Resolved: That people are motivated mainly by self-interest.


suggests people may not be that rational after all.31 Still, in aggregate, the assumption that people are rational will help us understand the economy.

Self-interest is not always about money. People can also be deeply interested in things such as family, love, and glory—and thus can be motivated by both monetary and non-monetary incentives.

Suppose you’re a manager at a company hoping to make its low-paid workers more efficient and enthusiastic. You could raise their wages—but suppose you wanted to use non-monetary incentives. You could rename them “associates” and award the best ones with special prizes. You might also remind them often of how important they are to you and of what a difference they are making. 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 at what prices.

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 the profit motive. Most people desire more things. Those who work harder tend to earn more and achieve a higher standard of living. 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. Some consumers are willing to pay more to ensure they get what they want. In a competitive market, inefficient firms and producers are forced out of business.

Limited Role of Government

In general, market economists believe efficiency declines if the government interferes with a market, leading to higher prices and less output. But most market economists accept that the government has a role to play. For example, it enforces laws that protect private property. A more controversial role is to “level the playing field” by regulating or even breaking up monopolies and trusts.

Voluntary Exchange

In an exchange, you trade one thing for another. You can trade something for money, or for another resource, good, or service. We’re mostly concerned with voluntary exchanges, but involuntary exchanges occur too—for example, if the government seizes your house to build a highway.32

Voluntary exchanges are easy to imagine because 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 basketball teams trade players, they both expect benefits; no one goes into a trade looking to lose. 31 I’m surprised this took a while to figure out. 32 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.

http://www.youtube.com/watch?v=jwgHIaU6tVU


One form of voluntary exchange is barter, which happens when we exchange resources, goods, or services for other resources, goods or services. No money changes hands. We have no trouble making an occasional exchange without money, but it would be terribly hard to run a whole economy that way.

Barter only works if there is a double coincidence of wants. It is not enough for you to have what I want. You must also want what I have.

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 says she is allergic to fish but would trade a hammer for 15 eggs. Okay—you go to the chicken-farmer and ask him to trade 10 fish for 15 eggs. He says fish make him gag but he loves spaghetti. It so happens that his neighbor grows spaghetti and loves fish. You walk next door and offer 10 fish in exchange for spaghetti. It’s a deal! You trade the spaghetti to the chicken-farmer for eggs, and trade the eggs to the hammer-maker for a 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 serving 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 find spaghetti, 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.

Specialization and Division of Labor

If you ever read Laura Ingalls Wilder’s classic Little House on the Prairie, you may have been stunned by her family’s self-sufficiency. Her mom ground wheat into flour, baked bread, raised chickens and cows, did laundry, cooked meals, 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 homes and wagons. He trained horses, slaughtered pigs, and even shot raccoons to make fur hats.

Suppose we somehow send this guide back in time. Laura’s mom finds it on the prairie and opens it to this section. “Wow,” she says, “I’ve had it all wrong. We may be self-sufficient, but we’re awfully inefficient.” She hastily runs door to door and gathers five farmwives for “something important.” They meet in her kitchen, where she asks each how productive she is at a series of chores.

In writing down the data, Laura’s mom observes that each of them is particularly skilled at one task. She circles each woman’s productive specialty.

33 It gets old, especially when the tide rises and takes away your backpack. I’m glad it didn’t take away my tent.

Even the most primitive economies have found ways to avoid barter.


Name

Productive Output for One Month Pounds of

Flour Ground Children Raised

Loaves of Bread Baked

Chickens Raised

Cows Raised

Loads of Laundry Done

Anna-Lee 3 2 16 6 1 12

Barbara-Jean 1 2 15 8 1 15

Laura’s Mom 2 4 14 7 1 28 Mae-Belle 1 3 13 5 3 16 Mae-Jean 1 5 20 4 2 20

Sarah 2 6 8 6 1 26 Group Total 10 22 86 36 9 117

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. There has got to be a better way. They decide to pool their efforts. Each can specialize, or do the thing she does best, and then they can share their products. The women agree to work together and become interdependent.

Fast-forward a year. Laura’s mom calls a meeting. She estimates their new group productive capacity:

Name

Productive Output for One Month Pounds of

Flour Ground Children Raised

Loaves of Bread Baked

Chickens Raised

Cows Raised

Loads of Laundry Done

Anna-Lee 30 0 0 0 0 0 Barbara-Jean 0 0 0 36 0 0 Laura’s Mom 0 0 0 0 0 150

Mae-Belle 0 0 0 0 9 0 Mae-Jean 0 0 200 0 0 0

Sarah 0 22 0 0 0 0 Group Total 30 22 200 36 9 150

Previous Total 10 22 86 36 9 117 Increase 20 - 114 - - 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 tend to be specialists. Some people fix cars or bake for fun, but most people specialize in specific skills, and use their income to buy other goods and services. Like the women in the co-op, people today are also interdependent. To earn a living doing what we are good at, we count on others to specialize in things we are not good at—but still need.

If, in college, you like critical thinking and you have writing skills, you could go on to study 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 would be very mixed up. As a lawyer, if you become sick, you will be dependent on a doctor; if, as a doctor, you are sued, you will need a lawyer to represent you. In either profession, you will be dependent on other specialists. The result is overall interdependence.

The assembly line is a classic example of division of labor: splitting production into separate tasks. Workers on an assembly line focus on one small part of a process; they become very specialized. The

34 The space-time continuum has probably been destroyed, but who’s counting?


downside is that they are so interdependent that if one worker falls short, the whole process could fail. Assembly line workers might also grow bored, and are often easy to replace with machines.

The Basics of Trade

A country, too, can improve quality of life for its people by trading with other countries. Any country 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 supermarket35, you have purchased a Malaysian import of a French export.

Trade allows countries to consume at points outside their PPFs. Like the housewives from Little House on the Prairie, they can specialize in what they produce most efficiently compared to other countries—and then trade for what those other countries produce most efficiently. Relative efficiency can be determined by comparing countries’ opportunity costs. The law of comparative advantage holds that whenever two countries producing two goods face different opportunity costs, they can benefit from trade—each trading the good for which it has a lower opportunity cost.

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 indicates whether a country is importing 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 and a surplus with another at the same time.

Sometimes countries want to import less of something—perhaps in order to encourage their own companies to manufacture it, even if they are not as efficient as foreign companies. 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. They can also be used to pressure or punish a would-be trading partner.

The most common trade barrier is a tariff, a tax on an import. Another is a quota, which limit on how much of a good can be imported. The most restrictive trade barrier is an embargo, which limits imports to zero. Embargos can be imposed on a single good, an industry, a country, or any combination of these—for example, on all cigars from Cuba.

To better understand why a country might want to impose a trade barrier, we will need to explore first microeconomics and then macroeconomics.

35 For example, at the World Scholar’s Cup World Finals in June 2011.

Mini-Directed Research Area: The WTO Over the last hundred years, the world has trended toward free trade. Free trade zones such as the European Union-----in which member countries can trade without any tariffs or quotas-----are appearing all over the globe, from NAFTA (in North America) to Mercosur (in South America). The most important global institution overseeing free trade is the World Trade Organization. Some questions to investigate:

• What is the WTO? Who belongs to it?

• How does the WTO relate to the General Agreement on Trades and Tariffs?

• How does the WTO work?

• What are some major issues facing the WTO? You can begin your exploration here: news.bbc.co.uk/2/hi/europe/country_profiles/2429503.stm

http://news.bbc.co.uk/2/hi/europe/country_profiles/2429503.stm#overview


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. We isolate specific markets to explore how they work and what

will cause them 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 made at a microeconomic level.

In macroeconomics, we look at the overall economy and at how its parts interact. We might measure its size or try to assess its health. We might also try to predict—rightly or wrongly—how a policy change could affect economic stability. In this resource, we explore first microeconomics and then macroeconomics. Much of what you learn in “micro” will be important to understanding “macro.”

Markets

We define 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 Exchange36 are all markets.

In the jargon of economics, 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. There’s an old saying: if you teach a parrot to repeat “supply and demand” you will have trained an economist. In this section, you will read about supply and demand, but they are only the beginning.

Prices

Without prices, markets would make little sense. 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-not37—so people can use them to make rational decisions.

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.

Now we’ll look into the meat of economics, supply and demand, to see what determines prices.

36 The New York Stock Exchange was just purchased by a stock exchange in Germany. Score one for the Deutschland. 37 Or, technically, what-notes.


Demand

In 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 increases, the quantity demanded will decrease. Similarly:

The quantity demanded of any good or service increases as the price of the good or service decreases.

This inverse relationship is known as the Law of Demand.

A demand schedule shows the quantities of a good or service consumers are willing and able to buy at different prices. The table is a demand schedule for 3D TVs. At low prices, such as $400 per TV, the quantity demanded is high; at high prices, like $1000 per TV, the quantity demanded is much lower.

If we plot a demand schedule on a graph, the result is a demand curve. To the right is one for TVs.

Now let’s look at the demand for another good: DECADOGS, a new line of smart hot dogs. The second table shown 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. Both are downward-sloping. They begin high above the origin, but move downward from left to right. The downward slope is a graphical representation of the law of demand: as price decreases, quantity demanded increases.

The income effect helps explain why demand curves downward. If a good’s price falls, people buying it are left with more money to spend. The price decrease feels like an increase in income. It results in a higher quantity demanded of that good—and of other goods too.38

Another reason the curve slopes downward is the substitution effect: as a good’s price falls, consumers choose it over other goods. If beef grows cheaper, you might buy less chicken and more beef. Moving down in price means moving right on quantity.

Demand vs. Quantity Demanded

We must be very clear about the difference between demand and quantity demanded. Every economics exam tests this pesky detail. Demand refers to the

38 The exceptions would be inferior goods. We’ll get to them soon.

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

DEMAND FOR DECADOGS Price ($) Quantity Demanded

.10 100

.25 75

.50 30

.70 15 1.00 5 2.00 2


entire curve—to an entire set of prices and quantities demanded. If price goes down, quantity demanded goes up—but the demand curve is unchanged. We still face the same conditions, just at a different point on the curve.

If price changes, there is movement along the curve to a new quantity demanded.

If demand changes, there is a movement of the curve to the left or right.

I know a teacher who throws a foam brick at students who claim price changes affect demand. It’s less scary over time—diminishing returns—but the lesson holds: demand and quantity demanded are not the same.

When demand increases, the curve shifts to the right. At each possible price, the quantity demanded is higher.

When demand decreases, the curve shifts to the left. Again, for each possible price, the quantity demanded is lower.

The demand curve can shift for several reasons. 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

Remember Steve, our hungry runner? Suppose he earns an allowance from his parents for doing the dishes and cleaning out the toaster. He uses all his earnings to buy waffles—but, because his allowance is low, he can only buy a few waffles at a time.

One day, Steve’s mother decides to raise his allowance—hurray! What will he do with the extra cash? Buy more waffles, of course. Imagine if a million Steves all received raises. The market demand for waffles would increase dramatically: the demand curve would shift to the right.

Usually, when consumers have more money, they demand more of a good. At each price along the new demand curve, consumers are willing and able to buy greater quantities. If the demand for a good increases when consumer income increases, the good is said to be normal. A TV is an example of a normal good; if your income increases, you might buy a nicer TV.


Not all goods are normal. When people have more money, there are some goods they avoid. When they have less, they buy more of these inferior goods. Many people discover inferior goods the first time they live on their own. Ramen noodles are an inferior good, as are macaroni-and-cheese dinners (the kind in little envelopes full of orange cheese-powder). American college students eat a lot of ramen and macaroni-and-cheese. Some love them, but, for most, it comes down to this: you can buy a lot of them for a dollar. Many students work part-time, if at all, and for little pay. Students are also new to budgeting, and are often strapped for cash when rent or tuition is due. That’s about when the demand for ramen and macaroni-and-cheese shifts to the right. When student loan checks come in, students suddenly start eating out, and the demand for ramen falls.

Luxury goods include Maseratis, yachts, and caviar. They are similar to normal goods in that people buy more as their incomes increase, but different in that, as they earn more, they spend a larger percentage of their income on them. (This should make sense, as you would spend zero percent of your income on things 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 heart disease39, 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 word gets out that car prices will come down next week, most people stop buying cars. Only a few desperate (or rich) buyers stay in the market at the current price. Because demand is falling, equilibrium price should actually decline sooner than expected.

Current demand will always decrease if consumers expect prices will be lower in the future.

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 prices will fall leads prices to fall. This kind of analysis is sometimes referred to as the theory of rational expectations.

Changes in Prices of Substitutes and Complements

A substitute good is one that 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 it decreases—leaving more people looking for a replacement good.

39 Maybe those DECADOGS weren’t so healthy after all.


This means the demand for the substitute good will increase, as the number of people in the market for it has increased. Presumably there was a reason they wanted the original good, and that drives them to become consumers of the substitute.

Suppose that, on hot days, you drink iced chai or lemonade. Both options cost the same amount. You usually choose chai because you like it better. But, if chai became more expensive, you’d probably buy less of it. To keep 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 cause the demand curve for lemonade to shift to the right.

A complementary good is associated with another good because both are consumed together. Peanut butter and jelly are complements. Laser printers and toner cartridges are complements. If the price of a good increases, the quantity demanded of the good will decrease, and the demand for its complement will decrease too, since fewer people will need it.

Imagine you’re in your posh office at DECADOGS HQ. You’ve just found a mustard stain on your shirt40 when your assistant charges in, her face pale. She places both hands on your desk and gasps, “Bad news! The price of hot dog buns is… on the rise!”

You jump to your feet. Forget the mustard stain: as CEO, and an astute economist, you know this is bad news. If the price of hot dog buns rises, you think, the quantity demanded of hot dog buns will fall, which means people will eat fewer hot dog buns, which means they’ll need… fewer DECADOGS.

“Oh no,” you say out loud, “Our demand curve is about to shift to the left.”

Remember: changing the price of a good will never change the demand (i.e. shift the demand curve) 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 (like chai and lemonade). An increase in the price of a good causes an increase in the demand for its substitute.

• Two goods are complements if they go together (like hot dog buns and DECADOGS). An increase in the price of a good causes a decrease in demand for its complements.

40 Hopefully the dry cleaner will get the mustard out.

http://www.youtube.com/watch?v=qDbAgPmqRw0

http://www.youtube.com/watch?v=d_fcXR6t14k


Changes in Consumer Tastes and Preferences

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 demand. If consumer taste changes to favor a good, then the demand for that good will increase—its demand curve will shift right.

Tickle-Me-Elmos were once such popular Christmas gifts that Americans literally fought in the aisles to buy them for up to $300 each—twenty times their list price! Effective advertising and social trendiness caused more consumers to join the population willing to pay $300 for a Tickle-Me-Elmo. For a short time, the demand curve soared 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 savvy folks bought extra iPhones, planning to resell them at top dollar on eBay. But no one was interested in buying them at a premium, because 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. It convinced many consumers to leave the population willing and able to buy and eat baked goods and spaghetti.41 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”—when it is most desirable—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, Chinese New Year firecrackers, menorah candles, Valentine’s Day cards, and swimwear. No one wants Christmas wrapping paper in July.

Supply

In the language of economics, supply is the relationship between the price of a good or service and the quantity supplied.42

The general relationship between price and quantity supplied is known as the law of supply: as the price of a good or service increases, the quantity supplied will also increase.

41 What would the impact be on the demand for Noodlebushes? 42 Mathematically, supply is a function that maps price to quantity supplied.

SUPPLY SCHEDULE FOR TVS Price per Number of TVs

TV Supplied $1100 3100 $1000 2400 $900 1800 $800 1300 $700 900 $600 500 $500 300 $400 200


A supply schedule shows the various quantities of a good or service that producers are willing and able to produce and sell at each price within a range of prices. The table below is a supply schedule for TVs. Notice that at lower prices, such as $400, quantity supplied is low, whereas at higher prices, like $1000, quantity supplied is high.

At any price above production cost, there will be a producer willing to supply a good or service. At lower prices, producers will only be willing to make a smaller amount—because they cannot make as much revenue. Opportunity costs rise.

If we plot the data from a supply schedule into a graph, we arrive at a supply curve. To the right is a curve for the supply of TVs. Recall that a demand curve is typically downward-sloping. The supply curve is the opposite—it is upward-sloping. A typical supply curve has a positive slope.

Supply vs. Quantity Supplied

Just as with demand, we must be super clear about the difference between supply and quantity supplied.

If there is a price change, there is movement along the supply curve until we reach a new quantity supplied.

If supply changes, there is a movement of the supply curve to the right or left.

The supply curve answers questions like, “When the price is $1.50, how many DECADOGS are supplied?” and “What price will result in 500 DECADOGS supplied?”

The main reasons the supply curve might shift are:

a change in the factors of production a change in production technology the expectation of a price change a change in the number of suppliers

We will discuss each of these reasons below.

Changes in the Factors of Production

Economics assumes producers supply goods and services to make a profit.43 Factors of production are the “ingredients” producers use to make their goods and services. If these ingredients become less expensive, producers earn more profit. Producers become willing to make more of the product. New producers also enter the market (if possible). At each price on the supply curve, there will be a greater quantity supplied; the supply curve shifts to the right.

On the other hand, if the factors of production 43 Profit can be defined broadly to include social benefits that producers find valuable; this helps explain why some people are willing to work in the non-profit sector.


increase in price, some producers will decide to stop producing, and some might leave the market. At each price along the supply curve, a lower quantity will be supplied. The supply curve shifts to the left.

Let’s go back to DECADOGS. If the price of low-quality 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 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 squirrels44 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.

Changes in 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.

Suppose a bright intern at DECADOGS invents a new Dog-o-Lator, a machine that produces hot dogs at double speed. Your company can now supply twice as many DECADOGS at any given price. To reflect the sudden increase in quantity supplied, the supply curve shifts to the right.

Expectation of a Price Change

If suppliers expect the price for a good or service to go up in the future, they will be less willing to supply it now. (At the same time, consumers will be more eager to buy it.) Suppliers will want to hold onto their product so they can have more to sell when the price is higher. Until the price increase happens—and there is a risk it might not—quantity supplied falls at each possible price. Expectations cause the supply curve to shift to the left.

If suppliers expect the market price of their good to go down, they will want to sell more of it now, while they can still sell at the higher price. At each price along the supply curve, they will be willing to supply more. The supply curve will shift right.

You might find it helpful to think like a supplier. If

44 But never, ever alpacas.


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 iPads 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 product, there will be more suppliers able and willing to produce and sell it at each price on the supply curve. The curve will shift to the right. The opposite is also true: a decrease in the number of suppliers will shift the supply curve to the left.

Suppose half the suppliers of bicycle wheels are hit by the bubonic plague. The plague also destroys all their shops and equipment.45 At every given price, quantity supplied decreases by half, because there are only half as many suppliers who can produce and sell bicycle wheels. The supply curve shifts left.

Market Equilibrium

If we plot the supply and demand curves on one graph, the curves intersect. The point at which they intersect is the point of market equilibrium. At this point, quantity supplied equals quantity demanded. The market clears—every unit produced sells.

At market equilibrium, buyers purchase everything producers are willing to sell. Every unit produced is consumed—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 known as 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 at the exchange price.

You can use a graph of equilibrium to predict the net effect of a shift in supply or demand on the market.

45 Don’t ask how. It’s an example.


Suppose you want to know what will happen to the macaroni-and-cheese market if the average income of college students increases. Because macaroni-and-cheese is an inferior good, the increase in income will cause demand to shift to the left, but it will not affect supply. In the new equilibrium, the exchange price and quantity will be lower.

Once more into the hot dog industry. When your intern invented the Dog-o-Lator, you were able to increase production. Supply of DECADOGS shifted to the right. As a result, the exchange price fell—good news for customers. At the same time, the exchange quantity increased—good news for you.

Suppose you had just returned from overseeing the installation of the Dog-o-Lator when you learned the price of hot dog buns was rising. Your supply curve had shifted to the right thanks to the Dog-o-Lator, but now demand was shifting to the left.46

Without more details, the overall change in quantity exchanged after these two shifts would be ambiguous. There would be no way of knowing how much the exchange quantity would change in the new equilibrium. All we know for certain is that the exchange price would be lower.

Summarizing Equilibrium Changes

When supply and demand move different directions, the equilibrium price follows what happens to demand. If supply decreases and demand increases, price increases. If supply increases and demand decreases, price decreases.

If supply and demand move the same direction, equilibrium quantity moves in that direction, too. If both supply and demand increase, so does equilibrium quantity. If both decrease, so does quantity.

The table summarizes this. Try not to memorize it—draw the curves and see what happens when you shift either or both left or right.

Consumer and Producer Surplus

Suppose you would pay up to $50 for an alpaca finger puppet—but someone47 gives you one for free at competition. You’ve gained a lot of value at no cost—$50 of value, in fact. Economists call this value your consumer surplus.

46 Remember, hot dog buns are complements to DECADOG meat. If hot dog buns are too pricey, consumers won’t buy as many buns—and thus won’t need to buy as many DECADOGS either. 47 Probably me (a.k.a. DemiDec Dan.)

If demand increases…

If demand decreases…

If supply increases…

Equilibrium price change is ambiguous. Equilibrium quantity

increases.

Equilibrium price decreases.

Equilibrium quantity change is ambiguous.

If supply decreases…

Equilibrium price increases.

Equilibrium quantity change is ambiguous.

Equilibrium price change is ambiguous.

Equilibrium quantity decreases.


A consumer surplus exists even when you’re paying for things that have prices. If Amazon sold the same puppet for $10, and you bought one, you’d still come away with a consumer surplus of $40: $40 you would have been spent, but didn’t have to.

Producers experience something similar. Suppose you were a maker of alpaca finger puppets in the mountains of Peru. You’re willing to sell your puppets at $4 each, because that’s how much it costs you to make them. But, thanks to strong demand from an importer in the United States48, the market equilibrium price is $15. You’re able to sell your puppets for $11 more than your bottom line. That $11 is your producer surplus.

Price and Wage Controls

Sometimes governments enact price and wage controls. They set maximum or minimum prices for a good or service. The United States imposed such controls widely during World War II, and they are still found in many markets around the world—such as for domestic airfares in China.

By definition, effective price controls interfere with equilibrium. Otherwise, they would have no impact on the market. There are two main forms of price control. 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 equilibrium price. Since price is higher than at equilibrium, there will be a greater quantity supplied than demanded. The result: a surplus.

A price ceiling is the top price for which something may be sold. A price ceiling must be set below the equilibrium price to have any effect. A price ceiling set below the equilibrium price leads to a shortage: a greater quantity demanded than supplied.

Consider the minimum wage—an example of a price floor. It imposes a minimum price at which laborers may sell their labor. A minimum wage usually results in a surplus of labor: more workers will be willing to work at the minimum wage than there will be employers willing to pay them. Some of these workers would be willing to work below the minimum wage but are no longer allowed to. Since labor is a factor of production, higher labor costs reduce supply.

48 Guess who.


It can be tempting to set a high minimum wage, but society must decide if the trade-off is worth it. Some workers will make more; some will make nothing.

In the United States, price floors are often imposed on agriculture to keep farmers in business. The result: farmers grow more crops than consumers want at the minimum price. The government buys 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, where rent controls take many forms. Some are outright limits; others restrict how quickly rent can rise. Current renters benefit from lower rent, but landlords earn less than they otherwise could. They may let apartments deteriorate or even use them for more profitable purposes—such as cultivating illegal drugs. Would-be renters face a shortage of units; would-be landlords have less reason to invest in buildings, depressing property values.

Those squeezed out of legal market by price controls may participate in a so-called black market: an illegal, unreported market for goods and services. Black markets were common in communist nations, and also appear in prisons for goods such as cigarettes. They are considered part of the underground economy.

Be careful not to confuse price floors and ceilings. If we put them on the same graph, they form an upside-down house: the floor is above the ceiling.49 The gaps where the floor and ceiling intersect supply and demand are surpluses and shortages, respectively.

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.

Utility and Income

Suppose you are at a bookstore (if any still exist) choosing between economics books and vampire romance novels. Perhaps you gain 10 utils from reading an econ book, and four from a vampire novel. In other words, you would obtain as much utility from two econ books as from five vampire novels: 20 utils in all.

An economist would call you indifferent between the two combinations. Both offer the same utility. How to

49 I’m sure this would be very awkward. Economics isn’t always about common sense.


decide which combination to buy? You might say, “I’ll buy whichever costs less!”

An economist would analyze this decision using indifference curves. An indifference curve displays all the combinations of two goods that bring you the same utility—meaning these are combinations between which you would, in theory, be indifferent.

If an indifference curve is close to the origin, all the combinations of goods along it do not bring you too much utility. The further out the curve, the more utility all the combinations on the curve offer.

The indifference curves on the last page represent utility from combinations of two candy bars: Mounds and Almond Joys. Like most indifference curves, they bow inward toward the origin. They curve like this because most people like variety—preferring a mix of two goods over lots of just one.50

Examine curve A. At any point on A, your total utility is the same. You would be as satisfied with five Mounds and one Almond Joy as with two of each. The same is true on curve B. You would be equally content with any point on B. The difference between the two curves is that B is further from the origin, so your total utility at any point on B is higher than at any point on A.

Utility is a tricky matter. We have no way of knowing how much more utility curve B offers than curve A; we only know it offers more. Something we can measure is the marginal rate of substitution: the amount of one good you would give up for one more of the other at any point on an indifference curve.51 To the right, as you move from point X to point Y, the marginal rate of substitution is 3: you would give up three Mounds for one Almond Joy. At point Y, it is 1. From Y to Z it is 1/3: you would give up three Almond Joys for one Mounds.

Sadly, when we walk into a candy store, we can’t simply grab every bar we want. If we could, it would be difficult to pick a point on an indifference curve. In the real world, we have to pay for our candy, and that helps us decide what to buy. Suppose you have $2 and all candy bars cost 50 cents each. You can take home 4 Mounds, or 3 Mounds and an Almond Joy, or 2 of each, and so on. If you plot all your possibilities onto a graph, they form a budget line.

Where an indifference curve represents what you want, your budget line represents what you can afford. Budget lines are usually straight because the prices of goods tend to be fixed. Everything to the right of a budget line is impossible to afford, and every point on or under it is within reach.

50 Sometimes you feel like a nut, and sometimes you don’t. 51 This, for all you calculus buffs, is 𝑑 (𝑚𝑜𝑢𝑛𝑑𝑠)

𝑑 (𝑎𝑙𝑚𝑜𝑛𝑑 𝑗𝑜𝑦) .


To maximize your utility with your $2, you will buy a combination where one of your indifference curves touches the budget line at only one point. In mathematics, we call a line that touches a curve at only one point tangent to that curve. If a line crosses a curve at two points, it’s no good: there must still be another, more satisfying curve further out that still touches your budget line.

In this scenario, the indifference curve tangent to your budget line 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, is beyond your budget line. They do not touch. Curve B would make you happier, but you cannot 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. You should buy two of each bar.

Indifference curves are a good lesson in thinking like an economist, but you’ll drive people crazy if you try drawing them out at the shopping mall.

Elasticity

Suppose if you increased your study time 10%, your SAT 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.

The most studied form of elasticity in economics is the price elasticity of demand, which relates changes in quantity demanded to changes in price. A common way to calculate it is:

𝑀𝐸𝐷 =% 𝑖ℎ𝑇𝑖𝑔𝑀 𝑀𝑖 𝑞𝑀𝑇𝑖𝑀𝑀𝑀𝑦 𝑑𝑀𝑚𝑇𝑖𝑑𝑀𝑑

% 𝑖ℎ𝑇𝑖𝑔𝑀 𝑀𝑖 𝑀𝑀𝑀𝑖𝑀

If the PED for a good is greater than one, demand is price elastic. This means the percent changes in quantity demanded is greater than the percent change in price. Perhaps 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, 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 ½.

If PED equals one, demand is said to be unit elastic with respect to price. A 10% increase in price leads to a 10% decrease in quantity demanded.

If PED is 0, demand is perfectly inelastic with respect to price. A change in price has no effect on quantity demanded.

And if PED is infinite—that is, if any increase in price leads to a decrease of quantity demanded to zero—demand is said to be 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 change, you would probably still prefer to pay a bit more than to find a salt substitute. If the price of salt went down, you probably would not increase your consumption of it very much. What could you do with more salt?

Ground beef is an example of a much less necessary good. The demand for ground beef tends to be more price-elastic than the demand for salt. Ground beef is not expensive, and many people find it delicious in the form of hamburgers. But, because it has many substitutes, demand for ground beef is


elastic. If its price went up a lot, people could switch to ostrich, buffalo, or even tofu burgers. These are all substitutes for ground beef.

There are three main reasons why the demand for a good might be price-inelastic:

A good is considered a “necessity.” Many people, for example, need certain prescription drugs to help keep them alive. The demand for those drugs is therefore very price-inelastic.

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 us to stop buying it when the price goes up. However, a Lexus is expensive enough that if the price increases ten percent, a rational consumer will consider a different luxury car.

A firm can gain from knowing the price elasticity of demand for its product. If demand is price-elastic, it has to be careful about raising its price; it could lose revenue. If a firm knows demand is price-inelastic, it has the power to increase revenue simply by increasing its price. Some firms spend giant amounts on advertising, hoping to convince customers their products have no substitutes—so 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 increase, you sell only 150 pairs per day. You can use this information to calculate the price elasticity of demand for Tevas in your store:

𝑀𝐸𝐷 (𝑇𝑀𝑣𝑇𝑖) =% 𝑖ℎ𝑇𝑖𝑔𝑀 𝑀𝑖 𝑞𝑀𝑇𝑖𝑀𝑀𝑀𝑦 𝑑𝑀𝑚𝑇𝑖𝑑𝑀𝑑

% 𝑖ℎ𝑇𝑖𝑔𝑀 𝑀𝑖 𝑀𝑀𝑀𝑖𝑀

= �200 𝑝𝑎𝑖𝑟𝑠−150 𝑝𝑎𝑖𝑟𝑠

200 𝑝𝑎𝑖𝑟𝑠$60 𝑝𝑒𝑟 𝑝𝑎𝑖𝑟−$70 𝑝𝑒𝑟 𝑝𝑎𝑖𝑟

$60 𝑝𝑒𝑟 𝑝𝑎𝑖𝑟

�

= 0.25

0.1667= 1.4997

As it turns out, demand for Tevas is price-elastic. You have to be careful about raising prices, because doing so could decrease quantity demanded so much your store will actually bring in less revenue.

This outcome suggests a quick way to determine if demand is price-elastic: compare total revenue before and after a price change. Here, you were selling 200 pairs for $60 apiece, so you were earning $12,000 daily. After the price increase, you sold 150 pairs for $70 apiece, bringing in only $10,500 in revenue per day—a $1,500 decrease.

As a rule of thumb, if you raise prices and…

… revenue decreases, demand is price-elastic. … revenue increases, demand is price-inelastic. … revenue does not change, demand is unit-price-elastic. … revenue plunges to zero, demand is perfectly price-elastic. … quantity demanded doesn’t change, demand is perfectly price-inelastic.


You increased prices and total revenue decreased, so you could have inferred the demand for Tevas 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

A market brings buyers and sellers together; markets mentioned in this guide so far have included eBay and supermarkets. In microeconomics, we define a market more precisely as all the buyers and sellers of a given product or service. There is a market for shampoo, a market for travel guides, etc.

We can classify each market by its market structure, as determined 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 many markets, suppliers engage in price competition, raising and lowering prices to attract customers. In others, suppliers cannot change their prices, so they engage in non-price competition.

Market structures are also distinguished by the uniformity of the product from one seller to the next. In some markets, the product is exactly the same no matter who makes it. In others, the product is so unique that there is only one seller.

Barriers to entry also vary. If there are no barriers to entry, sellers can easily enter or leave a market. This greatly affects the degree of competition.

Below we will explore four different market structures, from the most to the least competitive:

Perfect Competition

The classic example of perfect competition is the market for wheat. There are many farmers selling a virtually indistinguishable product; everyone has to charge the same price because there is no way to tell one wheat crop apart from another. New farmers can easily set up wheat fields, and existing farmers can easily leave the market and use their land to grow something else.

A perfectly competitive market has many buyers and sellers. There are no barriers to entry or exit: suppliers can join or leave whenever they want. The product is homogenous, so consumers don’t have a preference for one supplier’s version over another’s. A perfectly competitive market also assumes all participants have perfect information: equal and free access to knowledge about the price

Perfect Competition

(Most Competitive)

Monopolistic Competition Oligopoly

Monopoly (Least Comeptitive)


and availability of the product and about other buyers. Examples of perfectly competitive markets include nearly all farm products—rice, durian fruit, plums, etc.

In perfect competition, supply and demand set the market price. Each firm has a minimal impact on the market and must sell at whatever the market price is. Because there are so many buyers in a perfectly competitive market, a firm can sell as much as it wants at that price. The demand for any one firm’s product is perfectly elastic: if a firm raises its price, consumers will just shrug and go buy another firm’s product. A firm could lower its price, but this would only cost it revenue—since consumers would happily buy all its output at the market price anyway.

Economists describe firms in perfect competition as price takers; they “take” their price from the market. A firm has only to analyze its costs to decide how much to produce.

Monopolistic Competition

Monopolistic competition is the second-most competitive market structure. It features many buyers and sellers, and relatively few barriers to 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.

In monopolistic competition, all producers try to achieve product differentiation. They want to make their products seem better in taste, color, texture, or packaging. Most product differentiation comes down to effective branding. If advertising and word-of-mouth convince consumers a product has no close substitutes, they will tolerate higher prices. Two brands of pain medication are not very different, but you would never know it from the television commercials.

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 the same or only slightly different. Because there are so few sellers and each is large, they tend to be interdependent; each firm’s decisions affect all the other firms.

Barriers to entry are steep in an oligopoly. Natural barriers to entry exist when economies of scale favor a firm that has already developed the infrastructure and clientele to realize the savings of large-scale production. For instance, it would be expensive to start a new steel company, and it would need

Debate it! Resolved: That companies should not be allowed to

exaggerate distinctions between their products.


to begin by producing less steel than its established competitors—making the production process more expensive.

Artificial barriers to entry include patents, government regulation52, and import quotas. If three firms have patents for all the ways to manufacture the cure to the cold, no one else will be able to enter the market until those patents have expired, even if the drugs are inexpensive to produce.

In an oligopoly, if one firm lowers its price, others are forced to imitate it. When American Airlines puts flights on sale, United Airlines matches the sale right away. But when one firm raises its price, other firms tend to keep their prices the same—forcing the original firm either to lose business or to return to the original price. The result of this behavior can be seen in the kinked demand curve displayed above. This model concludes that if one firm lowers its prices, other firms will do the same, but no one will follow an increase in price.53

The firms in an oligopoly are limited to mostly non-price competition. For example, an airline might offer more comfortable seating or a larger checked baggage allowance. It could lower its fares, and airlines often do, but this usually starts 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 in an oligopoly watches the pricing and non-price incentives offered by other firms. Oligopolistic firms that discuss pricing decisions are said to be operating as a cartel. Because they prevent competition, cartels are illegal in the United States and in most of the world.

The markets for cars, breakfast cereals54, light bulbs, and air travel are examples of oligopolies.

Monopoly

In a monopoly, there is only one seller of a good or service with no close substitutes. Consumers have no choice but to buy from the one seller.

The barriers to entry into a monopoly are steep.

Natural monopolies develop in markets with high capital investment costs—such as public utilities, gas pipelines, and railroads. Imagine the fixed cost of building high speed railroad tracks for the entirety of China. It would be very expensive—costing billions—for a second company to enter the market and 52 Government regulations are often meant to limit foreign competition. Thus, 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 pick up only fuel, not passengers. If not for this regulation, Qantas could compete with domestic American airlines on this route. 53 For a price increase to stick, all firms in an oligopoly must quickly decide to go along with it. 54 Breakfast cereals are less an oligopoly than they once were, thanks to countless new organic cereals entering the market. But two companies—General Mills and Post—still control the bulk of cereal sales in the United States.

Creative Destruction 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 fusion 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

market upheaval: creative destruction.


lay down its own set of tracks. It would also be very expensive for a second electric utility company to string new power lines to all the houses in a city.

Exclusive ownership of a natural resource can lead to a monopoly. Suppose you control the only well on a desert planet. Everyone has to buy their water from you. You have complete market power, since there are no substitutes for water and no other sources. One famous real-world example of this scenario is the market for diamonds. One firm—De Beers—controlled 80% of world diamond production until the year 2000. While 80% was not a total monopoly, it was close enough to give De Beers great power over the market.

In a technological monopoly, a firm is the only seller of a product because only it has the technology to produce it—and it stays that way because the government has granted it a patent to protect ownership of the technology. Patents are meant to reward those who come up with new ideas—they are positive incentives.

The government can create an artificial monopoly, as when the United States granted its postal service a monopoly on mail. Firms such as FedEx can deliver packages to front doors, but not letters to mailboxes. The government sets up a monopoly if it has a special interest in a market; in this case, it wanted to ensure everyone had access to affordable mail.

A monopoly firm has market power. It can choose what price to charge. The monopoly still faces a demand curve: fewer units will sell at higher prices. But the monopoly creates all the supply in the market. A monopoly can pick the price and level of output that maximizes its profit.

Economists point to at least three problems with monopolies. The first is contrived scarcity: when a monopoly limits production so it can charge a higher price. Suppose a towel costs $11 to make. A monopoly that produces towels could sell 1,000 towels for $12 apiece, profiting $1 per towel—a

55 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. 56 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.

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 can charge. Assuming people’s consumption of electricity is price-inelastic, the utility’s profit won’t change much at all.55 Suppose it weren’t forced to keep its original rate of return. What if the state were to set a price and then allow the utility to keep profits that resulted 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 is probably the answer.56


total of $1000 profit. Or, it could sell 800 for $14 apiece, profiting $3 per towel—a total of $2400 profit. If the firm were in a more competitive market, it would have to sell at a lower price, or consumers would choose a different supplier. But, as a monopoly, it can sell fewer units at a higher price, making $1,400 more than it would have in a competitive market.

Another problem with monopolies is deadweight loss. A monopoly tries to maximize its producer surplus—taking it from the consumer surplus. But some surplus is just lost—going neither to the producer nor to consumers.

A third problem is known as X-inefficiency. Monopolies have less incentive to reduce costs and be more efficient. They lack the competition that would drive out inefficient firms.

Some economists believe monopolies can enable dynamic efficiency, or more internal innovation. For decades, scientists at Bell Labs could perform futuristic research (they invented the laser!) because they were funded by a monopoly, AT&T. Smaller firms could not afford such far-out innovation.

The Production Decision

In theory, all firms look to maximize profit. A firm produces up to the point where the marginal revenue from selling one more unit does not exceed the marginal cost of producing it. In other words, they produce the quantity at which marginal revenue equals marginal cost, or MR=MC.

We can find this quantity 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 sell every unit at the market price. If the market price is $5, selling one more unit always brings in $5 of marginal revenue.

For nearly all firms, marginal cost varies by unit. At first, marginal cost is high because to produce just one unit, a factory has to be set up, supplies purchased, and staff hired. As a firm produces more units, marginal cost will decrease. Eventually, as the best available resources are used up, the marginal cost will begin to rise again—a case of the law of diminishing marginal returns.


Price Discrimination

When you fly to the World Scholar’s Cup, look at the person squeezed into seat next to you.57 The odds are good he paid more or less for his ticket than you did. He might be a business traveler paying extra to take a one-way flight. He might have bought a bargain web special that requires him to fly home on a specific day. Or he might be a friend of an employee flying for next-to-nothing—but risking not having a seat if the plane is full.

Airlines are not alone in charging different people different prices. Some 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 in the morning for the same reason: to fill seats that might otherwise be empty, since they have only a limited number of seats to sell at night.

The demand curve shows that, for any good, some people are willing to spend a lot, and others much less. If a producer can charge each person the highest price he or she is willing to spend, it radically increases its profit—thus, the early bird dinner and the web special.

Some critics believe price discrimination results in some people unfairly paying more than others; many economists think it creates a more efficient market. Your position on this may depend on whether you’re in seat 19K for $29 or in 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 • labor unions • corporations • legal systems • property rights

We will focus here on financial intermediaries, labor unions, and property rights.

Financial Intermediaries

A financial intermediary stores money that firms and individuals are saving, using it to make loans to or to invest in other people and firms. We can divide financial intermediaries into three major categories:

• depository institutions • contractual savings institutions • investment intermediaries

57 Don’t look too long. It’s considered bad airplane manners.

AMERICAN AIRLINES ECONOMY FARE TYPES

Y Full fare, Tier 1

B Discounted fare, Tier 2

H Discounted fare, Tier 3

K Discounted fare, Tier 4: Military

M Discounted fare, Tier 5: Tourism

L Discounted fare, Tier 6: Round-the-World

W Discounted fare, Tier 7: Special

V Discounted fare, Tier 8: Bereavement

G Discounted fare, Tier 9: Government

S Discounted fare, Tier 10: Consolidator

N Discounted fare, Tier 11: Deep-Discount

Q Discounted fare, Tier 12: Web Special

O Discounted fare, Tier 12: Industry

Depository Institutions Contractual Savings Institutions Investment Intermediaries

Banks Savings and loan associations

Credit unions

Insurance companies Pension funds

Government retirement funds

Finance companies Mutual funds

Money market funds


You are probably most familiar with depository institutions—the most common of which are banks. Banks accept deposits from customers in exchange for payments of interest. To earn a profit, banks invest the funds they have collected. They earn profits on their investments—more profit than they pay their depositors in interest. Banks and other depository institutions are important to a market economy because they enable consumption and investment to be spread out over time. People and firms can save for the future and borrow money to consume and make investments in the present.

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.

Trade and craft unions consist of workers with a common skill. Dating back to the guilds of the Middle Ages, they limit supply through licensing and other restrictions.

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 employee unions consist of government employees, such as teachers and police officers.

Labor unions engage in collective bargaining to negotiate wages, hours, and benefits. Collective bargaining helps unions secure better deals because it limits an employer’s ability to divide and conquer employees.

When negotiations go sour, unions might call for a strike. Striking union members refuse to work until their demands are met. Union members who don’t honor the strike are criticized as “scabs" and might suffer retribution. Strikes can backfire when companies hire replacement workers to stay open—or when they annoy consumers so much that sentiment turns against the labor union.

Picketing often occurs in conjunction with a strike. When workers picket, they patrol outside their workplace, carrying signs and shouting slogans. Picket lines target both customers and other workers.

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 their resources, goods, and services. They reap the benefits and suffer the costs, so are likely to use property carefully and productively.

Types and Nature of Income

For most of us, the amount of 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

Labor Unions and Company Competitiveness Critics of labor unions claim they lock companies into

expensive contracts that make them uncompetitive in the face of foreign competition and fast-changing markets.

Watch it on YouTube In 1981, the Professional Air Traffic Controllers Organization

went on strike, grounding most air travel in the United States. President Reagan reacted swiftly-----giving the controllers 48

hours to return to work or be fired and replaced. Watch footage of the strike and of Reagan’s reaction here: http://www.youtube.com/watch?v=e5JSToyiyr8

If you supply… You earn… Labor Wage

Natural Resources Rent Capital Interest

Entrepreneurship Profit

http://www.youtube.com/watch?v=e5JSToyiyr8


are at 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 how often you are paid.

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 is the difference between a payment to a factor of production and the factor’s opportunity cost. Economic rent is any payment made for 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 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 brings in $106,000 in revenue. His accountant congratulates him on $6,000 in accounting profit. However, we 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 6.5 percent in interest 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 a resource is the sum of the demand for that resource in each of its possible uses.

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. If people everywhere become obsessed with the SAT and suddenly demand many more #2 pencils, the derived demand for wood will increase, too.

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 in an economy is the sum of the demand for all the labor needed to produce all goods and services: pencils, potatoes, pistols, Porsches, etc.

Let’s focus on the market for economists. The supply curve represents the number of economists willing and able to work at each possible wage rate, “W”. The supply curve slopes upward because more economists will be willing to work at higher wages.

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 more economists are hired by a firm, later hires add less value—a phenomenon called the diminishing marginal productivity of labor. Economists can only analyze so much data, no matter how many of them there are. In fact, as more get together, they start arguing about different theories, and it takes them longer to reach a consensus. As the saying goes, “Too many cooks spoil the broth.”

The 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, expensive economists, and a few cheap research assistants to help them. The firm is substituting cheaper labor options for actual economists. Hospitals might hire nurse-practitioners instead of actual doctors for the same reason.

Also, as economist wages rise58, 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 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.59

58 If inflation is high, nominal wages could skyrocket without real wages changing very much at all. 59 It might also be called the “boomerang” effect, except economists don’t use fun terms like boomerang.

Remember Price Discrimination? Just as companies might want to charge different

customers different prices, they might want to pay different wages to different economists. Perhaps

economists from less prestigious universities would be paid less-----or those willing to relocate to Kazakhstan

would be paid more.


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: by measuring its costs versus its benefits.

Every additional hour of labor produces a little more product for a firm. The marginal benefit of an additional labor hour is equal to the output it produces—multiplied by the revenue earned from the sale of that output. The actual output of an additional labor hour is called the marginal product of labor (MPN). The revenue generated by this output is the marginal revenue product (MRP).

MRP Marginal Revenue Product

= MPN

Marginal Product of Labor x

P Price

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 finished goods and services. Productivity is a measure of the efficiency of production. It is expressed as a ratio of output to input. In a widget factory, the output might be widgets, and the input might be labor hours. The productivity of laborers in the factory can be expressed as “widgets per labor hour.”

Labor productivity measures the output of a unit of labor input. One way to boost labor productivity is to improve physical capital. This can mean replacing a slow computer with a fast one, buying a printing press that makes fewer errors, or even just buying workers better chairs. The second is to invest in human capital. Human capital includes laborers’ knowledge, training, skills and experience. Better-educated or more skilled workers tend to be more productive.

Investments in Education

One way to invest in your own human capital is to become more educated. Historically, more educated people have tended to earn more. In the United States, the average 35-year-old man who completed four years of college earns about $25,000 more per year than the average 35-year-old man who completed only high school.

Debate It Resolved: That the Internet has made workers

more productive.

Labor Productivity

Suppose two workers each work eight hours in

a widget factory:

= 16 labor hours

At the end of the day, they have produced four

widgets:

Labor productivity is a ratio of output to input. Here labor productivity equals 4 widgets per 16

labor hours, or 1/4 widget per labor hour:

16 Labor Hours

=

per labor hour


Economists debate why the better-educated are better-paid. Does education make you more productive? In some fields, like computer science, this may be true. But does a Latin degree from Yale increase the productivity of a consultant? Why would an employer prefer to hire him over an economics major from a lower-tier college?

Higher education acts as a screening device, or a signal. Even if a degree is unrelated to a job, it screens out non-college-graduates who may be less talented or hardworking. The consultant had to do well in high school and on standardized tests to be admitted into an elite college. Rather than screen all applicants for intelligence, work ethic, and versatility, employers assume a college-educated person already has these qualities—and that graduates of top colleges have even more of them. If your parents are unsure if it is worth sending you to Yale to study philosophy, remind them of this.

Other Factors That Influence Income

My undergraduate professor in Science, Technology, and Society was a brilliant man60 and had more schooling than your average Harvard Law School graduate—but made much less money. Since he could probably have gone to law school, we can infer personal choice was a factor in his career decision. He must prefer the stimulating environment of a university to the shark-eat-dolphin world of private law practice. Other factors that correlate with differences in income include:

Region: Incomes tend to be higher in cities than in rural areas, and lower inland than near the coast. Incomes are higher in California than in Iowa; and lower in the Outback than in Perth.

Type of household: Married-couple families earn more than families headed by a single person.

Type or nature of job: Certain jobs pay more. Teachers tend to earn more than textile workers, while bankers tend to earn more than teachers.

Gender and ethnicity: Women often earn less than men in the same jobs, and in many places certain ethnic groups are paid less for their labor. The difference may be due in part to factors that are hard to address. For instance, more women choose to take time off to raise children, making them riskier investments for employers. But some of the difference may also be the legacy of discrimination.

Investment and Economic Growth

To improve labor productivity, economies need to invest in human and physical capital. Such investments can increase a society’s standard of living.

Standard of living is usually defined as the real value of the goods and services consumed by the average person in an economy. Calculating standard of living can be difficult. Economists normally

60 It helped that it looked like Christopher Lloyd in Back to the Future.

Master of Low Wages When the Harvard Kennedy School accepted me into its Master’s in Public Policy program, it sent me a brochure

describing the career opportunities ahead. Graduates were helping to build houses in Haiti, running for office in small towns, and volunteering at struggling schools. Inspiring! But the income statistics were oddly grim. The average

salary for someone coming out of the Kennedy School was lower than for someone from Harvard’s undergraduate

college. After a burst of panic, I realized it was likely a case of self-selection bias-----people choosing the Kennedy

School most likely weren’t looking for high salaries, but for the less profit-oriented pursuits that had drawn them to

the school in the first place. My parents probably still wish I had gone to the business school.

Mini-Directed Research Area: College Degrees in China The recent economic crisis has made it hard for college graduates in the United States to find jobs-----but the situation is even worse in China, where hundreds of new universities are churning out millions of college graduates who are unable to capitalize on their education. Read more here and here.

http://www.nytimes.com/2010/12/12/world/asia/12beijing.html


use a different statistic, Gross Domestic Product (GDP) per capita, to compare standards of living from one country to the next. We will cover GDP in macroeconomics; for now, think of it as national income and of GDP per capita as national income per person.61

If GDP per capita increases over time, an economy is experiencing economic growth. In the long run, most economists believe economic growth can only result from technological advances. Over shorter periods, investment in human and physical capital can also result in economic growth.

Suppose you live on a planet where everyone eats only the fruit they pick from trees. You can only eat fruit you pick with your own two hands. One day a spaceship lands nearby, carrying the survivors of a planet ravaged by angry robots. The aliens are peaceful, but hungry, and two-handed, just like you. There are exactly as many of them as there are people on your planet. The population has just doubled.62 There is an immediate shortage of food, and the standard of living has fallen 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.

Skip ahead. The new trees have been planted. The population crisis has subsided. Everyone is living peacefully again now, eating the same amount of fruit as before the alien refugee spaceship landed. In the long run, there has been no change in the standard of living of the original residents.

Now, the aliens invent a product to make trees infinitely fruitful. No matter how much fruit is picked, the trees never run out. This is an improvement in technology. Unfortunately, it is useless, because everyone still only has two hands. No one can pick any more than before.63 Then, a little alien develops a potion that gives everyone two more arms. 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 is someone who combines the factors of production to make goods and services. Entrepreneurs aim to make a profit; it is the reward for entrepreneurship. But profit is never certain. If it were, we’d all be entrepreneurs. The risk of entrepreneurship is losing your investment.

Consider Jack, an entrepreneurial eight-year-old who mixes lemons, sugar, and water to make lemonade. He opens a lemonade stand. If he can sell enough lemonade to cover the cost of his lemons, sugar, ice, and cups, he will profit. But many things could go wrong.

If a storm rolls in one day, people might not be willing to stop and buy Jack’s lemonade. He won’t collect enough revenue to cover his costs. If Katie, his adorable six-year-old sister, opens a stand next to his, people might choose hers instead of his.64 Again, he won’t be able to clear a profit. If his grandmother steals his lemons to make lemon bars, Jack will have to replace them before he can even open. And he’ll have to sell enough lemonade to pay for his usual lemons and new ones.

Jack has no way of changing the weather. He can’t control his sister. He certainly can’t control his grandmother. The risks of the lemonade business are vast, but Jack is an entrepreneur because he is willing to take those risks.

61 If income is concentrated in the top few percent of the population, average national income can be misleading—you might have a few wealthy people and many poor people in a country with an “average” average income. 62 Assuming you let them stay. Please don’t be mean. 63 The squirrels are happy, though. 64 Not until he hires an even cuter girl from down the street to man his stand. But then he has to pay her wages.


Well-enforced property rights help to minimize the risks of entrepreneurship. Suppose Jack uses his own lemonade-making machine, one he invented himself. As a business-savvy eight-year-old, he might have patented his machine before opening his stand. That way, when Katie copied his machine, he could have sued her. The court could have fined Katie and ordered her to pay Jack for his lost business.65

When Jack came upon his empty fruit bowl, he could have called the police. Upon discovering lemon bars in his grandmother’s kitchen, the police would have had cause to arrest his grandmother for theft. The court could order her to reimburse him, and to pay him for the damages he suffered.

Now imagine something completely out of Jack’s control: a recession hits. People are in such bad shape they stop buying lemonade. They are mostly drinking tap water. There is not much Jack can do other than shut down his lemonade stand and hope the economy will expand again soon.

But wait! The government might act to stop the recession—giving all citizens, say, a $1000 tax refund. Not everyone will want to spend a portion of that money on lemonade, but some will. Jack may be able to stay in business after all. This sort of government intervention is an example of macroeconomic policy.

65 Granted, Katie is only six. But years from now, she’ll thank her brother for teaching her a valuable lesson about life.

When Destruction Is a Good Thing Not long ago, to book a ticket from Chicago to London, you had to visit your travel agent. He or she would bring you coffee and

find you a decent fare. Then the Internet came along. Entrepreneurs realized people might want to book their own

tickets online, comparing prices in their pajamas. They launched sites like Expedia and Travelocity. Soon, 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 economist Joseph Schumpeter in the 1970s, is vastly overused; every Internet entrepreneur wants you to believe his or her idea is going to revolutionize an industry. But some do.

Word processors obliterated typewriters. The iPhone sent other phone makers back to the drawing board. Services such

as Netflix wreaked havoc on the movie rental business. E-readers like the Kindle are taking a giant bite out of bookstores.

Why is Barnes & Noble trying to sell its own, the Nook? It wants in on the new industry before the old one is gone.

Creative destruction happens all the time; look for it in the new products you choose to use. And, if you can figure out a way to

creatively destroy something, you might end up very rich.


IV. Macroeconomics “We’re all Keynesians now,” United States 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 expand them.

Times have changed. Keynesian economics, in which the government adjusts taxes and spending to smooth out the business

cycle, is now 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 to measure the macroeconomy and how different policies can affect it.

Gross Domestic Product and National Income

Everyone in an economy, combined, produces a lot of stuff. It is important to measure that stuff in order to see how the economy is doing—and to help guide future economic policy.

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).

“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 produced within the borders of an economy. If a Korean manufacturer produces shoes in Taiwan, those shoes are not part of Korean GDP. However, if a Taiwanese manufacturer produces shoes in the Korea, the shoes are included in Korea’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 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, most countries used Gross National Product, or GNP, instead of GDP. 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. GNP is like GDP, except GNP counts goods and services produced by the citizens of a nation, regardless of where they produce them.


If a Chinese-owned firm is making spaghetti in Idaho, it counts toward the GDP of the United States. It also counts toward the GNP of China. But, if an American-owned Starbucks sells lattes in Shanghai, the sales do not count toward United States GDP. They do count toward United States GNP, but they count toward China’s GDP.

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. 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 exaggerated.

Some economists criticize GDP for not capturing all the activity in an economy. For one, it does not include the value of used goods that are resold; they are only counted their first time on the market. This means that auction sites such as eBay add little to GDP. It also ignores black market66 and unreported dealings, which can be significant. Household activities, such as washing your clothes instead of sending them to the dry cleaner, also go uncounted.

Methods of GDP Measurement

There are various ways of calculating GDP. In the expenditures approach and the income approach, GDP is calculated as the sum of the market value of final goods and services. The outcome approach employs the value-added method, in which a factor of production is followed through the production process, adding value to GDP each time it changes form.

The outcome of each approach should be the same, though statistics being inexact, they rarely 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. Investment may be 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. Governments spend money on infrastructure, such as roads, bridges and dams. They also pay to provide services, such as police protection, health insurance, national defense, airport security, and environmental regulation.

66 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.

No single statistic can tell the whole story

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 they 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 sale of machine guns and cold medication. But are we really better off with more machine guns on the streets and more people suffering from colds?


“G” does not include transfer payments. A transfer payment is made by the government to an individual for nothing in return. They are excluded from GDP because they are not exchanges: they only move money around. After receiving a transfer payment, a person will spend or invest it; at that point, the spending is counted in GDP.

…“X” represents Net Exports. Net Exports is the value of all the exports a nation sells minus that of all the imports it buys. When there is a trade deficit (imports exceed exports), X is negative. An American-made television shipped to Paris adds to United States net exports. It subtracts from France’s GDP because, to France, it is an import. Currently, the United States has a negative X—it imports much more than it exports—while China has a positive X.

The Income Approach to GDP Measurement

National Income Accounting (known as the income approach) finds GDP by combining all wages, salaries, corporate profits, interest payments, and rents. It 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 government spending to lower a good’s price in the market.

GDP = Employee Compensation + Rents + Profits + Interest - Indirect Taxes + Subsidies

Suppose employee compensation one year were $4 trillion, rents $2 trillion, corporate profits $1 trillion, and interest payments $3 trillion. That same year, the government collects $1 trillion in indirect taxes and pays out $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

The Output (Value-Added) Approach to GDP Measurement

In the output approach, we calculate the value of everything produced in an economy by measuring the value added at each step in the production process. For example, in the production of a milk chocolate bar, the value of the cacao is counted, and then the value of the milk and sugar added to it. Later, the value of the chocolate wrapper is added, too. Nothing is included more than once. This is more difficult in practice than in theory, since it is easy to double-count by accident.

Real GDP and Nominal GDP

We use the sale price of every good and service produced in an economy to determine Gross Domestic Product. But, if a good’s price increases due to inflation, GDP will increase even though the economy is no more productive. 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.

The Lorenz Curve and the Gini Coefficient

Knowing a country has a high GDP is not enough to ensure that its citizens are all well off. To compare economies, we need a way to measure how that GDP is distributed—to see if any 10% of the population earns an equitable 10% of the income, or whether the top 10% earns, say, 90%.

In the real world, no country has perfectly equal GDP distribution. Someone always makes more than someone else. This holds even in planned economies, which may support perfect equality in theory but find it impossible in practice. The Lorenz Curve illustrates the inequality of real GDP distribution. The y-axis of the Lorenz curve shows the total income earned by the percent of people represented by the x-axis. Here, the bottom 50% of people receives about 20% of total income, while the top 10% receives more than 30%.

The so-called Gini coefficient measures the difference between a line of perfect equality and the real Lorenz curve in an economy. It is the area of the region titled A in the graph above. The lower the coefficient, the more equality exists in the economy. Gini coefficients generally range between about 0.24 in relatively 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.

The Circular Flow of the Economy

We can categorize economic activity as productive or consumptive. Productive activity is what producers do; consumptive activity is what consumers do.

Consumers consume what producers produce. Consumers get the money to buy their products from the producers themselves, in the form of wages and other payments made to them for resources such as land and labor.

This movement of goods, services, and money is 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.

Of course, no economy is as simple as the two-sector diagram. The model is incomplete without including the government that, in most economies, is taxing both sectors while also paying for some of their products and their resources.

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. Money is also injected when the government gives money directly to people as transfer payments.

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

Political leaders talk all the time about achieving economic growth. They usually mean creating more and better-paying jobs. For economists, economic growth has a more precise definition: 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 at 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 economic growth has occurred. Existing resources may just be coming into use. But if economic growth does occur, GDP will almost certainly increase.


The Business Cycle

When the economy is slipping into a recession, economists are usually quite calm about it. They are often more concerned with minimizing a recession’s impact and length than with asking, “How can we prevent all recessions?”

Economists recognize that the economy naturally moves back and forth between expansion and contraction. This pattern is called the business cycle.

Many economics textbooks contain graphs depicting the GDP of a country, or its annual rate of growth, over the course of many years. To the right is such a chart, showing the percentage rate of real GDP increase in the United States over the last 70 years. Points at which the change was positive represent periods of prosperity, and points at which it was negative periods of hardship.

In the business cycle:

Expansion occurs when real GDP increases 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 decreases for two consecutive quarters.

A depression is a severe recession. There is no textbook definition for how severe a recession needs to be before we can call it 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.

Wars tend to stimulate an economy—because in wartime the government must spend a lot on the military. If G increases, so does C + I + G + X. Note the growth around World War II (early 1940s), the Korean War (early 1950s), and the Vietnam War (late 1960s-early 1970s). This growth does not mean wars are always “good” for the economy. Yes, the dollars spent making bombs and planes flow to people and firms as wages and rent—but, if everyone is making bombs and planes, this 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 “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, 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 the relatively prosperous 1920s—known as the “Roaring Twenties”. When the economy is booming, people are quick to believe the good times will never end. In the 1990s, books with titles like Dow 30,000 predicted the stock market would rise

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

1930 1950 1970 1990

Percentage Rate of Real GDP Increase in the United States


forever. Caught up in what Federal Reserve chairman Alan Greenspan labeled “irrational exuberance”, many investors were unprepared for the end of the “dot-com bubble” around 2000.

The stock market spent much of the next ten years lurching around without going decisively up or down—a classic “bear” market. Home values soared, however67—as did consumer debt—creating yet another unsustainably exuberant state of affairs. It crashed in September 2008, when the United States suffered its greatest stock market decline since 9/11. Many banks collapsed under the weight of bad loans, and unemployment rates soared. This economic catastrophe was not limited to the United States; it spanned most of the globe. Some economists have called it the Great Recession. Since 2008, much of the world has edged out of this recession toward another period of expansion.

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 that, when the price of a good or service decreases, people are willing and able to buy more of it, so the quantity demanded increases. 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.

The aggregate demand curve combines the demand curves for every good and service produced in an economy. As a result, it looks similar to the demand curve for an individual good. The major difference is in the axes. The y-axis on the graph for a single good lists numeric prices, like $5 or $10. But a single price would not make sense for all goods at once.

Instead, the y-axis is of the overall price level for an economy. The price level does not matter, just whether it rises or falls. 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.

The aggregate demand curve has a negative slope for two reasons.

1) As the price level decreases, goods become cheaper; in effect, consumers have more wealth, so are willing to consume more. This is the wealth effect.

2) As the price level decreases, domestic goods grow cheaper for people from other countries. Exports increase and imports decrease. This is the exchange-rate effect.

Just as the demand curve for a single good can shift right or left, so can the aggregate demand curve. To understand how economic events affect the aggregate demand curve, we should revisit the expenditures approach to calculating GDP:

Y = C + I + G + X

67 Many people used money they had earned in stock boom of the 1990s to buy real estate, driving prices upward.

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.


If consumption, investment, government spending, or net exports change for any reason, you can expect that aggregate demand will change, too. Six specific factors affect the aggregate demand curve.

The first is a change in foreign income. Aggregate demand is just the total demand for a country’s goods. If foreign income falls, there will be less demand for 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; the aggregate demand curve shifts to the left:

1. A Change in Foreign Income

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.

If firms’ expectations of future income increase, they will be more willing to invest

in the present.68 ‘‘I’’ increases, so ‘‘Y’’ increases. Aggregate demand shifts to the right. Similarly, if consumers have positive

expectations about their future incomes, they will be willing to buy more output at

each price level in the present.69 The aggregate demand curve will move to the

right:2. Expectations about Future Income

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.

If firms’ and consumers’ expectations of future prices change, they will adjust their spending in the present. If they expect inflation, they will buy more now, while prices are lower. When consumers buy more, consumption (“C”) increases, increasing “Y.” Aggregate demand shifts to the right:

3. Expectations of Future Prices

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.

Exchange rates affect aggregate demand. If a country’s currency gains value (appreciates) relative to other currencies, domestic consumers will be more able to buy foreign goods. Foreigners will not

68 You may elect to treat yourself to dinner if you think your chances of getting a high-paying job in the future are good. 69 When students receive very good job offers for the coming year, many begin spending the money right away—on fancy clothing, expensive dates, etc.—months before they actually start at their new jobs.


want the country’s “more expensive” exports. Thus, when a country’s currency strengthens, its net exports decrease. A decrease in X leads to a decrease in Y. Aggregate demand shifts to the left:

4. A Change in the Exchange Rate

A decrease in the exchange rate makes U.S. goods more expensive when compared to

foreign goods. The demand for net exports decreases. The decrease in X results in a

decrease in aggregate demand, so the AD curve shifts to the left.

Lower-income families spend a much larger percentage of their income on consumption than do higher-income families. If distribution of income changes so that lower-income families receive a larger share of national income, there will be an increase in consumption. When “C” increases, “Y” increases, so aggregate demand shifts to the right:

5. 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 AD curve shifts to the right.

Many government policies aim to shift aggregate demand. If government spending (“G”) decreases, “Y” must decrease, too. Aggregate demand shifts to the left:

6. A Change in Government Spending

When the government runs a surplus, it spends less. The decrease in government

spending results in a decrease in aggregate demand. The AD curve shifts to the left.

Consumption and the Marginal Propensity to Consume

Suppose you earned $50,000 a year. Of this, you might spend $40,000 on consumption—paying for your house, meals, and car—and you might save $10,000 for future needs.

Now you are given a raise to a salary of $60,000. Will you spend the entire $10,000 raise on more consumption—say, on a new boat, or tons of waffles? Will you put it all in the bank? If you’re like most people, you’ll probably spend some 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 rest 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 new dollar earned will be saved and 85% consumed. Together, the MPS and MPC always equal 1.

The consumption function to the right plots American consumer spending versus disposable income over the course of 45 years. The points fall almost into a line, suggesting the percentage spent of disposable income stayed about the same over this period.

Keynes considered this more than a coincidence. He believed MPC remains about the same for a nation—through recessions, expansions, and alien invasions, consumers will always spend about the same fraction of their income. The data here has a slope of 0.9, implying Americans consistently spend 90% of their income on goods and services. If the slope were 1.0—as in the 45° reference line—they would spend 100%.

The Multiplier Effect

Suppose a woman has $20,000 under her mattress. On her 80th birthday she decides to spend it all on her bucket list. Her society has an MPC of 0.8, meaning we can predict that 80% of new disposable income will be spent on consumption.

The people who receive her $20,000—travel agents, car salesmen, telemarketers—will spend 80% of it, or $16,000, on their own shopping list—hair gel, cologne, DVDs. You can guess what happens next: the recipients of the $16,000 will spend 80%, or $12,800, and so on, until the money is exhausted.

The multiplier gives us a 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. In a society with an MPC of 0.8, the multiplier is 5; if the MPC were .5, the multiplier would be 2. The lower the marginal propensity to consume, the less often money will be spent.

To find the total spending that the injection of an amount of money into the economy will cause, we multiply that amount by the multiplier. If someone spends $15,000 in an economy with a marginal propensity to consume of 0.8, it will be spent 5 times—resulting in a total spending of $75,000.

‘‘Ideal’’ vs. ‘‘Real’’ Multipliers

We have been using what is known as the “ideal multiplier”. Experimental evidence suggests that, in the real world, the multiplier is not as high. Possible reasons for this:

some of the extra money is spent on imported goods (and thus goes abroad) taxes and miscellaneous expenses take a portion of the money out each time it is spent not all consumers behave in the same way—one savings-inclined consumer in the chain can

bring the process of multiplication to a screeching halt

Above we found the MPC for the United States was close to 0.9—suggesting an ideal multiplier of about 10. Most studies have shown the real multiplier is much lower than that. Analysts accept there is no precise way to measure it, since so many forces and confounding variables are involved.

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𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 1

1 −𝑀𝑀𝑀

𝑇𝑇𝑀𝑇𝑀 𝑀𝑖𝑖𝑀𝑀𝑇𝑖𝑀 = 𝐴 ∗ 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀

A = initial amount spent MPC = marginal propensity to consume


Aggregate Supply and Economic Equilibrium

Aggregate supply is the quantity of 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 that as the price of a good or service increases, the quantity supplied of the good or service increases too. Aggregate supply works roughly the same way. As 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. More of a single good or service can usually be produced by allocating resources from the production of other goods and services. But, in the aggregate, there is ultimately a limited supply of resources.

Suppose you wanted to enlarge your house. You could expand any one room by borrowing space from other rooms or from the yard. But you couldn’t expand the whole house beyond the plot of land you own.70

In the same way, when suppliers are producing at full capacity, the aggregate supply curve becomes completely price-inelastic. The economy is maxed out. Below full capacity, the aggregate supply curve has a positive slope—there is still room to grow.

When 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 Production Possibilities Frontier (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 at full employment, the aggregate demand curve intersects the aggregate supply curve at full employment. If the economy is in recession, they intersect at a point below full employment. The economy will be inside its PPF; suppliers will not be using all available labor.

In the long run, the supply curve is thought to be vertical—reflecting limitations on other available resources. Only changes in capital, labor, and technology can affect this long run supply curve.

70 Assume you can’t build a second floor. Perhaps the government has imposed a ceiling on floors.


The Labor Force

The definition of the labor force varies by country. In the United States, for example, it includes every civilian over age 16 who has a job—full-time or part-time—or who is actively seeking a job.

“…civilian…” Those who serve in the military are not included in the labor force. Civilians who work for the military, such as custodians at Guantanamo, do not count as servicemen.

“…over age 16…” Even if you have a job, you are not counted as part of the labor force until you are 16. This means there is no such thing as an unemployed 14-year-old, even if she is seeking a job.

“…has a job…” A person who has a job—and is over 16—is, naturally, part of the labor force.

“…full-time or part-time…” The CEO of United Airlines and the night shift fry cook at McDonald’s are both in the labor force, even if the cook works 60 hours per week and the CEO 25.

“…actively seeking a job…” Even if you do not have a job, you are part of the labor force as long as you want and are looking for one. According to the United States Bureau of Labor Statistics, you are only “actively seeking” a job if you are turning in applications and scheduling interviews. If your slacker friend is a couch potato who mopes that he would like to have a job but never leaves home, he is not part of the labor force. He has to be off that couch, polishing his shoes, combing his hair, and shaking hands with middle managers if he wants to be included.

The Labor Force Participation rate 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 non-institutionalized people over age 16 that are working or seeking work. Anyone over 16 who does not want to work, such as a housewife or full-time student, lowers this rate. In the United States, it1702623 hovers between 65 and 67 percent.

Categories of Unemployed Persons

Some people just lose their jobs. The Bureau of Labor Statistics calls them job-losers (really). Some are temporarily laid off. Some are laid off for good. Some are “encouraged” to retire. And, of course, some are fired. What all job-losers have in common is that they leave their jobs against their will.

Job-leavers voluntarily leave their jobs. Some move on to better jobs right away, so never count as unemployed. Others may leave a job without knowing what to do next.

New entrants are unemployed because they have just joined the labor force for the first time. 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. They were not considered unemployed whilst out of the labor force. But once they begin seeking jobs, they rejoin the labor force and drive up the unemployment rate. Some people temporarily leave the labor force to raise children, or to travel through rural Morocco. Some leave 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 between jobs for “normal” reasons. In the course of business, people quit and are fired. Frictional unemployment is a large part

Debate it! Resolved: That the government should not help unemployed

people who quit their jobs voluntarily.


of the reason the unemployment rate is never 0%, even at the best of times. Most economists think a rate of about 4% is natural and inevitable, and they do not worry much about it.

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 started sending only email. Structural unemployment is also caused by realignment of economic activities, such as the shift of manufacturing jobs from developed to developing nations. Unlike the frictionally unemployed, the 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 most swim teachers are out of jobs in the winter (except in places like Hawaii). Many agricultural jobs are also seasonal. The main way to minimize seasonal unemployment is for would-be employees to diversify their skills, with or without government help. If a ski instructor learns how to teach swimming, he or she could 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 is each typical of 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.

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 moment to consider how odd money really is. In the United States, it comes in pieces of mostly green paper with pictures of dead presidents on them.71 In China, the colors are different and the pictures are all of Mao Zedong. Everywhere, people sacrifice time and effort in return for the promise of these pieces of paper.

Of course, 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 British pounds, United States dollars, and other forms of currency that makes people willing to work so hard for them?

Simply put, they let us buy goods and services. World Scholar’s Cup certificates do not.72

Many people receive paychecks and pay for some goods with checks, too. The difference between dollar bills and checks is that a dollar bill is a form of currency. Currency includes only paper money and coins, but a check is written to represent some amount of currency held elsewhere. Checks allow pieces of paper to be shuffled offstage.

There are two main kinds of money. Fiat money has no inherent value—it is money only because the government declares it to be money. 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. They also make very uncomfortable toilet paper.73 Dollar bills are really only useful as money.

Unlike fiat money, commodity money has more value than just as money. If chocolate were money, you could spend it or eat it—and if cigarettes were money, you could spend them or smoke them. Both are often used as money in prisons. Gold and silver are more widely-employed forms of commodity money. They are both precious metals with market value and the raw ingredients of jewelry and other goods. Most currencies were once made from precious metals—leading people to try and fake the metals, or to secretly mix them with less valuable metals and pass them off as pure.

The term ‘commodity’ means that anything used for money must be widely available, standardized, and easy to value. If it were a more unique good, such as handmade hats, it would be hard to assess the value of one hat versus another, and we would be partly back to the problems of barter.

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, 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 need not necessarily be wanted by the people with the goods and services that you want.

Money acts as a unit of account. It measures the relative worth of goods and services and the relative wealth of people, organizations and nations. If you spend $5 on a Happy Meal in San Francisco, you

71 Except for Ben Franklin. 72 Don’t try it. You can’t even exchange them for alpaca finger puppets. 73 Trust me.


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.

Money also acts as a store of value. You can spend a five dollar bill on a dish of nasi lemak. But you could also keep it in your pockets, under your mattress, or at your bank. A year later, you could still use it to pick up some nasi lemak. Money retains value. If yogurt were money, you’d have to spend it before it went bad.74

The Money Supply

The money supply is all the money in an economy.

Not all money is equally easy to spend. Try buying a can of soda with a handful of coins—easy75. Try buying it with a certificate of deposit76—not as easy. The ease with which a type of money can be turned into something you can spend at 7-11 is its liquidity. If it takes a pawnshop to change something to cash, it isn’t very liquid—but it’s still more liquid than, say, your arm.

Currency is the most liquid form of money—literally the bills and coins in circulation. In the United States, there is only about $1,500 of currency per person.

M1 is the second-most liquid definition of the money supply. It consists of currency, demand deposits (i.e. checking accounts) and travelers’ checks.77

M2 is less liquid, but still liquid enough that most economists consider it the best measure of the money supply. When we discuss the price of money later on, we’ll be referring to M2. It includes all of M1, plus savings accounts, certificates of deposit (CDs) under $100,000, and money market and mutual fund shares.

There are also two broader categories—M3 and L—but these are rarely used.

Inflation and Price Indices

In 1962, when the first Motel 6 opened in California, it charged $6 a night per room—which is why they called it Motel 6. By the 1980s, it charged $40 a night. Today the same room costs $99.78

By the time we reach high school, all of us have probably seen some inflation. Prices for most things go up over time.

The official definition of inflation is a sustained increase in the price level, which lasts for at least two consecutive quarters (six months). In order to measure inflation, we have to observe and measure any

74 Or, you could feed it to Michael Weston in exchange for professional services. 75 Assuming they’re not foreign coins. Even then, some machines might fall for them. 76 A certificate of deposit is known as a CD: if you buy one, you deposit a certain amount in a bank for a specified time. The longer the period, the more interest you earn. There are penalties for early withdrawal. 77 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. 78 But it comes with free wifi!

Debate it! Resolved: That high inflation is better than high unemployment.

•You can use money to buy products from people who might not want to barter with you for your used socks, but are happy to take your used cash.

Medium of Exchange

•You can measure the cost of things—like headphones, puppies, and Cram Kits—in terms of the money it would take to buy them.

Unit of Account

•If it is worth $50 today, it will be worth $50 next year.

Store of Value

http://www.youtube.com/watch?v=L-W50U2RP6g


movement in the price level. From one quarter to the next, the price level may shift upward or downward. A shift upward for two consecutive quarters constitutes inflation.

Inflation is good news for borrowers with a fixed interest loan. Their debts become less expensive. For the same reason, inflation is bad news for creditors who provided those loans.

The Consumer Price Index (CPI) is the standard tool for measuring inflation in the United States. Similar tools are used in other countries. Each month, it measures what it costs to purchase a fixed market basket of consumer goods and services. The basket includes goods Americans buy frequently.79 The market basket does not include luxury items or financial instruments such as stocks. The CPI uses a fixed basket of goods so it can consistently measure prices. However, this is also a weakness, as increasing prices of goods may drive consumers to lower-priced substitutes.

The CPI is expressed as a percentage of a given base year. For example, if the CPI for a given year is 163, the price level is 63 percent higher than in it was in the base year.

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.

Another price index, the Producer Price Index (PPI) measures the prices of raw materials, and helps us to determine with certainty when the prices of the factors of production are rising.

Although price levels usually increase, they can also decrease. This is called deflation.

Hyperinflation means inflation is very high. There is no official threshold, but 50% per month would certainly qualify. When countries experience hyperinflation, their governments tend to become unstable.

Disinflation80 means the rate of inflation is decreasing. When disinflation occurs, inflation is still occurring—it is positive—just less quickly. If inflation in 2010 is four percent, and, in 2011, 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 steady and predictable—say, 2% per year. Constant inflation is not too problematic, as people can adjust their behavior around it.

Accelerating inflation is the opposite of disinflation: it means the rate of inflation is increasing. If the inflation rate is 5% one year and 7% the next year, inflation is accelerating. This is more harmful than constant inflation, as no one knows how much it will increase.

79 Thus, it includes breakfast cereal, but not congee. 80 Don’t mix disinflation with deflation. They are two different things.

Sample Goods from the CPI Market Basket

Food and Beverages breakfast cereal, milk, coffee,

Housing rent, fuel oil, bedroom furniture

Apparel men’s shirts, women's dresses

Transportation

Medical Care

new vehicles, airline fares, gasoline

drugs, hospital services

Recreation televisions, pets, tennis shoes

Education & Communication school tuition, stamps, telephone bills

Other Goods And Services tobacco, haircuts, funerals

Watch it on YouTube History’s most notorious period of hyperinflation

occurred in Germany in the 1920s. Watch this clip for a sense of what it was like for the German people:

www.youtube.com/watch?v=MCU6Fcnc2H0

http://www.youtube.com/watch?v=MCU6Fcnc2H0


Hyperinflation Disinflation a high rate of inflation -

“48%” a decreasing rate of inflation

“5%, 4%, 3%…”

Accelerating Inflation Constant Inflation an increasing rate of inflation

“3%, 4%, 5%...” a stable rate of inflation over time

“3%, 3%, 3%...”

Interest Rates

One way banks earn profit is by charging interest on loans. The original loan amount is the principal. Interest is added to the balance of the loan at specific intervals. Interest is calculated on the entire balance: the principal combined with accumulated interest.

Suppose you borrowed $10,000. Since then, you have incurred $2,000 of interest. Your next interest charge will be based on the combined balance of $12,000. The more frequent the interval at which interest compounds, the faster the balance will grow.

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

Roles of the Government in a Market Economy

Even most free market economists do not believe people should be allowed to do anything to make money—for example, to enslave children. There is no such thing as a “pure” market economy, one with absolutely no 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.)

Promoting competition among buyers and sellers is another government function. Laws protect buyers and sellers against anti-competitive practices. Most governments investigate and prosecute companies that commit anti-competitive behavior. Even when a company, like Microsoft, escapes punishment in the United States, it can still be penalized for anti-competitive behavior elsewhere—for example, by the more socially progressive European Union.

The government is also responsible for establishing and enforcing laws that protect private property. Individuals must believe their property rights are protected, or they will have little incentive to invent, invest, innovate, or take entrepreneurial risks.

Providing income security and redistribution is another role of the government in a mixed market economy. People cannot work forever or always; they grow old or may lose their jobs. The United States provides a modest Social Security income to the retired and the disabled. It also assists the

Islam, Interest Rates, and a Different Way of Banking The topic is 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 topic, but,

if you’d like to learn more, you could do worse than to start here.

http://www.american.com/archive/2007/march-april-magazine-contents/islamic-banking-is-it-really-kosher/


recently unemployed and impoverished families with children. Countries in which the government plays an active role in ensuring the economic well-being of its citizens are called welfare states.

To fulfill all these roles, governments collect taxes from consumers and producers. Taxes affect the economy: they alter the price of goods and services, they reduce the amount people can spend, and they change behavior—for example, a tax deduction on college tuition encourages parents to send their children to college.

Sales, Value Added, and Excise Taxes

Some kinds of taxes are on the money people earn, while others are on the money that they spend. Sales, value added, and excise taxes fall on the spending side, so are known as consumption taxes.

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—making the total price $11.82 Purchases for the purpose of resale—such as buying 100 DemiDec Cram Kits at a bookstore in order to resell them to 100 other students—are exempt from sales taxes.

A value added tax (VAT) is a tax on the value added at each step in a production process. DemiDec would pay tax on the paper used for manufacturing Cram Kits, a distributor would pay tax on the manufactured Cram Kits it bought from DemiDec, a bookstore would pay tax on the packaged, manufactured Cram Kits it bought from the distributor, and you would pay tax on the nicely-shelved, packaged and manufactured Cram Kits you bought from the bookstore. Each actor along the way would pay a tax on the value it added to the Cram Kits—the difference between what it spent and what it earned—and recover that tax from the next party in the process.

An excise tax is a tax on each unit sold of a specific good or service. A government usually imposes excise taxes for one of two reasons. It might want to discourage consumption of a good by making it more expensive. Such sin taxes (also known as Pigovian taxes) are imposed on products, like cigarettes, that have negative externalities. Or, it might be looking to generate revenue on items for which demand is price-inelastic. Travelers almost always need somewhere to sleep83—so demand for hotels is relatively inelastic. Local governments know this, so they often impose taxes on hotels, rental cars, and airplane tickets. Their impact on sales is minimal—and most of the burden is felt by taxpayers from faraway places, not by local voters.

81 Technically, people can work around such constraints—using services such as BitTorrent. But, technically, they could steal eggs from the market too. 82 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. 83 Unless they are up editing all night, and even then they need a place to edit.

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.81 Sometimes you can’t even exclude yourself from a public good-----such as national defense. If hostile aliens were to land in your hometown, some sort of government agency would try to protect you-----even if you insisted you hadn’t paid taxes and didn’t deserve the service.

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 one time will damage a park-----may still require government protection.


Excise Taxes and Deadweight Loss

The graph demonstrates the effect of a tax on a good.

Suppose DECADOGS are known to reduce World Scholar’s Cup scores. To protect scores, the government imposes a Pigovian excise tax of 20 cents per unit. Because this tax effectively increases the cost of DECADOGS at any given quantity by 20 cents, the supply curve shifts up and to the left, from S1 to S2, 20 cents higher.

The new equilibrium price is higher than the original price: $1.10 instead of $1.00. But wait: the tax was 20 cents, and price only rose 10 cents. Producers must be 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 experience a loss of overall utility, represented by regions B and C.

Since producers are earning less than they would be without the tax, they also experience a loss of overall utility, represented by regions D and E.

The government collects revenue—20 cents per each of the 40 units sold. The government’s revenue amounts to regions B and D: $8.

What happens to regions C and E? Their value is simply lost: consumers and producers no longer benefit from them, and the government doesn’t collect them. They are described as deadweight loss.

All taxes have a fundamentally similar effect on buyers and sellers. They raise the amount consumers pay and decrease the amount producers receive. They lower the quantity exchanged, they bring in revenue for the government, and they lead to a deadweight loss for society. (The government can try to compensate for this deadweight loss by using tax revenue for beneficial purposes.)

The terms “tax incidence” and “tax burden” refer to who bears more of the welfare loss that results from a sales or excise tax. Tax incidence tends to be shared between consumers and producers. Who bears more of it is determined by how price-elastic demand is.

If demand is perfectly elastic, producers bear the whole 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 buy.

The more price-elastic demand for a good is, the more of the tax burden falls to producers. Consider markets A and B. Demand in A is very price-elastic: a 20 cent tax is borne mostly by producers, and equilibrium price rises only 5 cents. Demand in B is relatively inelastic: more of the burden falls on consumers, and equilibrium price rises 15 cents.

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

http://www.youtube.com/watch?v=9F6PSIOJQuU&feature=related


Lump Sum and Property Taxes

A lump sum tax requires everyone to pay the same amount. All businesses in a region might need to pay $50 to operate—a so-called license or registration fee. Regions with lower lump sum taxes would tend to attract more businesses.

In many nations, owners of land and buildings pay an annual property tax—a fixed tax per some amount (in the United States, $100) of property value. A property tax is a tax on wealth, not income or spending. Property taxes affect the real estate market. If a city raises property taxes, fewer people will want to move there, and home prices will fall.

Income Taxes

A personal income tax is a tax on the money people earn as income each year. Income tends to be progressive: as a person’s income increases, he pays a greater percentage of his income in tax. To calculate tax liability, most governments, like the United States, divide 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 MARGINAL TAX RATE

$0-10,000 0% $10,001-$20,000 10% $20,001-$50,000 20%

$50,001 and up 30%

Someone who made $10,000 would pay zero tax.

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.

Critics of progressive taxes argue that 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 low income person’s limited salary would probably have a much greater impact on him or her than taking away 20% of a wealthy person’s investment income.

In this way, a proportional tax is a regressive tax. A regressive tax costs those with fewer resources a greater proportion of their income. If all people must pay $100 to vote—a lump sum tax—it costs poor citizens a greater percentage of their resources to be part of the democratic process. Steve Jobless might have only five hundred dollars in savings, while Steve Jobs might have five hundred million.

Laffer Curve

In theory, increasing taxes will result in less economic activity, since taxes reduce the marginal benefit of economic activity. In other words, they interfere with the profit motive.

Debate it! Resolved: That all people should be taxed the same rate.


At low tax rates, an increase in taxes shouldn’t have much effect on the profit incentive—but might significantly affect government revenues. Even if doubling the income tax rate from 1% to 2% slightly reduces the amount of economic activity, overall tax revenue will almost double. At some point, however, when the tax rate is too high, it stifles the economy, and further increases cause tax revenue to drop.

The Laffer Curve shows this theoretical relationship between tax rate and tax revenue collected:

• 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 culture.

Unlike a firm seeking profits, governments do not seek to maximize tax revenue. Most try to balance keeping taxes low to encourage economic activity and funding important public programs, such as health care and education.

Public Policy and Positive and Negative Externalities

If you buy a new electric car to save on fuel costs, it improves the quality of the air for everyone near you.84 Your neighbors, however, probably didn’t help you pay for the car. They just sit back and enjoy the improved air. You are buying it for your own reasons, but something broader is happening that isn’t reflected by traditional supply and demand.

An externality occurs whenever an economic transaction has an effect on someone other than the buyer or seller—on a party not directly involved in the transaction.

If enough people in a community pay to be vaccinated for the flu, those who were not vaccinated are still less likely to catch it—because there are fewer possible flu carriers to make them sick. Like the electric car, the vaccine offers a positive externality.

The most common example of a negative externality is pollution. An alpaca puppet factory might dump poisonous waste into a river, killing its fish and hurting the economy of a nearby village. When the factory decides how many puppets to produce, it considers only its own costs and revenues and does not consider the cost of pollution to the village. The factory owners underestimate the real social cost of puppet production—and thus produce more than the socially ideal amount.

To discourage negative externalities and encourage positive ones, economists and policy-makers might come up with market incentive programs. All factories might be given a number of pollution

84 It would also lower gas prices for everyone (through decreased demand).

Waiting on the Neighborhood to Change

A few years ago, my friend Craig bought a home in a struggling neighborhood of Boston. A few years later, the

government opened a new subway station nearby, making it possible to commute easily into Central Boston. Home prices shot up and businesses saw many new customers. The opening of the subway had positive externalities for

everyone already in the neighborhood-----but they paid nothing more for it than any other taxpayer in the state.


credits, with the right to trade credits with other factories. Cleaner factories could make a profit by selling their right to pollute to dirtier ones. Such policies give producers an incentive to pollute less.

The government may also try to “internalize” social costs into actual accounting costs. Consider the case of the so-called carbon tax. As a greenhouse gas, carbon dioxide plays a major role in climate change. The production of some goods emits more carbon dioxide than the production of others. Most people do not consider a good’s so-called carbon footprint when choosing what to buy. The government could impose a carbon tax to increase the cost of all products based on how much carbon dioxide their production added to the atmosphere. Polluting products would increase in price more than less polluting products, making them less attractive to buyers.

The market undervalues goods and services with positive externalities, so it produces less than the socially ideal quantity. To encourage their production and consumption, the government might offer incentives, such as a $10 tax credit to anyone who gets a flu shot.

Excise taxes meant to modify behavior are known as Pigovian taxes.

Fiscal Policy

Pigovian taxes are a narrow example of the government intervening in a market. The government can use fiscal policy, or changes in taxes and spending, to influence economic activity more broadly. The goals of fiscal policy are usually economic stability—softening the impact of the business cycle—and growth.

Discretionary fiscal policy involves efforts to affect the economy—such as a stimulus package that cuts taxes and creates jobs. Its first major advocate was economist John Maynard Keynes. Many people still refer to “fiscal policy” and “Keynesian policy” interchangeably.

Classical economists believed the government should try to balance its budget during a recession, so as not to interfere with the “invisible hand”. Keynes disagreed. He believed there was an economic justification for intervening. In his view, it made no 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 injected extra spending into the circular flow, this spending could jumpstart an economic recovery. Over time, the government could then gradually lower its spending and let private consumption replace it. A well-informed government could increase spending before a recession or depression ever took hold—preventing years of misery.

The Coase Theorem Suppose you use high speed Internet to run an online poker business in your bedroom. You use so much bandwidth that you’re slowing down the Internet for your neighbor, Susan.

The sluggish connection is making it hard for her to research, write, and get paid for freelance blog posts. The

traditional solution to such a problem-----a negative externality-----would be for the government to regulate

Internet usage. You might be blocked from using more than 50 gigabytes of bandwidth per day, or taxed $10 for every

gigabyte beyond that. The solution works-----but the economist Ronald Coase realized there might be another

way. What if your neighbor paid you to rent a server somewhere else? For Susan, the lost blogging revenue

makes it worth it to her to hand you $100 per month to rent a remote server and leave her Internet alone. The remote server would have no impact on your revenue, so why not

accept the money? Coase’s insight-----now called the Coase Theorem-----was that it didn’t matter who owned what. As long as the involved parties have clear property rights and can negotiate easily and freely, with zero transaction costs,

they can reach an efficient solution.

Most externalities are not so easily resolved. Property rights are not always clear (who owns the air, or the

climate?), and transactions and negotiations can be costly and complex, especially when they involve many parties.

Read more about the Coase theorem here.

http://www.econlib.org/library/Enc/bios/Coase.html


Keynes also reasoned that if the government increased spending—for instance, by hiring people to build roads—the increased economic activity would result not just from the spending, but, through the multiplier effect, from all the exchanges based on the money it had introduced into the economy.

Some fiscal policy is automatic. Automatic stabilizers adjust on their own in response to changes in the business cycle. The progressive personal income tax is an automatic stabilizer. In a recession, people earn less—so they pay less tax. A person whose income falls $10,000 will really only lose $7,000 if that $10,000 in lost income would have been taxed 30%. Welfare systems that deliver money to the unemployed also keep people contributing to GDP.

Expansionary fiscal policy is the use of government policy to boost aggregate demand and spark an economic upturn. The government can:

Increase Spending (G). Injecting money into the circular flow boosts aggregate demand. As more goods and services are demanded, more people are hired to produce them. GDP rises, unemployment falls, and the price level rises.

Cut Taxes. Lower taxes leave households and firms with more disposable income to spend. Their spending adds to aggregate demand, pushing it to the right. Unemployment falls, GDP rises, and the price level increases.

Contractionary fiscal policy tries to slow an economy, usually to fight inflation, by reducing aggregate demand. It can:

Decrease Spending (G). This takes money out of the circular flow, reducing aggregate demand. Unemployment rises; GDP falls.

Raise Taxes. Higher taxes leave households and firms with less disposable income. Aggregate demand shifts left. Unemployment rises; GDP falls.

Fiscal policy has its critics. Some believe government spending “crowds out” private investment. Others suggest that, in democracies, it takes a long time to implement fiscal policy. By the time a measure makes it through a legislature, a crisis might be over—or getting much worse. Also, because politicians usually champion fiscal policies, they may suffer from or be accused of political motives. For example, a president running for reelection might be tempted to boost government spending to create short-term growth—and more jobs—just in time to be voted back into office.

Budget Deficits and National Debt

When a government’s expenditures in a given year exceed its revenues, it is running a budget deficit. If its revenues exceed its expenditures, it runs a budget surplus.85

85 The United States has run a deficit most of the past 50 years. The main exception was during the Clinton administration of the 1990s, when it briefly achieved a surplus. It then relapsed into deficits under President Bush, spurred by tax cuts and massive spending. The deficit was a record $482 billion by the time Obama took office in 2009.


To run a deficit, a government takes loans: it issues and sells bills, bonds, notes, and other securities. It sells this debt to its citizens, to other countries, and to foreign investors. The accumulation of all this debt is known as a country’s national debt. In 2011, the national debt of the United States passed $14 trillion—about 90% of its annual GDP.

The United States is not the only country that runs a massive deficit, or that has accumulated major debt. For instance, the United Kingdom has a debt of about a trillion pounds (70% of GDP) and Japan’s is around 900 trillion yen (200% of GDP). Many other countries are in similar situations.

Politicians and their economists argue over the impact of so much debt. Most agree that the situation is unsustainable, but they disagree on what government spending to cut, whether to increase taxes to help pay it down, and how critical the situation is. The recent sovereign debt crisis in Europe has brought the issue to the forefront of political debate around the world.

Central Banking Systems

A financial panic in 1907 prompted the United States Congress to create a national banking system, which the United States had lacked for seventy years. By 1913 it had created the Federal Reserve System: essentially one central bank divided into twelve districts, each with its own bank. The Federal Reserve operates independently of other parts of government—but its chairman is appointed by the president and approved by the Senate, so it is not completely separate from politics.

Most major central banks around the world follow a similar model of partial political independence. Aside from the Federal Reserve, some of the most influential include the European Central Bank—which manages the 17-country Eurozone—and the People’s Bank of China, which has become a major force in China’s export-oriented growth economy of the last 30 years. Responsibilities of a central bank usually include controlling interest rates, printing currency, managing the money supply, deciding interest rates, and overseeing (and supporting) banks within its jurisdiction.

Price Stability

The goal of price stability is to have no more than moderate inflation, equal to or less than the real rate of personal income growth. When inflation is higher than this, people are growing poorer.

Demand-pull inflation occurs when aggregate demand increases, but supply is maxed out. When aggregate demand intersects aggregate supply at the full employment level of output, any further increase in demand pushes up prices without producing more output. Demand-pull inflation comes down to too many dollars chasing too few goods. To stop it means cutting aggregate demand.

Mini-Directed Research Area: Greece and the Sovereign Debt Crisis In 2010, the Greek economy nearly collapsed, as its government debt was downgraded to ‘‘junk’’ status-----meaning investors believed Greece was unlikely ever to pay back its massive and growing debt. Read a brief summary of the crisis here, or watch this YouTube video. Key questions to answer: What sorts of financial austerity measures did Greece pass in response to the crisis, and what has been their impact? Why was Greece’s situation complicated by its use of the Euro as its currency?

http://www.guardian.co.uk/world/2010/may/06/greek-debt-crisis-economy

http://www.youtube.com/watch?v=mEVqeaFHsHE

http://www.youtube.com/watch?v=mEVqeaFHsHE


Cost-push inflation occurs when the price of goods and services increases because the prices of inputs—such as oil—have risen. Firms pay more to produce, so aggregate supply shifts left. The equilibrium price level rises even though there is no more output.

Structural inflation is less common, caused by a demand shift from one type of good to another. For example, many companies have switched from glass to plastic containers. The change pushes the demand for plastic to the right, raising its equilibrium price. You might think the lower demand for glass would reduce its price, but not necessarily. Prices rise far more easily than they fall; economists say prices are sticky in the downward direction.86

Societies pursue price stability because inflation has some substantial economic costs.

Inflation lowers the buying power of people on fixed incomes, such as retirees. Some forms of fixed income do adjust for inflation, but not right away. Workers on salary find the real value of their wages reduced. Even those whose wages adjust quickly still face a cost called the hidden tax: progressive tax brackets do not adjust for inflation right away, so inflation can push them into higher tax brackets for the same real income.

In inflationary periods, people also find their savings suddenly worth less, especially savings held in cash, not in hard assets such as gold—the prices of which tend to rise with inflation.

The so-called shoe leather cost of inflation is a metaphorical term for the cost of making frequent trips to the bank to withdraw cash with which to cope with rising prices. This metaphor is less relevant now, as more people bank online87 and use credit cards.

If inflation is high or unpredictable, firms have no choice but to keep updating prices. In the past, restaurants had to keep spending to print new menus, so this is called the menu cost of inflation.

Worse, the relative prices of goods do not all adjust at the same rate. Suppose oranges normally cost half what headphones do. Orange growers can quickly raise prices in times of rapid inflation, but not headphone makers, who are locked in by published prices88. Oranges will briefly cost twice as much as headphones, causing consumers to favor headphones over oranges. This is hard on both orange growers89, who are selling less than they would like to, and headphone makers, who may lose money with every sale. Because goods will be allocated inefficiently, this is the allocative cost of inflation.

The planning cost of inflation refers to the fact that individuals and firms must devote time and effort to figuring out how to deal with inflation—instead of on actual economic activity.

86 This is not always the case, of course, especially with high-tech products such as flat-screen TVs, which tend to decline in price as production technology improves. In fact, a lot of people wait to buy new products until their prices fall. 87 Perhaps it could be renamed carpal tunnel cost. 88 As more commerce moves online, this becomes less of a problem; prices on the Internet can be updated instantly, as opposed to prices in actual paper catalogues—like the airplane magazines full of products you never knew you needed. 89 This might also lead to widespread scurvy.


Monetary Policy

Where the rest of the government uses fiscal policy to pursue economic goals, 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 skim over the history of economic policy.

In the beginning, there was classical economics, inspired by Adam Smith and his “invisible hand”. Classical economists urged governments not to tamper with their economies; laissez faire was the way to go. During a recession, they argued, wages would fall. Eventually businesses would hire new workers from the newly cheap labor pool, bringing down unemployment and restarting the cycle of rising economic activity. Business investments would also increase with falling interest rates.

That status quo mostly held until the Great Depression, when economies tumbled as governments stood by with invisible hands tied behind their backs—until John Keynes unshackled them with proposals for active fiscal policy. Governments increased spending to restore aggregate demand.

Keynesian economics dominated for years—but, in the 1960s, a new theory, monetarism, challenged it. Milton Friedman, an economist at the University of Chicago, had conducted research connecting the money supply to the business cycle. He concluded that recessions correlated with too little money in the economy, and inflation with too much.

Friedman believed the fundamental cause of the Great Depression was the destruction of the money supply. The effect of the stock market crash and the closure of banks was a drastic decrease in money in circulation.90 Earlier, we saw how banks help to multiply money and direct idle savings towards investments. To understand Friedman’s theory, imagine what would happen if most people suddenly pulled money from banks and stuffed it in their pillowcases.91 Much less would get bought and sold.

Since monetarists believe a reduction in the money supply is the main cause of recession, they conclude the best way to restore a down economy is to expand the money supply. The reason fiscal policy works, they argue, is that it does expand the money supply. But they see it as inefficient because it relies on the government to decide on what to spend money and whom to reward with tax cuts. The addition of money into the economy may focus on government goals instead of on what consumers and firms want—and the government may overshoot, 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 2-3% annual increase to allow consistent 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.92

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)

The velocity of money refers to how quickly it is spent. How many times a year does the average dollar (or lira, dirham, etc.) change hands? People and firms do not always spend money

90 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. 91 Today, I found an alpaca under my pillow. I quickly posted my discovery to Facebook, but no one seemed surprised. 92 This does not mean Keynesian theory had been forgotten, as recent stimulus packages around the world have shown.

Equation of Exchange

(M)(V) = (P)(Q)

M = Money Supply

V = Velocity of Money

P = general Price Level

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immediately. Suppose the average household or firm holds a dollar for two months. It would take about four months for a 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 would circulate 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.

It is straightforward to calculate GDP once you know the amount of money in an economy and its velocity. Consider the imaginary country of Bieberia, with $1000 in circulation. If velocity in Bieberia is 5, each of those thousand dollars will be spent on goods and services and re-earned 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.

But there is a third factor: the price level. If the money supply doubled to $2,000, the velocity of 5 would give us a GDP of $10,000, doubling Bieberia’s economic output. But what if it turned out prices 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 that the velocity of money tends to remain fairly constant. If you examine the equation of exchange, you will see that, if velocity stays the same, one needs only to change the money supply to change 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 the same five percent. Decreasing the money supply 10 percent decreases GDP 10 percent.

Nothing is that easy, however. For one, velocity does change. Check out the chart. During the recent economic crisis, velocity slowed in the United States, as concerned people held onto their money. Conversely, it surged during the booming 1990s, when Americans were spending more often on more things (including those exuberant dot-com stocks.) Also, increasing the money supply too quickly will tend to increase the price level more than it does GDP.

Still, according to Friedman and his followers, if a country maintains slow, steady increases in the money supply, it will tend to see equally economic growth.

Tools of Monetary Policy

Central banks have 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 central banks buy and sell them on the open market. If the Reserve Bank of India believes the Indian money supply should be increased, it buys bonds, injecting money into the economy. If it believes there is too much money out there, it sells bonds, taking money out of circulation. Open market operations are the most commonly used monetary tool.

Velocity of Money (M2) in the U.S.


Purchasing bonds and securities—Money supply increases. Selling bonds and securities—Money supply decreases.

The discount rate is the interest rate a central bank charges when it lends money to member banks. A lower discount rate decreases banks’ costs of borrowing, allowing banks to lower the rates for their loans to consumers and firms. As per the law of demand, this leads to a greater equilibrium quantity of loans. If banks make more loans, people have more money in their hands to spend.

Lowering the Discount Rate—Money supply increases. Raising the Discount Rate—Money supply decreases.

Suppose a bank has 5 clients each with $10,000 deposited in accounts. It owes each $10,000, so the bank has $50,000 in liabilities. It is unlikely they will all ask for their money back at the same time, so the bank loans some of it out (to make profit) and keeps the rest on reserve.

Central banks set the reserve requirement: the percentage of deposits a bank must keep on reserve. If this requirement is lowered, 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.

If total deposits are $50,000 and the reserve requirement is 10%, the bank must keep $5,000 on hand. It can lend out the other $45,000. If the central bank now lowers the reserve requirement to 2%, the bank will only be required to keep $1,000 on hand. It can lend out another $4,000.

Loans can have an even broader effect on the money supply. Assume a reserve requirement of 20%. A bank loans out $100,000. No one takes a loan to put it into a savings account; people take loans to spend them. The recipients of the spent money will deposit it in their own accounts—so deposits at other banks will increase by $100,000. These banks can loan out $80,000. The money is re-loaned, re-spent, and re-deposited at banks that can again loan out 80% of it. The cycle repeats.

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.

This should remind you of the spending multiplier, related to the marginal propensity to consume. As with the spending multiplier, the real money multiplier is not as high as the formula implies. Our calculation assumes all banks will loan out all the money they can. It also ignores taxes removing money in each exchange, and the fact that people might not spend the entirety of their loans. But it gives us a sense of the widening impact a change in the money supply can have.

Money, Supply and Demand

Just as with any good, the equilibrium price and quantity of money in the economy can be found by looking at supply and demand—as in the diagram to the right. Here, the good is money itself. The vertical axis, as usual, represents price.

Interest rates are used as the price of money because they represent the opportunity cost of holding and using it instead of saving it. If you could put $1,000 in an account for $60 of interest per year (6%), then $60 is your “price” for spending $1,000 of money instead of saving it.

Money Multiplier

Multiplier = 1/R

Total Increase In Money Supply = A/R

R = Reserve Requirement A = Initial Amount of Increase


The horizontal axis represents the quantity of money in the economy. By money, we mean M2—not just cash and coins, but the entire money supply after the multiplication that takes place when money is saved, loaned, re-saved, and re-loaned.

Now, let’s look at the diagram to the right. Assume the equilibrium of supply and demand sets the money supply at M0. If a country’s central bank enacts policies to tighten the money supply, supply will shift inward: from S0 to S2. Interest rates rise (from 9% to 15%), and fewer people will want to borrow money. If fewer people borrow, the money supply drops to M2—limiting economic activity.

If a central bank 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.

Advantages of Monetary Policy

Swift enactment of policy. Changes in monetary policy can be implemented immediately via the sale or purchase of securities and bonds. Interest rates are also easy for central banks to adjust. No complicated politics: just quick action. Even when fiscal policies have quick, dramatic effects, they must usually pass through a country’s legislative process.

Political immunity. Even if the best policy is to slow the economy down, politicians usually hesitate to call for increased taxes. They want to be reelected, and tax hikes or spending cuts can cost them support. Monetary policy, set by a central bank, puts less of a target on their backs.

Driven by economic experts. The average politician probably understands less economics than someone who has read this guide. Central banks are usually run by experienced economists.

Easier to fine-tune policy. A central bank can change interest rates in small increments, allowing it to guide the economy to a “soft landing” or to accelerate it gradually. Fiscal policies 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, economic activity slows. Loose money policies are harder to execute. They make money available in the form of cheaper loans, but, if a depressed public does not want loans, banks’ excess reserves just sit there. Fiscal policy, by contrast, can put money directly into people’s hands through tax cuts and transfer payments, and can directly add to consumption through government spending.

Changes in velocity. Consumer expectations can change velocity. If consumers expect prosperous times, they tend not to worry about keeping as much cash on hand. They spend money more quickly, raising V. If consumers expect a recession, they hold onto money longer, lowering V.

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. During a boom, optimistic firms may take out loans even at increased rates.

Time to take effect. It can take time for changes in monetary policy—often several cycles of loans taken and repaid—to filter into the economy. Fiscal policy’s effects are more immediate.

Linking Unemployment and Inflation

In the 1950s, Kiwi93 economist William Phillips devoted himself to studying unemployment and wage changes over a century of British history. He noticed that when wages were increasing the fastest, unemployment was lowest. In a booming economy, firms hire more workers, and an increase in demand for labor leads to an increase in wages.

Other economists took this relationship further. In a booming economy, wages were not the only thing rising—so were prices in general, pulled by demand. The lower the rate of unemployment, the higher the rate of inflation.

The Phillips Curve connecting unemployment and inflation is an observation, not a rule. It assumes there is a natural rate of employment at which the economy is neither depressed nor overheated. Inflation is low, the economy is stable, and children sing and dance. If unemployment is above the natural rate, there is a lot of slack in the economy. If unemployment is below the natural rate, the economy is overheating, and inflation surges.

Data from the 1960s seemed to confirm the Phillips Curve—but the 1970s ushered in high inflation and high unemployment. Economists concluded there was no single natural rate of employment. The Phillips Curve can shift. The 1990s saw low unemployment and low inflation, and today economists worry efforts to jumpstart the global economy are causing inflation without doing enough to lower unemployment.

Say’s Law and the Supply-Side Approach

A factory hires workers and pays them wages. The wages allow the workers to demand and buy other goods.94 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, now called Say’s Law: that supply creates its own demand. The revenues earned by those who produce goods and services are used to buy goods and services—including those they just produced.95

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

93 He wasn’t a bird, he was a New Zealander. 94 Henry Ford followed this principle: he paid his workers enough so they could afford to buy their own Fords. 95 This process is sometimes helped along with employee discounts.


aggregate demand. Say can be thought of as one of the first critics of Keynesian economics96. But Say was not a monetarist. He believed in monetary neutrality—that the size of the money supply has no effect on an economy and that only real wealth, consisting of goods and services, matters.

Say’s Law tries to answer the economic chicken-and-egg problem: does demand spur supply or does supply spur demand? Say’s Law suggests that employers and entrepreneurs are more important to economic prosperity than typical workers—because they pay workers the wages they need to demand anything at all. They also help control what consumers demand. Steve Jobs’ imagination and Apple engineers supplied the iPhone, which people then demanded.

One movement associated with Say’s Law is supply-side economics, championed by United States President Ronald Reagan and British Prime Minister Margaret Thatcher in the 1980s. They favored tax cuts for businesses, shareholders and investors, who would, in theory, use the tax savings to hire more workers and increase output. Critics call this trickle-down economics, arguing it takes a long time for benefits to “trickle down” from those enjoying tax cuts to the average worker.

With the value of that approach left open to debate (hint!), this economics guide trickles to a close. Be sure to move on to the New Economy Resource for a look at ongoing economic transformations in the modern world, from Facebook to the e-book.

96 He had to have been one of the first, since he died in 1832, 51 years before Keynes was born.


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 High School Academic Decathlon team to its second national championship; a jaywalking ticket then turned him into a factor of production, as which he founded both DemiDec and, eleven years later, the World Scholar’s Cup. Along the way, he has briefly managed a Japanese venture fund, ghostwritten for the Secretary-General of the United Nations, dropped out of school (twice), and altered the balance of trade between the United States and Peru through the importation of vast quantities of finger puppets. He has no idea how to nuclear missile a cow.

Daniel and his teammates had their share of run-ins with the law, including one that involved a helicopter and another that ended in an earthquake. You can e-mail Daniel at [email protected] or find him at Facebook at www.facebook.com/dan.berd.

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. Following his graduation from Harvard, Randy worked 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. Later, he forgot he had intended to go into law and moved to China, where rumors have it he is running a hedge fund.

In 2000, Randy led the Simi Valley High School Academic Decathlon team to its first win at the California state competition; it went on to take second at nationals in San Antonio. Randy is currently trying to find purpose in life and not be bothered by the eventual heat-death of the universe. Randy is sure that he will be in prison fifteen years from now, but is unsure if it will be for environmental activism, tax fraud, insider trading, or anti-trust violations.

About the Illustrator Vicky Ge is very good at figuring things out: challenge her to a game of online Scrabble at your own peril. She is not just an illustrator but an animator, a dancer, a writer, an economist, and an extraordinarily deep sleeper. Vicky currently attends Harvard University, where she religiously takes Gummy Bear vitamins, doodles, manages the production of books for orphans, and searches the Internet for deals, including Groupons. She is known to measure utility in pieces of sushi.

http://www.facebook.com/dan.berd

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Econ Fundamentals Resource