WB - Econ Fundies 2011-2012...

ECONOMICS WORKBOOK | 1

BASIC ECONOMICS DEMIDRILLS

Fundamentals of Economic Thinking

Table of Contents

I. Basics of Economics ................................................................................................. 4 II. Microeconomics ...................................................................................................16 III. Macroeconomics .................................................................................................84 About the Author ....................................................................................................142 About the Editors ....................................................................................................142 Answer Key .............................................................................................................143

Jessica Raasch Arizona State University 07

edited by

Dean Schaffer and Daniel BerdichevskyWilliam Howard Taft High School

Stanford University

re-edited by

Chris YetmanCanyon del Oro High School

DemiDec and The World Scholar s Cup are registered trademarks of the DemiDec Corporation. Academic Decathlon and USAD are registered trademarks of the United States Academic Decathlon Association.


IntroductionIt’s not easy to learn economics from a textbook. In fact, it’s not easy to learn economics, period. It’s a social science, but it’s filled with math and graphs. It’s an abstract field of study, but we read about it all the time in the business section as if economic theories were hard facts. If you’ve never paid much attention to this thing we call “the economy,” it can be difficult to get started.

That’s where this workbook comes in. It’s a special workbook, if I may say so myself. Yes, I’m one of the authors and I’m a bit biased, but I’m not making this stuff up. It’s special because we wrote it with you in mind, realizing that learning economics is tough. It’s nothing like memorizing dates, names, and other information the way you do to prepare for the other Decathlon events. You have to dig in and play with the concepts in order to learn them. For that reason, we do things differently in the economics workbook.

In the first three sections, we present you with short lessons, immediately followed by exercises to reinforce the material. We emphasize concepts, rather than testable facts. In the fourth section, we follow the format of our other workbooks, using exercises to help you learn the material in the USAD guide on the Economics of the Great Depression.

The lessons in the first three sections are short and generally more concise than what you find in our resources. They’re meant to supplement—not replace—the textbooks and other materials you should be using to prepare for the economics exam. You could probably work through most of the workbookwithout referring to another text, but I would caution you against doing that. I studied economics when I was a Decathlete and I later went and got a degree in the subject. My experience has been that it is sometimes necessary to get several explanations of the same concept. This year, USAD has come out with a wonderful economics resource and I encourage you to reference it often as you work through this workbook. Trust me, it will help.

To learn economics, you have play with the concepts. If you’re looking to win gold, my suggestion is that you take an active role in the learning process. Don’t just read the material; draw the graphs, work through some algebra, and ask a lot of questions. We created the “tutorial” workbook format to help structure that kind of active learning, but you’re certainly not limited to this text. You can also watch the news and make your own connections between real-world events and the lessons in your textbooks. That will help you. You can observe people so you can convince yourself that there is some truth in the laws of supply and demand, and that there are indeed predictable relationships between unemployment and economic events. That will help, too. And finally, you can talk about economics with your teammates, your parents, and your coaches. That will probably help more than anything.

Best of luck,

Jessica


I. Basics of Economics This section covers everything in Section I of the curriculum outline. If you

are using USAD guides, please note that it roughly follows pages 6—9 of the USAD Economics Resource Guide.

BASIC ASSUMPTIONS OF ECONOMICS (I.A)

Economics is a study of decision-making—why people make the choices they make, how they makethem, and what happens as a result. Sometimes economists look at what happens when whole groups of people make very similar choices, like when thousands stand in line to watch the latest Harry Potter film at midnight. Sometimes economists try to explain why a group of people simply can’t seem to come to a decision, as when peace talks are delayed because no one can agree about the shape of the table for the meeting. And other times, economists are just interested in the choices of individuals like you and me. An economist might examine what motivated your decision to read this workbook rather than sleep1. Or maybe she’d be interested in my decision to write it rather than campaign to save pelicans from environmental disasters2. But at the end of the day, whether it’s the decision to wage war or the choice between sleep and study, economics is nothing more than the study of choices.

Before we get going, it will be helpful for you to be aware of some of the basic assumptions that underlie much of mainstream economic thought. There are four basic you need to understand:

� Scarcity is everywhere.� Nothing is free.� People are rational.� Trade is good.

There is no need to memorize these assumptions, but you should try to think about how things might be different if any one of them—or all of them—were untrue. Let’s look closely at each.

Scarcity is Everywhere

There just isn’t enough stuff in the world for everyone to have as much of everything as they’d like. In fact, that is the basic problem of economics: we have unlimited wants, but only limited resources with which to satisfy them. In other words, scarcity is the basic economic problem.

Even if a resource is given away for free, it is scarce if people want more of it than what is available to them. You can probably think of things that seem to be abundantly available to you now. For instance, you breathe all the air you need, and you probably think you get more calculus homework than you really want. But the fact is that you get calc homework because you met the prerequisites and you snagged one of a limited number of seats in a class. The poor, underprivileged souls in first-year algebra can’t have any calculus homework because they’re not in the class and your calculus teacher simply

1 Although she wouldn’t have to think about it for very long. Choosing economics over sleep might actually be one of the easiest and most obvious decisions in the history of time. 2 But for the record, you should know that I actually did adopt a brown pelican after the recent gulf oil spill (when I say “adopt” I mean, “send $150 to a bird rescue agency in exchange for a certificate with a picture of”).


doesn’t have enough time to grade assignments for other students.

As it turns out, scarcity is everywhere. The people of the world suffer every day with less chocolate, fewer smart phones, fewer economists, and even fewer economics workbooks than they would like. Even calculus homework, like so many other things, is scarce. Scarcity is what forces people to make the difficult decisions that we study in economics.

Nothing is Free

Some resources seem to be available to everyone, so we have trouble recognizing that they are indeed scarce. Such goods are termed free goods. Air is the most common example, but, as you know, you can’t get breathable air everywhere in the universe. You might not pay cash to get breathable air now, but when you start packing for your next trip to Pluto (presumably to get some quiet study time), you will probably have to buy some oxygen. Even on Earth, people pay to get oxygen in hospitals and oxygen bars. In fact, the air we breathe every day has a price tag, too, although it’s a bit less obvious: we pay taxes to support the regulations that help keep our air breathable.

One of the basic assumptions of economic thought is that nothing is free, or to put it another way, that everything has a cost. Since resources are scarce, we have to give up something we already have in order to get something we want. If a gold medal in Economics is what you want, you will have to give up some time in order to get it. In economics jargon, the act of giving up one thing in order to get something else is called a trade-off. Every choice requires some kind of trade-off. That is why economists sometimes say, “There ain’t no such thing as a free lunch3.”

Every time you choose to do something, you are effectively choosing not to do other things. That means there could be countless choices (to not do things) related to your choice. For example, by choosing to study Economics today, you chose not to study for any of the other objective events. You chose not to work on your speech, not to practice for your interview, and not to work on your essay.

The opportunity cost of a decision is the value of the best alternative not chosen—the value of the thing you could have had, but didn’t. If looking through pictures of your friends’ friends on Facebook was the best alternative to an hour of studying economics, then the opportunity cost of studying was the value to you of seeing all those pictures4. It’s the cost of the lost opportunity.

1.011 FILL-INFill ‘er up, Phillip . Complete these statements by writing in the missing words.

1. There ain’t no such thing as a free lunch (TANSTAAFL).

2. The basic problem of economics is ______________________________.

3. If less of a resource is available to us than we like, then the resource is said to be ____________.

4. The most common example of a free good is ______________________________.

5. The _______________ _______________ of a choice is the value of the next-best alternative.

People are Rational—More or Less

Economists assume that people are rational, even though the world is full of evidence to the contrary5.

3 To be more precise, old economics textbooks say it. I worked in an economics research institute and I never heard any of my colleagues use that phrase. If they had, the rest of us probably would have made fun of them behind closed doors. 4 Someday, I hope you can appreciate what a wise choice you have made. 5 Actually, there is an entire school of economic thought dedicated to standing this assumption on its head and exploring the


The rationality assumption implies economists count on people to have consistent values and to act according to those values in a consistent manner. A rational person would never voluntarily do something to his own detriment—something that would leave him with less of what he values.

Suppose Fred loves chocolate but he’s deathly allergic to carrots6. If Fred is a rational person, it should be safe for an economist to assume he’ll be willing to do things that are rewarded with chocolate but will avoid doing things that are reciprocated with carrots. Based on the rationality assumption, a coach who wanted to encourage Fred to study could expect that offering him chocolate would make him more likely to hit the books. Or, Fred’s coach could punish him by giving him carrots every time he did poorly on an exam. Either way, the coach would be assuming Fred would never do anything to deprive himself of chocolate or to subject himself to carrots.

If Fred were irrational, the coach would have a hard time knowing how to motivate him, and an economist would have a hard time explaining his decision-making. An irrational Fred might actually study less when offered chocolate as an incentive for studying more.

In more technical terms, when faced with a decision, economists assume a rational person will carefully evaluate the benefits (what he might gain) of each choice and weigh them against the costs (what he might lose). Based on this thoughtful cost-benefit analysis, rational people are assumed to always make choices that leave them better off than they were before they made those choices. Costs and benefits do not necessarily have to be quantifiable. The benefits of accepting a particular job offer might include that the job is close to home. The costs might include a reduction in salary.

1.02 THINK FAST!Hurry up! How do we conduct a benefit-cost analysis?

_________________________________________________

_________________________________________________

Marginal Benefits and Marginal Costs

Economic decision-making rarely involves “all-or-nothing” choices. One of the most important economic decisions we make concerns the question of “How much?” To answer it, we have to decide whether to produce a little more or a little less, or whether to buy a little more or a little less.

The Margin

People make decisions at the margin. The margin is the incremental difference, for better or worse,between one option and another.

When economists speak of marginal cost, they are usually referring to the cost of one more unit of production. The marginal benefit is the benefit of one more unit of production. If we use benefit-cost analysis to make a production decision at the margin, then we weigh the costs of one more unit of production against the benefits of one more unit of production7.

When we make decisions, sometimes we are tempted to take too much into consideration. Marginal decision-making requires we consider only the marginal benefits and costs. We must ignore sunk costs,

real world, full of irrational people doing irrational things—but that’s another lesson for another workbook. 6 Fred and I could be twins (the sort of unrelated twins who happen to have the same favorite foods and food allergies). 7 For instance, is watching another episode of Star Trek worth the number of friends I will lose? Probably. -Andrew


or costs that cannot be recovered. Sunk costs typically include money that has already been spent. For example, the fee you paid to originate a cell phone contract will not be returned to you, regardless of whether you switch carriers or stay with the one you already have. Once you have paid the fee, no amount of decision-making will return your money to you. When you consider switching carriers, you’ll waste your time if you worry about the lost start-up fee. No amount of decision-making canavoid sunk costs, so we do not consider them when we make a marginal decision.

1.03 APPLYING KEY CONCEPTSPractice makes perfect. Below is a list of economic decisions and the reasons why they were made. For each decision, identify the marginal benefit of the alternative that was chosen.

1. Billy orders a combo meal at McDonald’s. He decides to Super-Size his meal because it only costs him 79 cents extra to have a few more ounces of French fries and soda.

_____________________________________________________

2. Wyatt wants to take his girlfriend to see a movie. He decides to take her to a matinee in order to save a few bucks off the regular price of admission.

_____________________________________________________

3. Evan turns down an offer from the University of Southern California and attends a state university in a snowy, mountain town in the southwest. Evan explains: “Snowboarding is just 20 minutes outside of town.”

_____________________________________________________

1.04 THINK FAST!What is the margin?

_________________________________________________

Trade is (Usually) Good

Very few people are capable of making everything they need or want. The rest of us mortals are forced to depend on each other. Some of us can fix cars, some of us can write footnotes8. Rather than learn to fix cars and write footnotes, we can choose to do only one and then trade to obtain the other9. Broadly speaking, economists assume that rational people will trade to make themselves better off. That is, rational people will voluntarily exchange goods and services because trade allows everyone involved to have more of what they want or need.

The important thing to note here is not just that trade is “good;” it’s good for everyone who participates.If it weren’t good for someone involved, we’d assume that a rational person would choose not to do it.If a mechanic voluntarily trades some of his labor for an economics workbook, it’s because he values the workbook more than he values those hours of his time. Similarly, if I trade a workbook for a few hours of labor on my car, it’s because I value the repair more than I value the workbook. Both of us

8 A niche market that I fill nicely. -Andrew9 Trust me; the world is full of mechanics that need good economics workbooks.


voluntarily enter the transaction because both of us expect to gain more of something we value.

Be careful: To say that trade is good for everyone who chooses to do it is not exactly the same as saying that trade is always good. There are times when it doesn’t make sense to trade, because it would not make everyone better off. When that happens, we expect rational people not to trade. What we’re really saying here is that if trade happens, and if all people are rational, then everyone who participates in trade must benefit. It might seem like we’re splitting hairs, but later on we’ll introduce the tools economists use to determine when exactly it makes sense to trade.

1.05 LISTING List-en up. List the four basic assumptions of economic analysis covered so far in this workbook.

a)

b)

c)

d)

1.06 EXAM PRACTICE“Is this gonna be on the test?” The questions below are similar to those that have appeared on Decathlon exams in the past. In this exercise, you’ll practice outsmarting them. First, in each question, underline the phrases you know to link together. Then, circle the letter of the correct answer choice.

1. The cost of a trade-off is known as its

a. opportunity costb. trade-off costc. explicit priced. real valuee. future cost

2. A firm can produce T-shirts or sweatshirts. The opportunity cost of the firm’s decision to produce T-shirts is BEST measured by the

a. fixed costs of T-shirt productionb. variable costs of T-shirt productionc. price of the T-shirts producedd. number of sweatshirts the firm chose not to producee. total costs of T-shirt production


TES

T-T

AK

ING

TIP

In your mind, you should link the terms “trade-off” and “opportunity cost.” Also, link “opportunity cost” with the phrases “did not choose” and “chose not to.” On an exam, if you see one term from a linked pair in a question stem, the other one could be lurking in the correct answer choice. Here is an example:

1. Bob made a trade-off when he chose a job located close to his home over a job he loved. The value of working a job he loved was his

a. alternative costb. economic costc. opportunity costd. marginal benefite. marginal cost

1.07 FALSE No way, José. Each of the statements below is false. Your job is to determine which piece of information is wrong and then correct it on the lines provided. An example has been done for you.

losesExample: Jessica loves it when she tries to save her workbook files and she gets a message indicating that, “A file error has occurred10.”

1. One of the basic assumptions of economics is that trade is usually beneficial for someone involved.

2. When you give up one thing in order to have another, you make a trade.

3. The rationality assumption means that economists expect people to respond to incentives in unpredictable ways.

4. If something is given away for free, it cannot be scarce.

5. People are forced to make economic decisions because they are irrational.

10 I do too. At times, I hate Microsoft Word. –Chris


1.08 THIS OR THAT And don’t say “neither,” either. In the chart below, indicate whether the behavior of the subject whose name is in parentheses is rational or irrational. The first one has been done for you.

Rational Irrational

The itsy-bitsy spider is thirsty. He goes up the water spout. (the itsy-bitsy spider) ×Jill has a fear of falling. Jack and Jill go up a hill to fetch a pail of water. When Jill sees Jack fall down and break his crown, she says, “I told you not to wear those shoes.” Jill calls her dad, who sends his private helicopter to rescue her from the top of the hill. (Jill)

Jack is in love with Jill. Jill is terrified of walnuts but she walks past a walnut tree every day on the way to school. Jack sneaks out of the house one night and chops down the walnut tree. (Jack)

Jill’s mom is a financial planner who helps her clients learn to save money. She loves designer shoes. Her company will match any contributions she makes to her retirement savings, but she won’t save because she doesn’t want to go without new shoes. (Jill’s mom)

Jack is a varsity decathlete who hopes to have the highest overall score at regionals. Jack has been scoring around 650 on his Economics practice tests, but he has been scoring above 950 in Speech. When Jill, who has been scoring around 850 in Economics, offers to help Jack, he says he would rather work on perfecting his speech. (Jack)

Jill is addicted to vampire novels (and their movie adaptations). Jack has finally realized that he needs Jill’s help with Economics, so he asks her to study with him. He offers to take her to opening night of Eclipse in return, but Jill—still offended that he turned her down in the first place—refuses to help him.


MODELS AND ECONOMIC THEORY (I.B)

Economists construct theoretical models11 that attempt to explain and predict economic phenomena. Models are mostly mathematical and/or graphical and they are necessarily simplified, with the goal of isolating the important relationships between cause and effect and measuring the extent to which variables affect one another. At this level, we don’t do much with mathematical modeling, but we will look at several graphical representations of economic phenomena (consider this fair warning!). In more advanced economics courses, a strong mathematical background is really helpful, if not required.

POSITIVE ECONOMICS AND NORMATIVE ECONOMICS (I.C)

There are two kinds of statements about economics. A positive economic statement is one of economic fact or proposed fact that can be tested. It states “what is.” When we make a positive statement, we describe what is known or we make inferences from what is known. A positive statement can be factually tested—it can be proved or disproved. Also, economic theories are stated positively. Theories are stated without biased language, usually in the form of “If X, then Y.”

A normative economics statement is one of opinion. It may be formed by interpreting the facts, but it can be neither proved nor disproved with facts. A normative statement expresses something that ought to be an economic goal or how a goal ought to be pursued.

Suppose the Bureau of Labor Statistics reports the unemployment rate is 5.6 percent. If I were to offer a positive statement about the report, I might say, “According to the BLS, the unemployment rate is 5.6 percent this month.” To make a normative statement, I might say, “Unemployment is too high12.”

1.09 CATEGORIZATIONAre you positive? Determine whether each statement below is positive (P) or normative (N). Circle your answer choices.

1. P N “Congress should approve the new bill to give prescription drug benefits to Medicare recipients.”

2. P N “Productivity increased last quarter.”

3. P N “The inflation rate in this country is normal.”

4. P N “The Bush administration created the largest budget deficits since the 1980s.”

5. P N “If the poverty line is raised, then those whose income level is currently at the bottom of the middle class will receive a tax break.”

11 Very cool, but much less interesting than supermodels. -Andrew12 And if I were running for governor of New York, I might say, “The rent is too [darn] high.”

Positive Economics Normative Economics

fact:�The unemployment rate is

5.6 percent this month.�

opinion:�The unemployment rate is

too high.�


TES

T-T

AK

ING

TIP On exam day, you should expect to see a question in which you’ll have to tell positive

economics statements from normative economics statements. Your best bet is to try to spot the normative statements first. Normative statements will contain words like “should,” “ought,” or “too” (as in “too high”). They also contain adjectives like “normal” or “under-funded.” By elimination, you know that if something is not normative, it has to be positive. You’ll have to watch for theories, which are usually expressed as “If _____, then _____.” Theories are always positive economic statements because they can be tested.

1.10 EXAM PRACTICEOn the test. The question below is similar to one you might see on exam day. In this exercise, you’ll outsmart it. First, in each question, underline the “opinion word” in the answer choices. Next, place an asterisk (*) next to the statement of theory. Finally, circle the letter of the correct answer choice.

1. Which of the following sentences is a normative economics statement?

a. The unemployment rate is less than five percent.b. The Federal Reserve implements economic stabilization policies.c. The Federal Reserve ought to keep the money supply constant.d. The reserve requirement is over ten percent.e. If the price increases, then the quantity demanded will increase.

EFFICIENCY AS A GOAL (I.D)

Since there is never enough of everything to go around, decisions have to be made about how to allocate resources among people. Efficiency is one criterion for evaluating how well society as a whole is making use of the resources it has available. A great deal of economic thought is dedicated to improving the efficiency of economic outcomes.

Pareto efficiency is a special outcome which is achieved when resources are allocated in such a way that no one can be made better-off without making someone else worse-off. It is important not to confuse efficiency with fairness. Pareto efficiency can certainly be achieved even if everyone involved is not convinced that resources have been allocated fairly.

Let’s consider an example. Suppose I tell you that I’m going to split $100 with you, and I take $99 and give you $1. Voila! We have achieved Pareto efficiency. To make you even $1 better-off, I have to make myself at least $1 worse-off. In a simple scenario such as this one, Pareto efficiency is achieved once all resources have been allocated.

1.11 THIS OR THAT Because it can’t be both. In the chart below, determine whether each allocation of pie is Pareto-efficient or not. The first one is done for you.

Pareto-efficient

Not

1. Amy, Keith, and Somesh are sharing a pie, but they don’t eat all of it. ×


Pareto-efficient

Not

2. The three friends share another pie, but this time, Somesh has brought an appetite13.

3. Nik and Sumanta are sharing a pie in front of Amy. They don’t finish it, but they don’t offer Amy the last piece, either. 14

13 Om, nom, nom! –Robb 14 As is often the case in the exercises I write, the characters here have been based on real people. Sumanta and Amy were fellow decathletes from my team. Sumanta was kind and funny, so she gets lots of pie. She is also getting married in a few weeks and I am going to send her this footnote. Nothing says “I wish you the best” like a DemiDec footnote.

Amy

Somesh

Keith

Amy

Somesh

Keith

Amy

Sumanta

Nik


Pareto-efficient

Not

4. After Amy drops several hints, Sumanta finally offers her the last piece.

5. Tricia invites her friends, Michael and Dave, out for pie. She then proceeds to eat nearly all of it, offering them none.15

6. Michael leaves the table to take a phone call and Tricia offers Dave the last piece. When Dave returns, he sees the two of them finishing the pie.

MICROECONOMICS AND MACROECONOMICS (I.E)

We divide economics into two broad areas of study. In microeconomics, we study the economic decision-making of the individual and the consequences of those decisions. We isolate individual markets and we try to explain how they function and what will cause their behavior to change. In

15 These last few problems were inspired by a decathlete (who is a very good economics student and a terrific student in general) and her coaches from Rockwall High School in Rockwall, Texas. If I get to work with them again, I am going to suggest that we have pie at our next late-night dry erase board graphing session. I’ll bring the markers and the enthusiasm; you guys bring the pie.

Sumanta

Nik

Amy

TriciaDave

Michael

Tricia

Dave

Michael


macroeconomics, we study the behavior of an economy as an aggregate, or as a whole. We might try to measure the size of the economy or we might try to assess its health. We might also try to predict how a policy change could affect the economy.

1.12 CATEGORIZATIONThe big picture. Below is a list of topics in the study of economics. Determine whether each topic is in the area of microeconomics (“Micro”) or macroeconomics (“Macro”). Circle your answer choices.

Ex. Macro How an individual decides which brand of cereal to buy

1. Micro Macro How the Federal Reserve influences consumer spending in the U.S.

2. Micro Macro How a household decides which brand of laundry detergent to buy

3 Micro Macro How a firm decides when to go out of business

4. Micro Macro How debt affects the income gap among Americans

5. Micro Macro How new parents decide whether to work or stay home with their children

1.13 MATCHINGIt’s better than clashing. Match the letter of each term in the column on the left to the BEST description in the column on the right. Write your answers in the blanks provided. An example has been completed for you.

a. opportunity costb. scarcityc. cost-benefit

analysisd. everyonee. increase in

Facebook friendsf. efficiencyg. free goodh. positivei. voluntarilyj. trade-offk. individuall. aggregatem. cost

1. a decision to have more of one thing and less of another2. the scale of the study of microeconomics3. a general criterion to evaluate how well society is making use of its

available resourcese 4. an externality of working for DemiDec

5. in economics, everything has one of these6. how rational people decide between alternatives

7. the type of economic analysis that focuses on the factual relationships between cause and effect

8. equal to the value of the best alternative not taken

9. the manner in which people decide to trade10. the scale of the focus of macroeconomics11. seemingly available in a sufficient quantity to anyone who wants it

12. why people are forced to make decisions

Micro


II. MicroeconomicsThis section covers everything in Section II of the curriculum outline

except for some topics related to money, which are found in the macroeconomics section. If you are using USAD guides, please note that it

roughly follows pages 10—55 of the USAD Economics Resource Guide.

INTRODUCTION

In microeconomics, we focus on individuals—individual markets, individual people, even individual companies. We try to understand how individuals behave when they’re left alone, isolated from other individuals like themselves. To do that, we construct basic theoretical frameworks that allow us to zero in on particular behaviors. From this point forward, much of the curriculum will be theoretical, with each theory building on the basic assumptions you learned in the previous section. As you work through the material, it might be helpful for you to keep those four assumptions in mind. Remember: scarcity is everywhere, nothing is free, people are rational, and trade is good

PERFECTLY COMPETITIVE MARKETS (II.A)

I’m sure you’ve heard of markets before, such as flea markets, farmers markets, or stock markets. In economics, there is a particular definition of “market” that you need to learn. To an economist, a market consists of all the buyers and sellers of a particular good or service. When you read about the “national housing market,” economists are referring to all the people in the U.S. who have homes to sell and all the people who are looking to buy homes in the U.S. in the near future. It’s important that you understand that in microeconomics, we use a narrow definition of “market.” By this definition, the farmers' market in your city is not a market. However, all the people who are there to sell corn and all the people who are there to shop for corn are part of the local market for corn.

2.01 THINK FAST!Hurry up already. Write a brief response to the following question.

What constitutes a market?


PERFECTLY COMPETITIVE MARKETS (CONT’D) (II.A.1)

There are a few different kinds of markets. Perfectly competitive markets are perhaps the easiest to understand, so we will begin there. A perfectly competitive market has the following characteristics:

1) There is a large number of buyers;

2) There is a large number of sellers;

3) Sellers offer very similar products; and

4) Buyers and sellers have equal access to information. In other words, they can easily find out what price people have been paying for the product or service.

The market for wheat is often cited as an example of a perfectly competitive market.

2.02 LISTING Making a list, checking it twice.... Write a few short responses to the following prompt.

List four characteristics of a perfectly competitive market.

a)

b)

c)

d)

2.03 THIS OR THAT You can’t have your cake and eat it, too. In the chart, indicate whether the market for each good or service is perfectly competitive. If you choose “not,” explain your reasoning in the last column.

Good or ServicePerfectly

CompetitiveNot Reason

DemiDec Cram Kits × There is only one seller.

gasoline

copper

DroidTM Incredibles

bananas

software


Good or ServicePerfectly

CompetitiveNot Reason

Microsoft Office

cell phones

cars

notebook computers

DEMAND (II.A.2)

To understand markets, it helps to break them down into two parts: buyers and sellers. In economics jargon, a buyer will “demand” a good and a seller will “supply” it. We’ll start with demand.

We can create a demand schedule to show what quantity of a good or service consumers are willing and able to buy at each price. At a price of $200, you might only be willing to buy one phone. At a price of $100, you might be willing to buy two, thinking you’ll use one and give the other to your coach. And at a price of $20, you might gamble and buy ten, hoping the price will go up and you can sell them later for profit. A demand schedule would show all of the possible prices between $20 and $200, and how many phones you’d buy at each price. As the price gets higher, you buy fewer phones. According to the law of demand, as the price per unit increases, consumers will demand less of a good or service.

If we plot the data from a demand schedule, we create a demand curve. As you move from left to right, the curve slopes downward because of the inverse relationship between price and quantity demanded. As the price goes down, the quantity demanded increases. Moving from right to left, quantity demanded decreases as price increases. Quantity demanded is the quantity of a good or service that consumers are willing and able to buy at one given price. It applies to any one given point on the demand curve. At a high given price, quantity demanded is low, and vice versa.

In the graph below, you’ll see that a change from one price to another will force you to move along the curve. In other words, movement along the demand curve represents a change in quantity demanded.

Demand

Price

Quantity $5 5000

$500

0

1000

4000

3000

2000

Demand SchedulePrice Per Unit Quantity

$2,500

$2,000

$1,500

$1,000

D


Movement along the Demand Curve

2.04 FILL-INThe filling is the best part. Use the terms in the Word Bank to fill in the blanks in each statement below.

WORD BANK

price decreases point on the curvecurve law of demand increases

1. The ___________________________ holds that, as price increases, quantity demanded

___________________________.

2. As price decreases, quantity demanded ___________________________.

3. Demand is a schedule, which can be represented by a downward-sloping ___________________.

Quantity demanded corresponds to a _____________________.

2.05 GRAPHINGConnect the dots. Plot the price and quantity demanded data from the table into the grid, below. When you’ve finished, connect the dots to form a demand curve.

PriceQuantity

Demanded

$15$20$25$30$35$40$45

50301810765

P

Q

a change in price

a change in quantity demanded

D

Demand Curve for Toasters

05101520253035404550

0 10 20 30 40 50 60

Quantity Demanded

Pric

e


2.06 FILL INDetails, details. The difference between “demand” and “quantity demanded” is important, and the Decathlon likes to test you on your understanding of it. In this exercise, you’ll practice using the terms correctly. Use the demand curve below to complete the statements that follow.

Begin at point A on the demand curve. By moving to point B, price drops from 100 to 70 and

_________________________ __________________________ increases from five to seven.

A move from point E to point D represents a price increase. It also represents a decrease in

___________________________ _____________________________.

When considered all together, points A, B, C, D, E, F, and G, as well as all theoretical points in

between, represent ___________________________________.

Moving leftward from any given point results in an increase in price and a decrease in

__________________________ __________________________.

Moving rightward from any given point results in a decrease in price and an increase in

_______________________ _________________________.

According to the law of __________________________, price is inversely related to

_________________________ _________________________.

SHIFTS IN THE DEMAND CURVE (II.A.3)

As you know, a demand curve represents the quantity demanded of a given product at each price within a range of prices. When the price changes, we move from one point on the curve to another. Now we’ll see that when there is a change in something other than the price of a good, the entire demand curve might shift.

A change in demand can result from any of a handful of factors. The most important ones are

Demand Curve

GFED

C

B

A

0

20

40

60

80

100

120

0 5 10 15 20

Quantity Demanded

Pric

e


summarized in the table below and explained in greater detail in the paragraphs that follow.

FACTOR CHANGEDIRECTION OF THE

DEMAND CURVE SHIFT

Consumer incomeincrease rightdecrease left

Price of a complimentary goodincrease leftdecrease right

Price of a substitute goodincrease rightdecrease left

Consumer tastesfavorable right

unfavorable leftConsumer expectations about the future price

increase rightdecrease left

Number of buyersincrease rightdecrease left

A change in consumer income. It’s probably not hard to understand that when people make more money, they have more money to spend. Of course, we don’t always spend everything we make, but that’s another lesson. For now, just remember that an increase in consumer income will often result in an increase in demand. That’s true for normal goods, anyway. By definition, a good is “normal” if people buy more of it when they have more money.

There are some goods that don’t elicit the same kind of behavior as normal goods. Sometimes, when people make more money, they buy less of certain goods and more of others. These goods are called inferior goods. By definition, a good is inferior if people buy less of it when they make more money16.In college, people tend to eat a lot of inexpensive food, because they have very little income.

A change in the price of a related good. Sometimes, a change in the price of one good will affect demand for another good. Related goods are either substitutes or complements. We’ll look more carefully at each of them later in this workbook.

A change in consumer tastes. It should be no surprise that people try to buy more of what they like and less of what they don’t. When something suddenly becomes fashionable, demand increases. When it goes out of style, demand decreases, and the demand curve shifts back to the left.

A change in expectations. Sometimes people get ahead of themselves and demand changes in anticipation of some other change. For example, if you know you’re about to get a promotion and a raise, you might run out and buy all the Economics Workbooks you can afford, so that you can give them to your friends as party favors when you celebrate. In that case, your expectation of an increase in income is enough to cause your demand for Economics Workbooks to increase.

A change in the number of buyers. If the number of buyers changes, the number of people who can (and will) consume a given item will also change.

When there is a change in demand, the entire demand curve shifts to the right or left. Be sure not to

16 One of the joys of revising your own workbook, several years after you wrote it, is to see how much your mindset has changed. When I first started writing for DemiDec, at the age of 17, my examples of inferior goods were all the things that college kids buy because they have very little income: mac n’ cheese, Ramen noodles, and so on.


confuse a shift in the demand curve with a change in quantity demanded (a movement along the curve).Another way to think of it is this: if the price does not change, but quantity demanded does change, there must be a shift in the demand curve.

Let’s consider an example. Suppose brie cheese is a normal good for me and all of my co-workers.17 At a price of $12 per pound, the group of us would buy three pounds. Now suppose we all get raises on the same day, and we decide to have some hors d’oeuvres to celebrate. We all run out and buy some more brie. The price has not changed; it’s still $12 per pound. However, the quantity demanded has changed. Now, at a price of $12, we buy five pounds. On the graph below, you can see that the demand curve has shifted to the right as a result of our change in income.

Movement of the Demand Curve

2.07 CATEGORIZATIONOne of these things is not like the other... In this exercise, you’ll see groups of phrases or concepts that are somehow related. In each group, one item has been included that does not belong. In each problem, cross out the one that does not belong and then write a brief explanation of your reasoning.

The candidates: Your explanation:

Dr. YangDr. GrayDr. 90210Dr. O’Malley

The group consists of doctors who are characters on Gray’s Anatomy. Dr. 90210 is way too spiffy for that show. And anyway, Seattle is nowhere near the 90210 zip code.

price dropsconsumers make more moneyconsumers convince their friends to consumeconsumers decide not to consume any more

the price of a substitute good increasesthe price of a complementary good increasesthe number of consumers increasesconsumer income increases

17 It shouldn’t be too hard to imagine, since it’s true. In fact, all this talk about brie is making me hungry.

D D1

$12

3 5


change in consumer preferencechange in pricechange in seasonchange in the number of consumers

change in the price of a substitutechange in the price of a complementchange in pricechange in consumer income

SUBSTITUTES AND COMPLEMENTARY GOODS

Two goods are said to be related if a change in the price of one will impact the demand for the other. A substitute good is one that can easily replace another good. Some goods are sold as substitutes, such as “non-dairy creamer” or I Can’t Believe It’s Not Butter!®, but usually, the relationship is less obvious. For instance, tea can be substituted for coffee, or a cruise might take the place of a backpacking trip through Europe. When the price of a good increases, the demand for its substitute will also increase. The price of a good and the demand for a substitute good are positively related. In other words, the demand for one good will change in the same direction as the price of its substitute.

A complementary good is one so closely related to another that when the consumption of either good changes, the other is affected in a similar way. Examples of complementary goods include movie tickets and popcorn, razors and blade cartridges, or cars and auto insurance. For example, if the price of movie tickets drops, we would expect to see an increase in quantity demanded of movie tickets. With more people at the theater, there are more people waiting in line to buy popcorn; in other words, there is an increase in the number of consumers who want to buy popcorn. Thus, a decrease in the price of movie tickets would cause an increase in quantity demanded of movie tickets and an increase in demand for popcorn. In general, when the price of a good increases, the demand for a complementary good decreases.


2.08 UPS AND DOWNSWhat goes up must come down. Well, sometimes, anyway. In this exercise, you’ll see what happens to the price of one good. Your job is to indicate what happens to a related good by adding an arrow that points in the appropriate direction.

IF GOES THEN GOES

Ex: The number of days left before this workbook is due: The number of footnotes I write:

1. Price of Sprint Demand for Verizon Wireless

2. Price of HP Notebooks Demand for Toshiba Notebooks

3. Price of movie tickets Demand for popcorn

4. Price of peanut butter Demand for jelly

5. Price of Economics Workbooks Demand for highlighters

6. Price of auto insurance Demand for bicycles

7. Price of bicycles Demand for bus tickets

8. Price of bicycles Demand for helmets

9. Price of homes Demand for rental apartments

10. Price of tea in China Demand for alpaca finger puppets


2.09 IN BRIEFYou’ve been briefed. Write a brief response to each prompt, below.

1. In your own words, write a definition of “demand.”

2. In your own words, write a definition of “quantity demanded.”

3. Name the two factors that explain the shape of the demand curve for a normal good.

4. Explain the relationship between the price of a good and the demand for its substitute.

5. Explain the relationship between the price of a good and the demand for its complement.

2.10 GRAPHING Mean curves. In each problem below, something happens to one of the non-price factors that affects demand. The original demand curve, D1, has been provided. Draw a new curve, D2, reflecting the change in demand.

Change: Your Response:

Ex.: Yet another popular new diet has everyone afraid to eat carbs. Indicate what will happen to the demand curve for bread, which are carb-rich.

Demand for Bread

D1D2

P

Q


1. The price of hotdog buns increases sharply. Indicate what will happen to the demand for DECADOGS, a nationally-recognized brand of hotdog.

Demand for DECADOGS

2. The price of iced tea decreases. Indicate what will happen to the demand for lemonade.

Demand for Lemonade

3. In April, the last of the snow at the local ski resort has melted. Indicate what has happened to the demand for snowboards.

Demand for Snowboards

4. A conservative new president is elected, and his first order of business is to give an immediate tax break to anyone who earns $250,000 per year or more. Indicate what will happen to the demand for Porsches when the tax break goes through.

Demand for Porsches

5. The price of peanut butter decreases. Indicate what will happen to the demand for jelly.

Demand for Jelly

D1

Q

P

0

D1

Q

P

0

D1

Q

P

0

D1

Q

P

0

D1

Q

P

0


6. Student loan checks are disbursed and college students suddenly have more “income.” Indicate what will happen to the demand for macaroni-n’-cheese dinners.

Demand for Macaroni-n’-Cheese

2.11 MATCHINGIt’s how eHarmony makes money. Match the letter of each term in the column on the left to the BEST description in the column on the right. An example has been completed for you.

a. complementb. movement along

the curvec. movement of the

curved. quantity

demandede. substitutef. inferior goodg. fire alarmh. buyersi. marketj. demand curvek. normal good

1. people buy less of this when they have more money2. consists of all of the buyers and sellers of a particular good or service3. demand for this is positively related to the price of a good

4. a graphical representation of the information presented in a demand schedule

5. people buy more of this when they have more money

g 6. the reason Jessica woke up at 6 a.m. this morning and limped down ten flights of stairs with an icepack on a very sore foot

7. results from a change in price8. can result from a change in consumer expectations

9. demand for this is inversely related to the price of a good10. one of the two sides of a market11. increases in response to a decrease in price

SUPPLY (II.A.4)

Now we turn our attention to the other half of the market: the sellers. In the language of economics, a seller is a supplier. To supply a good or service, a seller must produce it (or buy it from someone who produced it) and make it available for sale to buyers. Like a demand schedule, a supply schedule shows what quantity of a particular good or service sellers are willing and able to produce and sell at each price within a range of prices. However, unlike a demand schedule, a supply schedule is different because generally, as the price rises, quantity supplied will increase. According to the law of supply, as the price per unit increases, sellers will supply more of a good or service. In other words, quantity supplied is positively related to price.

If we plot the data from a supply schedule, we create a supply curve. The curve is upward-sloping because of the positive relationship between price and quantity supplied. Quantity supplied is the quantity of a good or service that sellers are willing and able to produce and sell at one given price. Just

D1

Q

P

0


like quantity demanded, quantity supplied refers to one point on a curve, whereas supply refers to the whole curve.

Observe below that a change from one price to another represents a movement along the supply curve.

Movement along the Supply Curve

2.12 SENTENCE COMPLETIONDecisions, decisions. Circle the word or phrase that best completes each statement.

Ex. The best part of writing a DemiDec workbook is (EDITING THE ANSWER KEY,DRAWING STICK FIGURES).

1. The law of (SUPPLY, DEMAND) holds that quantity supplied is (POSITIVELY, INVERSELY) related to price.

2. As price (RISES, FALLS), quantity supplied will decrease.

3. Supply is graphically represented as a (CURVE, POINT ON A CURVE). Quantity supplied is graphically represented as a (CURVE, POINT ON A CURVE).

4. A normal supply curve slopes upward and to the (LEFT, RIGHT). It has a (POSITIVE, NEGATIVE) slope.

5. An increase in quantity supplied is graphically represented as a movement (ALONG, OF) the curve.

2.13 GRAPHING

Quantity Supplied

2000

$500 1000

$0 0

Price Per Unit Quantity Supplied

Pric

e

$2,500 5000

$2,000 4000

$1,500 3000

$1,000

Supply Schedule Supply

S

P

Q

a change in price

a change in quantity supplied

S


Connect the dots. Plot the data from the table into the grid. Then, connect the dots to form a supply curve.

Price Quantity Supplied

$15$20$25$30$35$40$45

56710183050

SHIFTS IN THE SUPPLY CURVE (II.A.5)

There are non-price factors that can cause the whole supply curve to shift (just like demand). When there is an increase or decrease in supply, the entire supply curve shifts to the right or left, respectively.

Movement of the Supply Curve

A change in supply can result from any of a handful of factors. These factors are the most important:

1. A change in the price of resources. To produce goods, suppliers have to spend money on the resources they use in production. If those resources become more expensive, suppliers can’t make as much money from each good they sell, so they are less likely to want to keep selling. When resource costs rise, the supply curve will shift to the left, reflecting a decrease in supply.

2. A change in the technology used for production. Sometimes new technologies make it possible to produce more of a good for less. When that happens, suppliers can sell the same products at the same prices as before, but they’re able to make more profit from each one. Thus, an improvement in technology can cause the supply curve to shift to the right, reflecting an increase in supply. The price of the good doesn’t change, but quantity supplied increases.

3. A change in the number of suppliers. When more suppliers enter the market, there are more people who are willing and able to sell a good at every single price along the curve. Once again, the price has not changed, but quantity supplied has increased all along the supply schedule. Thus, an increase in the number of suppliers will cause the supply curve to shift to the right.

4. A change in producers’ expectations. Like buyers, sellers have expectations. When sellers expect

Supply Curve for Toasters

05101520253035404550

0 10 20 30 40 50 60

Quantity Supplied

Price

P

Q

S2

a change in supply

S1


something in the market to change in the future, that may affect how much they’re willing to supply in the present. A change can cause the supply curve to shift to the right or left.

2.14 IN BRIEFOne liners. Briefly respond to each of the following prompts.

1. In one line, write a definition of “supply.”

2. In one line, write a definition of “quantity supplied.”

3. In one word, describe how price is related to quantity supplied.

2.15 UPS AND DOWNSIt’s not polite to point. In this exercise, your task is to indicate how supply is affected by drawing an arrow that points in the appropriate direction: up for an increase, down for a decrease.

IF GOES THEN GOES

Ex: The number of times Snooki goes sunbathing Snooki’s life expectancy

1. Quality of production technology Supply

2. Labor costs Supply

3. Vehicle maintenance costs Supply

4. Price of raw goods Supply

5. Expected future exchange price of a good Supply today

6. Number of suppliers Supply


IF GOES THEN GOES

7. Price of oranges Supply of orange juice

8. Price of peanuts Supply of peanut butter

9. Number of cell phone manufacturers Supply of cell phones

10. Expected price of crude oil next month Supply of crude oil today

2.16 GRAPHINGLearning curves. In each problem below, there is an explanation of something that has happened to one of the non-price factors that affects supply. The original supply curve, labeled “S1,” has been drawn for you. Draw a new supply curve that reflects the change in supply. Label the new curve “S2.”

Ex.: The price of low-grade meat increases. Indicate what will happen to the supply of DECADOGS, a nationally-recognized brand of hotdog.

Supply of DECADOGS

1. A major international accounting firm gets bad publicity for a rash of accounting scandals.18 Feeling bad about the whole thing, accountants get together and decide to volunteer to take a pay cut. Indicate what happens to the world supply of accounting services after accountants’ wages are lowered.

Supply of Accounting Services

18 Having worked for such a firm, I can tell you accountants are very unlikely to get together and take a voluntary pay cut.

S1

0 Q

P

S2

Q

S 1

P

0


2. U.S. gasoline producers hear that automakers expect to sell twice as many gas-guzzling SUVs in the next quarter as they did in the previous quarter. When SUV sales increase, gasoline producers plan to raise the price of a gallon of gasoline. Indicate what happens to the present supply of gasoline.

Supply of Gasoline

3. The world’s best economics professors are gathered for a cocktail party in the headquarters building of The Economist.19 Sometime during the party, a bomb goes off, killing the professors and everyone else inside the building. Indicate what happens to the world supply of economics lectures.

Supply of Economics Lectures

MARKET EQUILIBRIUM (II.A.6)

Now we’re ready to bring supply and demand together to see the whole market. Since both are graphed on the same plane—with quantity along the horizontal axis and price on the vertical axis—we can put them together and see where they intersect. Market equilibrium is the point at which supply and demand are equal, the point where the two curves intersect. The equilibrium price is sometimes called the market-clearing price because it represents the price at which the market “clears”—where suppliers sell all they planned to sell and buyers buy all they planned to buy at a given price.

MarketEquilibrium

CHANGES IN MARKET EQUILIBRIUM (II.B.1)

Equilibrium has two components: an exchange quantity and an exchange price. Equilibrium will

19 Now that sounds like a good time, doesn’t it? My Super Sweet 16 has nothing on an economics party.

D

S

exchange price

exchange quantity

market equilibrium

S 1

Q

P

0

S 1

Q

P

0


change when either supply or demand, or both, changes.

ChangesinEquilibrium

By graphing both curves together, we can see how market equilibrium—both price and quantity—are affected by a change in either supply or demand, or both. An increase in supply will lower the exchange price and increase the exchange quantity. An increase in demand will raise the exchange price and raise the exchange quantity.

If both curves shift simultaneously, the outcome is less obvious. The net result varies according to how much movement occurs in each curve. Either price or quantity (but not both) will be indeterminate. The change in the other will be known. To find which is indeterminate, try graphing the change in each curve separately and seeing what happens to price and quantity. One will vary in the same direction both times; the other will move in different directions. The latter is indeterminate.

2.17 SENTENCE COMPLETIONChoose (WISELY, FOOLISHLY). Circle the word or phrase that best completes each statement. An example has been completed for you.

Ex. Jessica became an economist so she could SAVE THE WORLD).

1. An increase in (SUPPLY, DEMAND) will cause the equilibrium price to increase and the equilibrium quantity to (INCREASE, DECREASE).

2. If the equilibrium price falls, (SUPPLY, DEMAND) must have decreased.

3. A decrease in both the equilibrium price and quantity would be caused by a(n) (INCREASE, DECREASE) in (SUPPLY, DEMAND).

4. An increase in both equilibrium price and quantity would be caused by a(n) (INCREASE, DECREASE) in (SUPPLY, DEMAND).

5. An increase in equilibrium price and a decrease in equilibrium quantity would be caused by a decrease in (SUPPLY, DEMAND).

p S

D D

qan increase in demand raises the equilibrium

quantity and price

1

p S S

D

qan increase in supply raises the equilibrium quantity and lowers the equilibrium price

1

(WRITE WORKBOOKS,


2.18 GRAPHINGHugging curves. For each question set, you’ll have “starting curves,” for supply and demand. Draw new curves to illustrate how supply or demand is affected. Use your drawings to answer the questions that follow.

1. Suppose demand increases.

Does market equilibrium change?

__________________________________

What happens to the exchange quantity?

__________________________________

What happens to the exchange price?

__________________________________

2. Suppose the number of suppliers in the market doubles.


___________________________________


___________________________________


___________________________________

3. Suppose demand decreases and supply increases.


___________________________________


___________________________________


___________________________________

4. Suppose supply decreases but demand increases.


___________________________________


___________________________________


___________________________________

2.19 CHARTING

P

D S

Q

P

D S

Q

P

D S

Q

P

D S

Q


Everything is on the table. Below is a table of how changes in supply or demand will affect market equilibrium. For each scenario in the table, indicate whether the resulting exchange price and exchange quantity will increase or decrease, or whether the exact outcome cannot be exactly predicted. Use an appropriate arrow to indicate an increase or decrease, or a question mark to indicate that the outcome cannot be exactly predicted. Two scenarios have been completed for you.

Changes in Market Equilibrium

No Change in Supply Increase in Supply Decrease in Supply

No Change in Demand

P:Q:

P: ↓Q: ↑

P:Q:

Increase in DemandP:Q:

P:Q:

P:Q:

Decrease in DemandP:Q:

P:Q:

P: ?Q:↓

CHARACTERISTICS OF COMPETITIVE MARKET EQUILIBRIUM (II.A.7)

In a competitive market, the equilibrium quantity and price find each other naturally and then the market clears. That is a unique and important feature of perfectly competitive markets: they clear automatically. Later in this workbook, you’ll see that markets won’t always clear. For now, let’s look at what it means exactly when we talk about the market clearing.

As you know, the demand curve represents the quantity that buyers are willing and able to buy at each price point. Often times, the equilibrium price is below the price that many buyers were willing to pay, so buyers (collectively) get to keep the difference and spend it on other things. That difference is called the consumer surplus. Graphically, it is the area below the demand curve but above the market price.

ConsumerSurplus

Similarly, the supply curve represents the quantity that sellers are willing and able to sell at each price point. If the market price is higher than the price some sellers were willing to accept, sellers effectively keep the difference. That difference is the producer surplus. Graphically, it is the area above the supply curve but below the market price, up to the exchange quantity.

D1

P

exchange price

exchange quantity Q

theconsumersurplusisthedifferencebetweendemand(whatconsumerswerewillingtobuyateachprice)andmarketequilibrium(whattheyactuallyboughtatthemarketprice)


ProducerSurplus

When we put supply and demand together on the same plane, we can see that the consumer surplus and the producer surplus together account for all of the space between the demand curve and the supply curve. That means that any available surplus has gone to someone who is participating in the market, and nothing is lost. In equilibrium, we can say that a market “clears” if there is no leftover surplus.

Equilibrium in a Perfectly Competitive Market

This concept will mean more when we get to other market structures. For now, just make note of the fact that in a perfectly competitive market, any surplus goes to producers, consumers, or both.

2.20 THINK FAST!Spit it out. Write a short response to the following prompt.

What’s so special about equilibrium in a perfectly competitive market?

S1P

exchange price

exchange quantity Q

theproducersurplusisthedifferencebetweensupply(whatsellerswerewillingtosellateachprice)andmarketequilibrium(whattheyactuallysoldatthemarketprice)

D1

P

exchange price

exchange quantity Q

inaperfectly competitivemarket,anyavailablesurplusgoestoproducers,consumers,orboth

S1


2.21 MATCHINGMatch-o man... Match each term in the column on the left to the BEST description on the right.

a. consumer surplusb. supplyc. market equilibriumd. quantity suppliede. footnotesf. market clearingg. exchange priceh. demandi. quantity demandedj. producer surplus

___ 1. the price at which a perfectly competitive market will clear___ 2. a decrease in this will cause equilibrium quantity to decrease and

equilibrium price to increase___ 3. the difference between what sellers are willing to sell and what

they actually sell at the market price ___ 4. in equilibrium, equal to quantity demanded___ 5. an increase in this can cause both the equilibrium price and

quantity to increase___ 6. the difference between what buyers are willing to buy and what

they actually buy at the market price___ 7. the point at which quantity supplied equals quantity demanded___ 8. a unique feature of equilibrium in a perfectly competitive market

___ 9. one of the better aspects of writing for DemiDec___ 10. equals the quantity exchanged in a perfectly competitive market

2.22 GRAPHINGPaint-by-number.20 Follow the directions to create your own graph of equilibrium in perfect competition.

Begin by labeling the axes, P and Q, where appropriate.

Draw a dot at the point of market equilibrium and label it accordingly.

Draw a straight line to connect market equilibrium to the horizontal axis. Label the point where the line reaches the axis.

Draw another straight line to connect market equilibrium to the vertical axis. Label the point where the line reaches the axis.

Use your pencil to shade the area that represents the customer surplus and label it.

Use your pencil to shade the area that represents the producer surplus and label it.

20When I was about five, I tried to convince one of my mom’s friends that my paint-by-number of a wild cat was my own creation. I was busted when my mom asked me to identify the animal. I had no idea. As they say, “Cheetahs never prosper.”

S

D


ELASTICITY (II.B.2)

At this point, you’ve learned how market equilibrium is affected, in general, by changes in supply or demand. Later in this workbook, we’ll show you how to determine who is affected more (producers or consumers). But before we can get to that, we need to take a short detour to discuss elasticity.

Elasticity is a measure of how responsive one variable is to a change in another. As you know, price affects quantity demanded and quantity supplied. There are also some non-price factors that affect demand and supply. Some non-price variables have a stronger effect on supply or demand than others. We can describe the relationship between two variables in terms of elasticity.

Elasticity is expressed as a percentage. In other words, the “Y elasticity of X” expresses the percent by which variable X will change for each percent change in variable Y. Elasticity is determined as follows:

When we calculate elasticity, the cause is in the denominator and the effect is in the numerator—that is, the change in the denominator causes the change in the numerator. The percent change in Y is in the denominator; it causes the change in X. The percent change in X is in the numerator; it is the effect of the change in Y.

At this level of economics, we often calculate elasticity using average values for each variable, as follows:

“Xn” and “Xo” refer to “new X” and “old X,” respectively.

We use the coefficient of elasticity to tell us just how responsive one variable is to another. The coefficient of elasticity is the absolute value of E(X,Y) before it is converted to a percentage. When the coefficient of elasticity is greater than 1, variable X is elastic with respect to Y. In the language of economists, we’d say that “X is Y-elastic.” That means that an incremental change in Y will elicit a substantial response in variable X. If E < 1, X is inelastic with respect to Y; an incremental change in Y will elicit little response in variable x. If E = 1, X is unit elastic with respect to Y. An incremental change in Y will result in a change of equal increment in X.

Interpreting the Coefficient of Elasticity

If you tuned out during this page because of all the letters and equations, you’re not alone. But reread it, because you’ll definitely need it. The point to take home is that elasticity is amount of change over cause of change. The higher the elasticity, the more change will result from any given cause.

the effect is in the numerator

the cause is in the denominator

E(X,Y)% Change in X

% Change in Y=

2100%x

% Change in Y

=

Change in XXn + Xo% Change in X

Change in YYn + Yo

2

E(X,Y) = E(X,Y)

E(X,Y) = 1.62 E(X,Y) = 1 E(X,Y) = 0.5

�X is Y-elastic� �X is unit-elastic with respect to Y� �X is Y-inelastic�


2.23 SENTENCE COMPLETIONRetention check. Circle the word or phrase that BEST completes each sentence, below. Circle your.

Ex. Economics is sometimes called the [DIMWITTED, DISMAL] science.

1. Variable X is said to be [ELASTIC, INELASTIC, UNIT ELASTIC] with respect to Y if E(X,Y) >1.2. Variable X is said to be [ELASTIC, INELASTIC, UNIT ELASTIC] with respect to Y if E(X,Y) <1.3. Variable X is said to be [ELASTIC, INELASTIC, UNIT ELASTIC] with respect to Y if E(X,Y) =1.4. Elasticity is a measure of [RESPONSIVENESS, DURABILITY].5. In the equation for elasticity, the [CAUSE, EFFECT] of the change is in the denominator. The

[CAUSE, EFFECT] of the change is in the numerator.6. The Y elasticity of X is a measure of [HOW RESPONSIVE Y IS TO INCREMENTAL

CHANGES IN X, HOW RESPONSIVE X IS TO INCREMENTAL CHANGES IN Y].

2.23 APPLYING KEY CONCEPTSPlug-ins. In this exercise, you’ll practice calculating E(X,Y) by answering a few questions and then plugging values into the equation for elasticity. An example has been completed for you.

Ex: Y changes from 19 to 21. In response, X changes from 72 to 65.

What is the change in X? Xn—Xo = 65—72 = -7

What is the average value of X in this region?

Xn + Xo

2= (72 + 65) / 2 = 68.5

What is the change in Y? Yn - Yo = 21—19 = 2

What is the average value of Y in this region?

Yn + Yo

2= (21 + 19) / 2 = 20

What is the Y elasticity of X?% Change in X

% Change in Y= | (7 / 68.5) / (2 / 20) x 100% | = 102 %

1. Y changes from 10 to 15. In response, X changes from 50 to 60.

What is the change in X? Xn—Xo =


Xn + Xo

2=

What is the change in Y? Yn - Yo =


Yn + Yo

2=


% Change in Y=

2. Y changes from 28 to 30. In response, X changes from 100 to 80.


What is the change in X? Xn—Xo =


Xn + Xo

2=

What is the change in Y? Yn - Yo =


Yn + Yo

2=


% Change in Y=

2.24 CATEGORIZATIONMind stretch. In this exercise, you’ll see the coefficient of the price elasticity of demand for some good. In each problem, indicate whether demand is elastic (“E”), inelastic (“I”), or Unit Elastic (“U”).

E = Elastic I = Inelastic U = Unit Elastic_________ 1.32_________ 1.00_________ 0.96_________ 0.12_________ 0.04

_________ 1.37_________ 1.08_________ 0.36_________ 1.52_________ 1.11

PRICE-ELASTICITY OF DEMAND (PED)

The price-elasticity of demand is a measure of how responsive quantity demanded is to changes inprice. It is determined as follows:

If demand is perfectly inelastic with respect to price, then quantity demanded will be unaffected by changes in price. On a graph, perfect inelasticity is a straight vertical line. On the other hand, if demand is perfectly elastic with respect to price, then any change in price will completely eliminate the possibility of exchange. On a graph, perfect elasticity is a horizontal line. Unitary elasticity describes a “one-to-one” relationship of two variables. A percentage increase in price will decrease quantity demanded by exactly the same percentage (the same unit). On a graph, unitary price elasticity of demand is represented by a smooth curve, bowed inward toward the origin.

% Change in Quantity DemandedPED = % Change in Price


Price Elasticity of Demand

There are a few factors that influence the price-elasticity of demand for a particular good, including:

Availability of close substitutes. If a good has a close substitute available, consumers have no need to tolerate a price increase. For example, if I’m looking to buy a plane ticket from Phoenix to Las Vegas, I can get a non-stop flight on at least two different airlines. Since it’s a short flight, it’s not likely that one airline is going to provide substantially better amenities than another. That means that a price difference of even $1 would probably cause me to pick the airline that charges the lower fare. For this market, my demand is highly price-elastic.

Presence of consumer necessity. If you absolutely need something, you may not have a choice but to keep buying it at any price. That means your demand is price-inelastic. Some extreme examples of price-inelastic demand are found in life-saving ambulance rides and prescription medications. A less extreme example is gasoline, which many of us “need” to get to work, play or school every day.21

Relevant market definition. The price-elasticity of demand really depends on how you define the relevant good or service. Are we talking about the demand for Brie or are we talking about semi-soft cheeses? Or is it all just cheese? You might think the demand for Brie is price-elastic if you observe that when you raise the price, people buy less of it. But if you’re only talking about cheeses in general, you might change your mind. No matter how far you drop the price, some people just won’t be induced to buy any more cheese. In this case, Brie is a narrow definition of the market, so it is more likely that we’ll see more price-elasticity. When we define the market more broadly, demand loses some of its elasticity.

Relevant time horizon. If you observe the market for only a short period after a price change, you may have a different sense of the price-elasticity of demand than if you keep watching for a while. Over time, people can come to terms with higher prices and find ways to adjust spending. Also, over time people can make lifestyle changes that allow them to avoid using a good that has become more expensive.

Price as a proportion of a consumer’s disposable income. The demand for a good whose price is a large proportion of consumer income tends to be more price-elastic. On the other hand, the demand for a good whose price is a small proportion of consumer income tends to be less price-elastic.

21 Well, many people need it, anyway. I actually take a train to work these days. I often say it’s because I’m trying to do my part to get more cars off the road. But between you and me, the truth is that the 8-minute trip is just a rich people-watching opportunity. “Train People” could probably contribute a footnote to this workbook every day.

P

QPerfect Inelasticity

P

QPerfect Elasticity

P

QUnit Elasticity


A HELPFUL TIP

In years past, DemiDec “math guy” Craig Chu offered a helpful suggestion for visualizing the price-elasticity of a demand curve. Craig observes:

Brick walls are vertical, and very inelastic.

An inelastic demand curve is vertical, like a brick wall.

An elastic demand curve is horizontal.

It’s like a rubber band you would shoot at somebody.

CROSS-PRICE ELASTICITY OF DEMAND (CPED)

The cross-price elasticity of demand (CPED) indicates how much a change in the price of one good will affect the demand for another. The elasticity of the quantity demanded of Good A with respect to the price of Good B is determined as follows:

When the coefficient of cross price elasticity is positive, the two goods are substitutes. When it is negative, the two goods are complements. If CPED = 0, or if the coefficient is very close to zero, the two goods are independent. Cross-price elasticity of demand is not expressed in absolute values.

PRICE-ELASTICITY OF SUPPLY

Quantity supplied is also sensitive to changes in price. Higher prices will induce suppliers to produce and sell more goods and services. We calculate the price-elasticity of supply just like the price-elasticity of demand, with the change in price in the denominator and the effect—the change in quantity supplied—in the numerator.

The price-elasticity of supply is affected by a few factors:

Ease of entry and exit for sellers: In some markets, sellers have a hard time entering the market because there are so many costs upfront. Even a large increase in the market price will not increase supply because it is too difficult for new sellers to get involved. For example, it takes a lot of money, time, and expertise to open a new hotel/casino. So even if the market price of hotel rooms increases, there aren’t many people who will be in the position to suddenly open a new casino. It’s just not that easy to enter the market. On the other hand, it is much easier to open a lemonade stand. I could stop writing this workbook right now and probably have a fully operational lemonade stand on my street within an hour.

Elastic Rubber Band Inelastic Brick Wall

% Change in Quantity Demanded of Good ACPED = % Change in Price of Good B

% Change in Price=PES

% Change in Quantity Supplied


If I saw people paying $10 per lemonade, I might be tempted to enter that market.22 When it’s easy for new sellers to enter a market, supply is likely to be price-elastic.

Scarcity of inputs: A change in the market price won’t have much effect on supply if the inputs needed to make a product are difficult to obtain. If the market price of diamonds spiked this morning, I still wouldn’t go open a jewelry store because I don’t have access to any diamond mines. I’d have to go find one first. In that case, supply is probably fairly price-inelastic. In the case of my lemonade stand, however, supply is more price-elastic because the inputs are pretty abundant. Most grocery stores would have plenty of lemons, water, sugar, ice, and cups to keep me in business for a while.

Time. Sellers respond to price changes differently as time goes by. In general, over a longer time horizon, supply is more price-elastic. But in the immediate aftermath of a price change, sellers may not be able to make changes that allow them to respond.

INCOME-ELASTICITY OF DEMAND (YED)

The income elasticity of demand (YED) is a measure of how much quantity demanded will respond to incremental changes in consumer income. Keep in mind that the demand curve is only a plot of quantity demanded against price. That means that if there is a change in income that causes a change in quantity demanded, the demand curve would have to move in order to show that effect graphically (since the price has not changed).

YED is determined as follows:

Remember that when consumers have more to spend, they will buy more normal goods and fewer inferior goods. We can use the income-elasticity of demand to determine whether a good is normal.

With normal goods, an increase in income results in an increase in consumption. The relationship is positive, so for a normal good, YED is positive. With inferior goods, an increase in income results in a decrease in consumption, because consumers become able to buy nicer alternatives. Income is inversely related to the demand for an inferior good, so YED for an inferior good is negative. For many people, public transportation is an inferior good.23 When they make enough money to afford a car (and gas, maintenance, and insurance), they will switch from taking the bus to driving a car. In that case, an increase in income results in a decrease in the quantity demanded of bus rides.

In general, the demand for luxury goods is most sensitive to income changes. The demand for necessities tends to be less sensitive.

22 Come to think of it, I do see people paying $10 for lemonade—at baseball games. I think I’d rather just watch the game. 23 Foolish people. Clearly they have never met Rosalie, the little old lady on my morning train commute. When I met her, she explained she had once been abducted by aliens in the desert, but they had brought her back because she told them she needed to say goodbye to her husband. Rosalie was also a beauty queen once, and she was blonde with green eyes (like me). But after the abduction, she came back as a brunette with brown eyes.

YED =% Change in Income

% Change in Quantity Demanded


2.25 WORD BANKBank on it. Complete each statement below. Any answer choice may be used more than once.

WORD BANK

informal unit elastic complements inelasticnormal substitutes elastic independent

1. A 16% increase in price results in a 16% decrease in quantity demanded. With respect to price,

quantity demanded is ____________________________.

2. A 10% change in price results in a 50% change in quantity demanded. With respect to price,

quantity demanded is ______________________________.

3. A 26% increase in consumer income results in a 13% decrease in quantity demanded. With respect

to consumer income, quantity demanded is _____________. This is a(n) _______________ good.

4. A 20% change in price results in a 5% change in quantity demanded. With respect to price,

quantity demanded is ____________________________.

5. A 22% increase in consumer income results in a 22% increase in quantity demanded of Good M.

With respect to consumer income, quantity demanded is _____________________________. M

is a(n) _____________________________ good.

6. A 5% increase in the price of good X results in a 10% increase in the demand for good Y. X and Y

are ______________________________.

7. Demand for Z remained stationary after a 50% increase in the price of Q. In terms of cross-price

elasticity, Z and Q are _________________________________ goods.

8. If the price of J increases by 12%, quantity demanded of K will decrease by as much as 20%. J and

K are ______________________________.

9. If the price of R increases by 5%, quantity demanded of S will increase by 5%. R and S are

________________________________.

10. If consumer income rises by 6%, demand for E will fall by 12%. E is a(n)

________________________________ good.

11. If consumer income increases by 8%, demand for F will increase by 10%. F is a(n)

_______________________________ good.

12. A 14% increase in the price of good C results in a 30% decrease in quantity demanded of C. With

respect to price, demand for C is ___________________________.

13. Although the price of N has fluctuated severely in the past 10 weeks, quantity demanded of N has

not changed. With respect to price, the demand for N is perfectly ____________.

2.26 IN BRIEF


Short and sweet. Write a brief response to each of the following prompts.

1. What do you know about the relationship between two goods when the coefficient of the cross-price elasticity of demand is positive?

2. What do you know about the relationship between two goods when the coefficient of the cross-price elasticity of demand is negative?

3. What do you know about the relationship between two goods when the coefficient of the cross-price elasticity of demand is near zero?

4. Explain what is measured by the Y elasticity of X.

5. Explain what is measured by the income elasticity of demand.

6. Explain what is measured by the price elasticity of demand.

7. For what type of good is demand most sensitive to changes in consumer income?

8. For what type of good is demand inversely related to changes in consumer income?

2.27 UPS AND DOWNSWhat romance has in common with the stock market. In this exercise, you are shown what happens to one of the factors that affects elasticity. In response, indicate what happens to the dependent variable in the column on the right by drawing an arrow in the appropriate direction.

IF: GOES: THEN: GOES:

Ex: Number of other artists sampled by Lady Gaga

Number of costume designers and makeup artists needed on her tour

1. Consumer income Quantity demanded of inferior goods


2. Time consumers have to respond to changes in price Price elasticity of demand

3. Consumer income Demand for luxury goods

4. Number of available substitutes Price elasticity of demand

5.Price of a good as a proportion of consumer income

Price elasticity of demand

6. Consumer income Demand for BMWs

7. College student income

Demand for macaroni & cheese (the kind that comes in a box with a little white pouch of bright orange cheese-substance)

8. Number of available cell phone carriers

Price elasticity of demand for cell phone service

2.28 LISTINGFeeling listless? Write brief responses to complete the lists below.

1. List the factors that affect the price-elasticity of demand.

_____________________________________________________

_____________________________________________________

_____________________________________________________

_____________________________________________________

_____________________________________________________

2. List the factors that affect the price-elasticity of supply.

_____________________________________________________

_____________________________________________________

_____________________________________________________

2.29 SENTENCE COMPLETION“You complete (HIM, ME).” Circle the word or phrase that best completes each statement, below.


1. The demand for wheat is (PRICE-ELASTIC, PRICE-INELASTIC).

2. When you book to catch a flight the same day for a business meeting, your demand for the ticket is more (PRICE-ELASTIC, PRICE-INELASTIC). When you need to book a flight that leaves in 30 days for a vacation in Egypt, your demand is more (PRICE-ELASTIC, PRICE-INELASTIC).

3. A consumer’s demand for a pair of running shoes is probably (MORE, LESS) price-elastic than his demand for a pair of luxury sports cars.

4. The demand for housing near a university is relatively (PRICE-ELASTIC, PRICE-INELASTIC).

5. The demand for running water is (MORE, LESS) price-elastic than the demand for bottled water.

USING ELASTICITY (II.B.3)

Now that you’ve mastered elasticity, we can return to market equilibrium. When there is a change in supply or demand that affects market equilibrium, we can use elasticity to determine whether buyers or sellers will be affected more by the change. The side of the market that has the greatest elasticity will be affected the least. The side that is more price-inelastic will be affected the most. That means the change in equilibrium will have a greater impact on the surplus of the side that is least price-inelastic.

Study the two graphs below. On the left, you see a perfectly competitive market in equilibrium. Supply is relatively price-inelastic (because it’s more vertical) and demand is relatively price-elastic (because it’s more horizontal). In the graph on the right, the demand curve has shifted to the left, resulting in new market equilibrium. Compare the producer surplus (the darker of the two gray triangles) in each graph to the consumer surplus (lighter gray) in each. You should be able to see that the change in demand had a larger impact on the producer surplus than on the consumer surplus. The producer surplus is affected more because supply is more price-inelastic.

Using Elasticity to Anticipate Change in Producer or Consumer Surplus

Even without the graphs, this concept should be fairly intuitive. When demand is price-inelastic, consumers consider the good a necessity: they aren’t buying it because it’s cheap, they’re buying it because they need it. If demand is price-elastic, consumers feel they have other options. If the price goes up, they can go buy something else. Being on the inelastic side of the market means having few alternatives when there is a price change. Since price-inelasticity corresponds to an undesirable position in the market, it should also correspond to a greater loss of surplus.

2.30 THINK FAST!Go, Speed Racer. Write a short response to the prompt below.

D1

P

Q

S1 P

Q

D1

P

Q

S1

D2


What is the relationship between price elasticity and a change in the producer or consumer surplus?

2.31 GRAPHINGThis is where I draw the line. Actually, it’s where you draw it. The prompts on the left explain what has happened to a factor that affects supply or demand. Read each prompt and then draw a new supply or demand curve on the graph on the right to reflect the event. Then, judging from the slope of the supply and demand curves, answer the question on the left about how the surplus is affected most by the change. An example has been completed for you.

EVENT & RESPONSE GRAPH

Ex. An increase in the number of consumersWhich surplus is most affected by the change?

producer surplus

1. A decrease in resource costsWhich surplus is most affected by the change?

2. A number of buyers are expecting to get raises within the monthWhich surplus is most affected by the change?

3. Suppliers are expecting input prices to riseWhich surplus is most affected by the change?

D1

P

Q

S1

D

D1

P

Q

S1

D1

P

Q

S1

D1

P

Q

S1


4. Someone discovers a better way of making a productWhich surplus is most affected by the change?

5. The price of a complementary good increasesWhich surplus is most affected by the change?

2.32 DEFINITIONS Word-ology. We’ve thrown a lot of terminology at you in this section. Define each term as clearly as possible, using this workbook and Section II of the USAD Resource as a guide.

Term Definition

Example: “Journey”1. a distance to be traveled 2. the theme of New Directions’ performance at Regionals

elasticity

price-elasticity of demand

price-elasticity of supply

income-elasticity of demand

cross-price elasticity of demand

normal good

inferior good

complement

substitute

D1

P

Q

S1

D1

P

Q

S1


ELASTICITY AND TOTAL REVENUE (II.B.3)

We can use the price-elasticity of demand to predict what will happen to sellers’ revenue in response to a price change. Revenue is the total amount of money that firms collect in exchange for their goods or services. For any one good, total revenue for the market is calculated as the product of the market price and the exchange quantity.

Total Revenue = Price x Quantity Exchanged

When demand is price-elastic, any change in price will result in a larger change (in percentage terms) in quantity demanded. In other words, quantity demanded moves more than price. As you know, demand is price-elastic when consumers have other options, when they have ample time to find something else, or when the price of a good is a large proportion of their income. If any of these criteria are met, a price change will just cause buyers to look for alternatives. In other words, when demand is price-elastic, an increase in price will cause a decrease in total revenue.

On the other hand, when demand is price-inelastic, a change in price will result in a smaller change (again, in percentage terms) in quantity demanded. Demand is price-inelastic when consumers believe there are no close substitutes, when they believe a good is a necessity, or when they don’t have time to look for an alternative. If these conditions are present, a price increase might deter a few buyers, but the increase in price will more than offset the decrease in quantity demanded. In other words, when demand is price-inelastic, an increase in price will cause an increase in total revenue.

It may be easier to understand this concept with a graph. The first graph to the right is just a downward-sloping demand curve like you’ve seen before. On the left half of the demand curve, where the price is high, demand is price-inelastic. On the right half of the demand curve, demand becomes price-inelastic. The next graph is the corresponding total revenue curve, shown as a function of quantity demanded. On the right side of the curve, total revenue is increasing. On the left side total revenue is decreasing.

If we look at both graphs together, we see that where demand is price-elastic, the falling price in the top graph causes the quantity demanded to increase; then, in the lower graph, total revenue increases. Where demand is price-inelastic, the falling price in the top graph causes the quantity demanded to continue to increase; but then, in the lower graph, total revenue falls, indicating that the change in price outweighed the change in quantity demanded.

P

Q

TR

Q

demand ispriceelastic

demand ispriceinelastic

apricedecreasecausestotalrevenuetoincrease

apricedecreasecausestotalrevenuetodecrease


2.32 THINK FAST!Move it, move it. Write a brief response to the prompt below.

Based on the graph of total revenue in this section, what happens on the demand curve when total revenue reaches its highest point?

2.33 TRUE/FALSE Truer words were never spoken. Some of the statements below are true. Others are false. Circle, or check the correct option. If it’s false, make it true and explain why the statement is wrong. An example has been provided.

T F Example: Jessica’s favorite thing to do on Sunday is sleep in late and read a book.

write an Economics workbook

T F 1. If a demand curve is a straight, downward-sloping line, price-elasticity is constant all along the curve.

T F 2. When demand is price-elastic, a decrease in price will result in an increase in total revenue.

T F 3. If the price-elasticity of demand is exactly equal to 1, any change in price will increase total revenue.

T F 4. If the price-elasticity of demand is 0, an increase in price will increase total revenue.

T F 5. Total revenue is equal to price times elasticity.

T F 6. If the demand curve has a slope of 0, an increase in price will decrease total revenue.

T F 7. If a good accounts for a large share of consumer income, a decrease in price will increase total revenue.

T F 8. If consumers have several close substitutes from which to choose, a decrease in price will decrease total revenue.

T F 9. An increase in the price of a life-saving medication is likely to decrease total revenue.

T F 10. As you move along the demand curve from left to right, total revenue tends to decrease and then increase.


PRICE CONTROLS (II.C.1)

We’ve seen how to use the perfectly competitive market model to anticipate how buyers and sellers will be affected by certain non-price events. Now we’re going to use it to see what happens when the government gets involved. Price controls are one form of government intervention. When a government entity sets a price control, it creates a maximum or minimum price for a good or service.

A price floor is the lowest price for which a good or service can be sold. In the U.S., we sometimes use price floors to protect sellers of commodities, such as wheat or milk. If there are too many suppliers, the market price may fall so low that farmers cannot afford to live. To help, the government will set a minimum legal price per unit, preventing people from selling the good for less.

We say the limit is a “floor” because the exchange price cannot fall beneath it. To make a difference, a price floor has to be set above the market equilibrium price. If an effective price floor is imposed, asurplus will occur, and quantity supplied will exceed quantity demanded.

A price ceiling is the highest price for which a good or service can be sold. The most common example of a price ceiling is rent control. In high-population areas such as New York or San Francisco, there is so much demand for rental space that rent prices get to be very high, making it hard for people to live near their work. To help, local governments sometimes establish rent controls, effectively setting a maximum rent that is below the market equilibrium price.

We say the limit is a “ceiling” when the exchange price is not allowed to rise above the limit. In order to be effective, a price ceiling must be set below the market equilibrium price. If an effective ceiling is imposed, a shortage will occur; that is, quantity demanded will exceed quantity supplied.

Price Controls

If we graph a price floor and a price ceiling together on the same plane, we will create an upside-down market-house; the ceiling is beneath the floor.

The Upside-Down House of Price Controls

DD

S S

A price floor is set above the market equilibrium price. We

call it a "floor" because the price can't go any lower.

A price ceiling is set below the market equilibrium price. We call it a "ceiling" because the price can't go any higher.

price floor

equilibrium price

price ceiling

equilibrium price

D

S

price floor

price ceiling

upside-down house


2.34 THINK FAST!Fast-en up. Write a short response to the prompt below.

What is a price control?

2.35 APPLYING KEY CONCEPTSPractice makes perfect. Use the graph below to answer the questions. Write your answers in the blanks provided. Express each shortage or surplus as the difference between two quantities (e.g., “Q4—Q5”).

Suppose the government insists that prices cannot fall below P3.

What is being imposed? ____________________________

What will be the result? __________________________

By what quantity? ________________________

Suppose elections are held and the government changes its philosophy. A new law is passed, requiring that prices do not exceed P1.

What is being imposed? ____________________________

What will be the result? ___________________________

By what quantity?___________________________

Suppose the government enacts a new minimum wage.

What is being imposed? _________________________

By which price could the new minimum wage be represented? _________

DS

P3

P2

P1

Q1 Q2 Q 3 Q4 Q5


2.36 SENTENCE COMPLETIONDon’t leave me hangin’. Choose the word or phrase that BEST completes each sentence below.

1. If a price floor is imposed, there is a (MINIMUM, MAXIMUM) price (ABOVE, BELOW) the market equilibrium price.

2. If a price ceiling is imposed, there is a (MINIMUM, MAXIMUM) price (ABOVE, BELOW) the market equilibrium price.

3. A price floor will result in a (SURPLUS, SHORTAGE).

4. A price ceiling will result in a (SURPLUS, SHORTAGE).

TAXES (II.C.2)

Another government intervention is tax. We can use the perfectly competitive market model, combined with what you’ve learned about elasticity, to anticipate how buyers and sellers are affected when a tax is imposed. When the government imposes a tax on a good or service, it has the effect of raising the price in the market. The government usually collects the tax from the seller, but the seller often passes the price increase onto buyers. At first, it might seem as though only buyers are affected by a tax, but it turns out the tax usually affects both buyers and sellers: it interferes with market equilibrium.

You’re probably familiar with the sales taxes that we pay for many goods and services. Those taxes are often calculated as a percentage of the total purchase price. To make life simple, we will assume here that taxes are always imposed as a flat price per unit. For instance, instead of examining a 7 percent tax on an orange that costs $1, we will assume that all oranges have a flat tax of 7 cents—regardless of their original sale price. That means that at a price of $1.00, the after-tax price becomes $1.07. At $2.00, the price becomes $2.07, and at $5.00, it becomes $5.07.

On a graph, we show a tax increase by changing supply or demand, but not both. If you give it some thought, you should be able to convince yourself that it doesn’t matter which side of the market showsthe tax, as both end up paying it. I prefer to show it on the supply side, so that is how we’ll do it here.

On the graph below, the government has imposed a tax on lattés: $1 per latté. Let’s assume the government is going to collect the tax from sellers. With the tax in place, sellers now collect $1 per unit more at every price along the supply curve. The tax has the effect of shifting the supply curve upward by the amount of the tax. The dotted lines mark the equilibrium price before and after the tax. Notice the vertical shift in the demand curve—equal to the amount of the tax—is larger than the vertical shift in the equilibrium price. That means the equilibrium price has increased by less than the tax (less than $1).

ImposingaTaxonLattés

The market price doesn’t increase by exactly the amount of the tax because buyers are sensitive to the

$1 tax

Q

D1

P

S1

S2

increaseinmarketprice


price change. In other words, demand—as you know—is somewhat price-elastic. Although sellers may view the tax as a pass-through cost (it doesn’t affect what they have to pay to produce and sell one latté), buyers experience it as a price increase. Some buyers will choose to not to buy a latté once the tax is imposed. On the graph below, notice that the exchange quantity has decreased in response to the tax.

TheEffectofaTaxontheQuantityExchanged

The perfectly competitive market model can give us some valuable insight into how the market is affected by a tax. First, we can see the change in the producer and consumer surpluses. When you compare the two graphs below, you should see that both surpluses are smaller after the tax. To determine the amount of tax revenue that will be collected, we simply multiple the amount of the tax (in this case, $1) by the quantity exchanged after the tax is imposed. On the graph below, the taxrevenue is represented as the black rectangle.

TheEffectofaTaxonProducerandConsumerSurplus

Perhaps you’ve noticed that part of the producer and consumer surplus appears to have vanished. The rectangle that represents tax revenue was once part of those surpluses, and so was the triangular area just to the right of it, up to the original market equilibrium. With the tax in place, part of the surpluses has gone to the government in the form of tax revenue, and part of it has simply vanished. That effect is called a welfare loss.

We can also use this model to determine who is most affected by the tax—that is, who bears the burden of the tax. Since the tax revenue comprises parts of the producer and consumer surpluses, both sides effectively pay for the tax. Buyers pay for it in the form of a higher price. Sellers “pay” in the form of lost revenue when some buyers decide to stop buying expensive lattés. Here, more of the tax revenue

$1 tax

Q

D1

P

S1

S2

decrease�in�exchange�quantity

Q

D1

P

S1

S2

Q

D1

P

S1

S2

tax


appears to have come from the consumer surplus, so it appears buyers have the greater tax burden.

As you may recall, we can use price-elasticity to determine which side of the market is affected more by a change in equilibrium. In this case, the demand curve is very steep. It appears a bit more inelastic than the supply curve. The side that is more price-inelastic should be affected more. Sure enough, we have already determined that consumers have the larger tax burden. Even without calculating the exact effect of the tax, you could have already known that consumers would effectively pay for more if it.

2.37 GRAPHINGDraw a line in the sand. Actually, better to draw lines on the page. In each problem below, a market is in equilibrium. Draw a new supply curve to show how the market will look after a small per-unit tax is imposed on the good. Then, judging from the slope of the supply and demand curves, indicate which side of the market has the greater tax burden. An example has been completed for you.


Ex. A tax of $1 per latté.

Which side of the market bears the greater tax burden?

producers

Market for Lattés

1. A tax of $0.10 per minute


Market for Cell Phone Minutes

2. A tax on hospital beds


Market for Hospital Beds

D1

P

Q

S1

S2

D1

P

Q

S1

D1

P

Q

S1


3. A tax on text messages to American Idol


Market for Text Messages to American Idol

2.38 TRUE/FALSE Truer words were never spoken. Some of the statements below are true. Others are false. Circle the correct option. If it’s false, make it true and explain why the statement is wrong. An example has been provided.

T F Example: When I was in high school, Justin Bieber was really popular.√ Timberlake

T F 1. When a tax is imposed, the market price of a good will increase by exactly the amount of the tax.

T F 2. Tax revenue is calculated as the product of the tax per unit and the quantity exchanged.

T F 3. A tax usually has the effect of increasing the exchange quantity.

T F 4. A tax usually has the effect of raising the equilibrium price.

T F 5. Price-elasticity can be used to predict which side of the market will prefer a tax.

INTERNATIONAL TRADE (II.D)

Individuals can benefit from specializing in the production of a single good or service and then making exchanges to obtain the other goods and services they want. Similarly, countries can benefit from specializing in the production of some goods and trading to obtain other goods. Remember, one of the basic assumptions of economic thought is that trade is good for everyone who participates. In this section, we’ll look more closely at that assumption.

RelativePriceThe relative price of a good is the cost of producing it, expressed in terms of an alternative good. In other words, the relative price of a good is the opportunity cost of producing one more unit of it, expressed as a quantity of the alternative good.

D1

P

Q

S1


Let’s consider an example. Suppose we can combine all of one country’s resources (land, labor, etc.) into “units” of resources. In the country of Decalon, one such unit of resources can produce 10 missiles but no milk. Alternatively, it can also be used to produce 20 gallons of milk but no missiles24. And of course, one unit could be used to produce some combination of missiles and milk. To produce a missile, two gallons of milk must be given up. Thus, the relative price of one missile is 2 gallons of milk. On the other hand, the relative price of milk is ½ missile per gallon. To produce one more gallon of milk, the country must trade off ½ missile.

The graph below depicts the trade-off decision between two goods. The PPF for Decalon can help us to visualize the relative prices of milk and missiles:

The relative price of a good is important when we compare it with the relative price of the same good in another country. From one country to the next, the relative price of a good will differ if each country has natural resources or a different climate. Also, the social values in one country might differ from those of another, so the people in one country might be eager to work more hours than the people in another country. When the relative price of a good is different in each of two countries, those two countries should trade because both will benefit. Later in this workbook, we’ll further explore the benefits of trade.

2.39 APPLYING KEY CONCEPTSRelatively speaking. Answer each of the following questions in the form of “____ units of (the alternative).”

24 Evidently, Decalon is run by a militant, lactose-intolerant tyrant.—Jessica

Total Possible Units of Good BTotal Possible Units of Good A

Total Possible Units of Good ATotal Possible Units of Good B

=Relative Price of Good A

Relative Price of Good B =

Missiles

Gal

lons

of M

ilk

Production Possibilities in Decalon

4 5

10

12

20

10

Decalon produces one more missile.

Decalon gives up two gallons of milk.


1. The U.S. can produce 12 units of nuclear missiles or 60 units of milk. What is the relative price of one unit of missiles?

2. The U.S. can produce 150 units of clothing or 2 units of fighter planes. What is the relative price of one unit of fighter planes?

3. The U.S. can produce 200 units of toothbrushes or 20 units of squirt guns. What is the relative price of one unit of squirt guns?

4. The U.S. can produce 50 units of grain or 2 units of clothing. Nicaragua can produce 20 units of grain or 1 unit of clothing. What is the relative price of one unit of clothing in Nicaragua?

5. Japan can produce 15 units of cars or 30 units of food. Germany can produce 10 units of cars or 35 units of food. What is the relative price of one unit of cars in Japan?

COMPARATIVE ADVANTAGE & THE GAINS FROM TRADE (II.D.3)

Just as a dairy farm can produce milk more efficiently than it can produce nuclear missiles, a country can produce some goods more efficiently than others. If one country can produce a good at a lower relative price than another country, the first has a comparative advantage in the production of the good. According to the law of comparative advantage, if a country has a comparative advantage in the production of a particular good, the country should produce and export that good.

A country can improve its domestic production possibilities by trading with other countries. When a nation uses its comparative advantages for trade, it specializes in the production of those goods or services. In turn, the country imports other goods in which other countries specialize.

In theory, if every country were to strictly adhere to the law of comparative advantage, everyone involved in trade would benefit from it, because each country would produce goods and services at the least possible relative cost. This is why economists often advocate free trade. Unfortunately, protectionism often interferes with such beautiful economic theories. Rather than specialize in some goods and import others, countries impose trade barriers that protect their domestic markets for goods they ought to be importing—rather than producing.

For example, a few years ago, the U.S. imposed a tariff on imported steel. The purpose of the tariff was to protect American steel producers from international competition. Of course, the American steel industry was delighted by the tariff when it was imposed.

Unfortunately, the implications of the tariffs are bad news for production. If the steel industry cannot be successful without that kind of protection, we can infer that steel production in the U.S. makes inefficient use of our scarce resources. Like it or not, the U.S. simply does not have a comparative advantage in the production of steel. But just try arguing about comparative advantage with a steelworker who might have lost his job without that tariff. For that matter, try explaining it to his


family. We can certainly understand why a country will sometimes choose to protect an industry, rather than pursue efficiency.

2.40 SHORT ANSWERIt’s all relative. Answer each question below in the space provided.

1. Suppose the relative price of a bushel of wheat in the U.S. is three pairs of shoes. If the relative price of a bushel of wheat in Mexico is six pairs of shoes, which country has a comparative advantage in the production of shoes and why?

2. Suppose the relative price of a nuclear missile in the U.S. is 35,000 gallons of milk. If the relative price of a nuclear missile in Decalon is 12,000 gallons of milk, which country has a comparative advantage in the production of nuclear missiles and why?

3. Suppose the relative price of a pound of beef in Spain is three pounds of potatoes. If the relative price of a pound of beef in Peru is 30 pounds of potatoes, which country has a comparative advantage in the production of beef and why?

4. In the previous question, which country has a comparative advantage in the production of potatoes—and why?

2.41 APPLYING KEY CONCEPTSDare to compare. Know a comparative advantage when you see one.

Use the data in the table to answer the questions that follow.

Production Possibilities with One Unit of Resources

Country Pieces of Clothing CarsU.S. 60 or 20

Germany 15 or 25

1. What is the relative price of a car in the U.S.? __________


2. What is the relative price of a car in Germany? __________

3. What is the relative price of a piece of clothing in the U.S.? __________

4. What is the relative price of a piece of clothing in Germany? __________

5. Which country has the comparative advantage in the production of cars? __________

6. Which country should export cars? __________

7. Which country has the comparative advantage in the production of clothing? __________

8. Which country should export clothing? __________

Use the data in the table to answer the questions that follow.

Production Possibilities with One Unit of Resources

Country Pounds of Cheese Pounds of FishJapan 10 or 50France 40 or 20

What is the relative price of a pound of cheese in Japan? _________

What is the relative price of a pound of cheese in France? _________

What is the relative price of a pound of fish in Japan? _________

What is the relative price of a pound of fish in France? _________

Which of the two countries has a comparative advantage in the production of cheese? _________

Which country should export cheese? _________

Which of the two countries has a comparative advantage in the production of fish? _________

Which country should export fish? _________

ABSOLUTE ADVANTAGE (II.D.3, CONTINUED)

Some countries are more efficient than others at producing certain goods. When one country can produce a good with fewer total resources than another country, the first has an absolute advantage in the production of that good.

One way to determine whether a country has an absolute advantage over another country is to compare their production possibilities for two goods. If one country can produce more of both goods than the other, then the first has an absolute advantage.

Let’s consider an example. Earlier, we looked at Decalon’s production possibilities, using one imaginary “unit of resources.” Decalon can produce 10 missiles or 20 gallons of milk with that unit. This means Decalon uses 1/10 unit of resources to produce a missile, or 1/20 unit to produce a gallon of milk. Now suppose Demilon can produce 20 missiles or 200 gallons of milk with one unit of its resources. Demilon uses 1/20 unit of resources to produce a missile, or 1/200 unit to produce a gallon of milk. Demilon uses fewer total resources to produce either good, so Demilon has an absolute advantage over Decalon in producing either good.


We might be tempted to think Demilon should produce both milk and missiles, and export both of them to Decalon. But recall the rule about relative price: When the relative price of a good is different in two countries, the two countries should trade. Keeping this rule in mind, we can expand on the law of comparative advantage: Regardless of whether one country has an absolute advantage, if a country has a comparative advantage in the production of a particular good, the country should produce and export that good.

Returning to our example, we see that Decalon can produce missiles for the lower relative price: two gallons of milk per missile. Demilon can produce milk for the lower price: 1/10 missile per gallon. We’ll assume the two countries have good relations, so they agree to each specialize in their comparative advantage good. The graphs below represent the production possibilities in both countries.

Now suppose Demilon and Decalon decide to exchange milk for missiles at a rate of 8 gallons per missile (or 1/4 missile per gallon). If Decalon traded all 10 of its missiles, it could buy 80 gallons of milk from Demilon. If Demilon traded all 200 of its gallons, it could buy 25 missiles, in theory, but Decalon can’t quite produce that many. Suppose Demilon trades only 40 of its gallons of milk. The country buys 5 missiles and keeps 160 gallons of milk. Decalon sells 5 missiles for 40 gallons, and keeps the other 5 missiles. Without trade, Demilon could only have had 5 missiles and 150 gallons of milk, and Decalon could only have had 5 missiles and 10 gallons of milk. With trade, Demilon gains 10 more gallons of milk and Decalon gains 30 more gallons.

Although Demilon has the absolute advantage in the production of both goods, both countries benefit from trade. Both countries increase their consumption possibilities.

You might find it helpful to see a graph of the effects of trade. In the graphs below, I’ve reproduced the original production possibilities frontiers for both countries. I’ve also added a frontier to each graph to represent the goods each country could possibly consume after trade. Notice how in each country, trade moves consumption into the “unattainable” production region.

Gal

lons

of M

ilk

Missiles

Production Possibilities in Decalon

Gal

lons

of M

ilk

Missiles

Production Possibilities in Demilon

20

10

Decalon produces 10 missiles.

200

20

Demilon produces 200 gallons of milk.


2.42 IN BRIEFBrevity is the soul of a date at MIT. Write a brief response to each question below.

1. What term describes the position of a country that can produce a good more efficiently than another country?

2. If country A has an absolute advantage over country B in the production of each of two goods, which good should country A produce?

3. When a country has an absolute advantage in the production of each of two goods, why shouldn’t it produce and export both goods?

2.43 CASE STUDYPractice makes perfect. Read the scenario below and answer the questions that follow.

Scenario: Spain can produce 300 pounds of potatoes or 60 bushels of wheat. Peru can produce 500 pounds of potatoes or 25 bushels of wheat. Suppose Spain produces only wheat and Peru produces only potatoes. The world price of a bushel of wheat is 10 pounds of potatoes.

1. How many bushels of wheat can Peru buy? __________________

Gal

lons

of M

ilk

Missiles

The Effect of Trade in Decalon

Gal

lons

of M

ilk

Missiles

The Effect of Trade in Demilon

20

10

Decalon produces 10 missiles.

200

Demilon produces 200 gallons of milk.

80

25

Decalon buys 40 gallons of milk and keeps 5 missiles. Demilon buys 5 missiles and keeps

160 gallons of milk.


2. How many bushels of wheat can Peru gain from trade (over and above what it could produce if it specialized in wheat)? __________________

3. How many pounds of potatoes can Spain buy?__________________

4. How many pounds of potatoes can Spain gain from trade?__________________

5. Will both countries benefit from trade?__________________

THE PROFIT MOTIVE AND THE BEHAVIOR OF FIRMS (II.E)Now we turn our attention from individual countries to individual firms. When economists refer to “firms,” we are referring to all of the business entities that provide goods and services to the economy, including large corporations, small restaurants, and even your neighbor’s son’s lawn-mowing service.Firms go into business in order to make a profit. They may have other reasons, too, but if they don’t make profit, they won’t stay in business for very long. Since we assume all people are rational, we also assume firms are run by rational people. Rational people pursue strategies that maximize profits.25

2.44 THINK FAST!OK, not that fast. Write a brief response to the prompt below.

What is the most important goal of a firm?

ECONOMIC PROFIT AND ACCOUNTING PROFIT (II.E.1)

There are a couple ways to determine a firm’s profit. Accounting profit is simply the difference between total revenues and total costs. (Total revenue equals the price per unit times the number of units sold.) Economic profit is the difference between total revenues and total costs, minus the opportunity costs of production. Opportunity cost for a firm is the value of the next-best opportunity to produce or sell something else.

Suppose Shane, not knowing zombies are about to take over the world, has just opened a new coffee shop.26 He estimates it costs him about $1 to pay for the materials and labor to make one latté. He also spends $500 per month on rent. In a given month, Shane sells 500 lattés. His total costs are (500 lattés x $1) + ($500 rent) = $1000. If Shane charges $4 per latté, his total revenue will be (500 lattés x $4) = $2000. At the end of the month, Shane has accounting profit of ($2000 - $1000) = $1000.

Now suppose that before Shane opened his coffee shop, he was a street musician. He would stand on street corners in busy areas and play his saxophone for tips. He made about $30 per day, for a total of $900 per month. If playing on the streets is the next-best thing to making lattés, Shane’s opportunity

25 This is why DemiDec’s accountant is confused about the existence of the World Scholar’s Cup. 26 Zombies prefer to drink brain.


cost is $900 per month. By making coffee, he’s giving up the opportunity to make $900 per month playing his saxophone. His economic profit is $1000 - $900 = $100 per month.27

2.45 DEFINITIONS BYO Dictionary. Define each term as thoroughly as possible.

Term Definition

opportunity cost

accounting profit

economic profit

FINDING THE FIRM’S SUPPLY CURVE (II.E.2)To maximize profits, firms have to find the right level of production. In the previous example, Shane didn’t seem to be making very much money, so maybe he hadn’t figured out how to maximize profits yet. My hunch is that Shane’s rent expense is so high that he needs to sell more lattés. But Shane shouldn’t take my word for it. Like any firm, Shane should do his own careful analysis of his costs.

CostsandtheShortRun

Firms must fully understand their costs to make effective production decisions. In the short run, firms have both fixed costs and variable costs. Variable costs increase or decrease with the level of production. If the firm does not produce anything, it incurs no variable costs. Typically, variable costs include employee wages, the raw materials used for production, and plant utilities. In Shane’s case, his variable costs amount to $1 per latté—covering espresso beans, milk, a cup, some water, and wages for a few minutes to pay the employee who makes the drink.

There are also fixed costs, which have to be paid regardless of the level of production. Fixed costs include rent and administrative salaries. For example, even if Shane sells no lattés, he will still have to pay rent for his coffee shop. A marginal change in production will not affect fixed costs. If Shane sells one latté or one hundred lattés, his rent will remain the same.

In the long run, all costs are variable. Ultimately, Shane could renegotiate his lease or move to another building if he wanted to lower his rent expense.

Fixed Costs and Variable Costs

27 Evidently, Shane still lives with his parents.


2.46 CATEGORIZATIONGet your pets fixed. Or let them be variable, whatever that might mean. Determine whether each expense below is a fixed cost or a variable cost to a firm. Circle “F” or “V” as appropriate.

1. F V a lease payment on a vehicle2. F V rent3. F V utilities to operate factory equipment4. F V salaries of top-level management5. F V utilities to operate administrative facilities6. F V property taxes7. F V interest payments8. F V raw materials9. F V hourly pay to part-time employees10. F V depreciation of equipment

PROFIT MAXIMIZATION (CONTINUED)

In addition to variable and fixed costs, there are some other costs to consider:

Marginal cost: the change in total cost from producing one more unit. At first, marginal cost decreases as more units are produced—production grows more efficient. Over time, marginal cost increases as a firm approaches its peak productive capacity.

Marginal revenue: the change in total revenue that results from producing and selling one more unit. Total cost: the sum of total variable costs and total fixed costs.Average variable cost: the variable cost per unit of production.Average fixed cost: equal to the total fixed costs divided by the total quantity produced; the fixed

cost per unit of production.Average total cost: total costs divided by quantity; the total cost per unit of production. At first,

average total cost falls as more units are produced. Then the law of diminishing returns kicks in: it grows increasingly expensive to continue increasing production.

Marginal costs tend to decrease first and then increase. At first, even one unit of production requires a lot of up-front expense. For Shane, he has to buy the espresso machine, the milk steamer, and all of theother kitchen equipment. He then has to hire workers and find a building for his business. All of that has to be done before he can produce even one cup of coffee. That means the marginal cost of the first cup is very, very high. Once he has all those elements in place, however, he can keep producing coffee

Cost

TotalCosts

VariableCosts

Quantity

TotalFixedCosts


for a while before he has to buy any more equipment. He can probably even keep just one employee at first. During this time marginal costs are decreasing.

Eventually, Shane will reach a point where he can’t sell any more coffee without incurring significant costs. He might have to hire more employees or spend more money on advertising. Or perhaps he’ll need to get a bigger space for his café. Whatever the case may be, at some point, Shane’s marginal costs will begin to increase again.

Ultimately, firms maximize profit at the point where marginal revenue equals marginal cost. Since Shane’s marginal cost is only $1 per cup, he’s probably reached the bottom of the marginal cost curve. He can spend money to increase sales and production, up to the point where marginal cost equals $4—the price of one coffee cup. At this price, marginal revenue equals marginal cost, so he is maximizing profit.

2.47 MATCHINGMatch-stick boy. Match the letter of each item on the left to a description on the right.

a. marginal cost

b. marginal revenue

c. profit maximization

d. fixed costs

e. variable costs

f. average total cost

g. average fixed cost

h. average variable cost

i. total cost

j. short run

1. _______ the goal of a firm

2. _______ the total cost per unit of production

3. _______ the change in total cost that results from one more unit of production

4. _______ the period over which some costs are fixed and some are variable

5. _______ the fixed cost per unit of production

6. _______ the variable cost per unit of production

7. _______ costs that vary with the level of production

8. _______ the change in total revenue that is gained by producing and selling one more unit

9. _______ costs that remain constant in total, regardless of the level of production

IMPERFECT COMPETITION (II.F)

Economists have identified different market structures that can help to explain how firms and consumers behave in different market conditions. We characterize market structures by the number of buyers or sellers who are present, the relative ease with which a new seller may enter the market, the variation in the product from one supplier to the next, and the amount of competition present.

PERFECT COMPETITION REVISITED

Perfect competition is the most competitive market structure and the simplest to understand. Before we get into other market structures, let’s expand on what you’ve learned about perfect competition.

A perfectly competitive market has a large number of buyers and sellers. In this type of market, there are no barriers to entry or

Examples of Perfectly Competitive Markets

� wheat� livestock� gold

� silver� euros� yen


exit, which means a new seller will have an easy time if he wants to start doing business. The product is homogeneous: one bushel of wheat isn’t really all that different from any other bushel of wheat. A perfectly competitive market is also characterized by perfect information, or free and equal access for everyone to information about the product, its price, and the firms. A firm in perfect competition sells a product with perfectly price-elastic demand (the “rubber band” variety). The firm is forced to be a price-taker. It has no choice but to sell at the market price. If a firm tries to sell its product above the market price, it won’t earn any revenue—since goods are homogeneous, consumers will simply switch to another firm’s product.

2.48 IN BRIEFShort answer. Write a response to each of these prompts about perfectly competitive markets.

1. How many buyers and sellers are there?

2. How easy or difficult is it for a new seller to enter the market?

3. How price elastic is the demand for the product?

4. How different is one seller’s product from the next?

5. How much information is available to buyers and sellers about the market?

6. How does a seller decide upon a sale price?

MONOPOLY (II.F.1)

A monopoly is the least competitive market structure. It has only one seller. There are no substitutes to a truly monopolized good, so the firm can be a price searcher (or price seeker). The firm can produce and sell its product in the sole interest of profit maximization.

A monopoly can develop for a number of reasons. A natural monopoly results when it seems impractical for multiple firms to control a single resource, as is often the case with public utilities, such


as electricity. Also, if a firm captures economies of scale, it can prevent other firms from being able to produce at a cost that would allow them to be competitive. A firm that holds a copyright or a patenthas an artificial monopoly.

Monopolies can be problematic. One reason is that the product scarcity is partially contrived. A firm can withhold resources from consumers in order to earn a higher price. A second reason is welfare loss, or “deadweight loss.” When a firm withholds goods, it eventually sells fewer goods, as some consumers can’t afford the higher price. As a result, production must decrease. Although the price rises above the market equilibrium price, there is no surplus. The lost surplus is the “welfare loss.” X-inefficiency is another reason why monopolies often take heat. Without competition, there is little incentive to keep costs down; resources may be used inefficiently.

2.49 MATCHINGGot a light? Match each term in the column on the left to a description in the column on the right.

a. deadweight lossb. X-inefficiencyc. colluded. price ware. price leadershipf. contrivedg. economies of

scaleh. copyrights,

trademarks, and patents

i. price searcherj. price takerk. non-pricel. branding

1. ______ an approach to product differentiation2. ______ what is lost in a monopoly when the selling price rises above

the equilibrium price but there is no surplus3. ______ the role of a seller in perfect competition4. ______ the problem of resources being used inefficiently due to the lack

of competition in a monopoly5. ______ what firms in an oligopoly do when they agree to fix prices or

to divide the market among themselves6. ______ savings that are captured by a firm because of its size and

buying power7. ______ the kind of scarcity that can exist in a monopoly8. ______ what happens if one firm in an oligopoly lowers its selling price

and the others decide to compete9. ______ the role of a monopoly firm in determining its selling price10. ______ways in which an artificial monopoly or oligopoly can be created11. ______the type of competition in which firms in an oligopoly engage12. ______what happens when one firm, typically in an oligopoly, sets a

price and other sellers follow by selling at the same price

2.50 IN BRIEFSpeak softly and carry a big Droid. Write a brief response to each of the questions about monopolies.

1. How many buyers and sellers are there in a monopoly?

2. How easy or difficult is it for a new seller to enter a monopoly?

Examples of Monopolistic Markets

� postage stamps� cable TV service� patented pharmaceuticals

� trash collection� public transportation� electricity


3. How does a firm in a monopoly decide upon a selling price?

4. What is the long-run strategy of a firm in a monopoly?

5. What are some of the problems with a monopoly?

MONOPOLY SUPPLY (II.F.2)

Firms maximize profits by producing and selling at the point where marginal revenue equals marginal cost. That rule holds for a monopolist, too. Since the entire market demand curve is the monopolist’sdemand curve (buyers have no alternatives), we can use the market demand curve to figure out themarginal revenue the monopolist will collect at each price point. It turns out the monopolist’s marginal revenue has twice the slope of the demand curve. We won’t get into the math behind the analysis, but you can refer to any intermediate microeconomics text if you’re interested in understanding it better. For now, just know that the marginal revenue function is derived from the demand curve, and it’s twice as steep. The graph illustrates the relationship between marginal revenue and demand in a monopoly:

MarginalRevenueforaMonopolist

As you know, marginal costs tend to start high, decrease, and then increase. That holds true for a monopolist, too. Since the monopolist will maximize profit at the point where marginal revenue equals marginal cost, we can find the profit-maximizing level of output in a monopoly. On the graph below, the monopolist produces where marginal revenue equals marginal cost.

P

D

MR


TheProductionDecisionforaMonopoly

2.51 THINK FAST!Do you have any idea how fast you were going? Write a brief response to the prompt below.

How does a monopolist decide what quantity to produce and sell?

WELFARE CONSEQUENCES OF MONOPOLY (II.F.3)

Earlier in this workbook, we saw how a perfectly competitive market will “clear” in equilibrium, with no loss of welfare. Equilibrium has a different effect in a monopoly market, however. A monopolist can have a negative effect on the marketplace, resulting from its ability to set its own price. The best way to understand the welfare consequences of monopoly is to compare a monopoly to perfect competition. The graphs illustrate the difference. On the left, there is a perfectly competitive market. In equilibrium, both consumers and producers enjoy their maximum surplus. On the right, we add the monopolist’s marginal revenue curve, leaving the same demand curve because the buyers are the same in either case (we’ve simplified the marginal cost function, but it won’t affect the important part of this lesson). In the monopoly scenario, the equilibrium price (PM) is higher and the equilibrium quantity (QM) is lower.

EquilibriuminPerfectCompetitionvs.Monopoly

To measure the welfare loss from monopoly, we can compare the resulting producer and consumer surpluses to what they would have been in perfect competition. On the graph below, you can see that the monopolist effectively takes part of the surplus away from consumers. The monopolist’s revenue is the exchange quantity multiplied by the market price (PM). On the graph, that revenue is represented by the rectangle from the Q axis up to PM, and from the P axis up to QM. The part of that rectangle that is

P

MC

D

MRQ

the monopolist will produce at the point where MR = MC

P P

SPCPM

PPC PPC

D D

MRQPC Q QPC Q

MC

QM


above the marginal cost curve is now the producer’s surplus. There is a portion of both surpluses that has simply vanished. You should recognize this, as it is very similar to the welfare loss that results from introducing a tax. Here, the deadweight loss, or welfare loss due to monopoly is the empty triangle that is left where the producer and consumer surpluses used to be.

WelfareLossDuetoMonopoly

2.52 FILL IN THE BLANK Bringing context to a theater near you. Below is a word bank and a series of statements about monopolies. Fill in each blank with the appropriate word from the word bank. All words will be used once.

WORD BANK

consumer surplus perfect competition marginal cost

price marginal revenue welfare loss

profit producer surplus quantity exchanged

a. ____________________ A monopolist, like any other firm, will maximize (a) at the point where

marginal revenue equals marginal cost. The firm’s (b) curve is derived from

the market demand curve, and it is much steeper. In equilibrium, a

monopoly (c) is higher and (d) is lower, compared to equilibrium in (e).

Also, the (f) is larger, while the (g) is smaller. Part of the producer and

consumer surplus disappears in a monopoly. That effect is called the (h).

b. ____________________

c. ____________________

d. ____________________

e. ____________________

f. ____________________

g. ____________________

h. ____________________

DEALING WITH MONOPOLIES (II.F.4)

Monopolies have attracted some attention from lawmakers since the end of the 19th century. The Sherman Act, which was passed in 1894, was the first piece of federal legislation that addressed monopolies. The Act essentially made it illegal to engage in anti-competitive behavior. In modern-day applications, the Sherman Act has been the basis for blocking proposed mergers and forcing companies

P P

SPCPM

PPC PPC

D D

MRQPC Q QPC Q

CS MC

QM

PSPS

CS

the welfare loss from a monopoly is the portion of the consumer and

producer surpluses that is lost, by comparison to perfection competition


to end certain practices that have been deemed anti-competitive. The U.S. Department of Justice has an Anti-Trust Division that spends a great deal of time looking into potential abuses of market power. Some monopolies, such as utility companies, are now regulated. Their price changes often have to be approved by some sort of oversight body.

2.53 THINK FAST!Fasting can be good for you. Write a brief response to the prompt below.

What was so special about the Sherman Act?

2.54 LISTING The A-List. Write a few short responses to the following prompt.

List three things the U.S. does to manage monopolies.

a)

b)

c)

OLIGOPOLY (II.F.6)

An oligopoly is less competitive than a market with monopolistic competition. It has only a few sellerswho produce either homogeneous or slightly differentiated products.

There are steep barriers to entry in an oligopoly. Barriers can be artificial, as in the examples of patents, trademarks, copyrights, or regulation. Barriers can also be natural, as in the case of only a few firms controlling all the available resources that are critical to production.

A market can evolve into an oligopoly if a few firms manage to capture economies of scale. An economy of scale is a savings, which results from the size (“scale”) of the firm. Large firms can buy raw materials at bulk discount rates, for example. If a small handful of firms become low-cost producers, they will drive higher-cost producers out of business and create an oligopoly. Potential new entrants may be discouraged by the industry’s high start-up cost.

The few sellers in an oligopoly are interdependent. An action by one will impact all the others. If one firm tries to raise its price, the firm’s market share will be lost to its competitors. No firm wants to lose its market share, so no firm will be foolish enough to attempt a price increase. On the other hand, if one firm lowers its price, then the other firms will be forced to lower their prices, too. In the end, each firm will be left with the same market share, but everyone will earn less profit. As it turns out, there is almost no incentive to raise or lower prices in an oligopoly. The firms engage in non-price competition.

To be successful in the long run, the firms in an oligopoly must work at maintaining the market structure. In other words, they have to try to remain in an oligopoly. In a market economy, their strategic

Examples of Oligopolistic Markets

� steel� oil� tobacco

� automobiles� breakfast cereal� airlines


behavior can be very aggressive. Without regulation, it can quickly become anti-competitive, too.

Historically, oligopolistic markets have seen all kinds of now-illegal behavior, all at the hands of firms who aimed to maintain market power. One anti-competitive strategy is collusion. When a few firms collude, they agree to divide the market among themselves, or to fix the market price. In effect, they eliminate the need to compete for business by agreeing not to compete at all. Collusion results in all sorts of inefficient and inequitable problems, including higher prices and lower output.

Another anti-competitive strategy is to pressure legislators to create tough, new regulations for any firm that wishes to enter the market. If this strategy is carried out successfully, then the new regulations will be easily met by the existing firms, but nearly impossible for a new entrant to satisfy. As a result, the barriers to entry will be so high that new suppliers cannot enter. This is common in the airline industry. Other oligopolies engage in price leadership: when one firm raises prices, the rest follow.

2.55 IN BRIEFShort answer. Write a brief response to each of the following questions about oligopolies.

1. How many buyers and sellers are there in an oligopoly?

2. How easy or difficult is it for a new seller to enter an oligopoly?

3. How different is one seller’s product from the next in an oligopoly?

4. How does a seller in an oligopoly decide upon a sale price?

5. What is the long-run strategy of a firm in an oligopolistic market?

6. What are some ways in which existing firms try to prevent new suppliers from entering an oligopoly?

MONOPOLISTIC COMPETITION

A market with monopolistic competition is the second-most competitive market type. It is characterized by a large number of sellers and few barriers to entry or exit. Competition occurs in the form of product differentiation. Through branding, firms hope to convince buyers of the uniqueness of their products. Advertising and packaging are essential to branding. In perfect competition, perfect information is available to everyone; in monopolistic

Examples of Monopolistic Competitive Markets

� ice cream� pantyhose� athletic shoes

� clothing� convenience stores� shampoo


competition, firms rely on some consumer ignorance for their advertising to be effective. The aim of product differentiation is for consumers to develop brand loyalty. If a consumer believes a particular brand is superior, then she will be unlikely to consider other suppliers’ products as substitutes. With fewer substitutes, demand becomes price inelastic. If a firm can successfully differentiate its product, it can earn above-normal profit in the short run. In the long run, most firms will earn normal profits.

2.56 IN BRIEFMark my words. Write a brief response to each question about a market with monopolistic competition.

1. How many buyers and sellers are there?

2. How easy or difficult is it for a new seller to enter the market?

3. How different is one seller’s product from the next?

4. What are some of the techniques sellers use to try to differentiate their products?

2.57 CATEGORIZATIONWhat type of market is it? In part A, determine whether each market is an example of Perfect Competition (PC) or Monopolistic Competition (MC). In part B, determine whether each item is a characteristic of Perfect Competition or Monopolistic Competition, or both (PC and MC). Circle your answer choices.

A.

1. PC MC breakfast cereal

2. PC MC wheat

3. PC MC fast food

4. PC MC milk

5. PC MC video rentals

B.

6. PC MC large number of buyers and sellers

7. PC MC advertising is critical to short-run economic profit

8. PC MC the seller “takes” the market price

9. PC MC the seller aims to maximize profit

10. PC MC perfect information is available

11. PC MC the seller’s strategy is to create price-inelastic demand

12. PC MC demand is perfectly price elastic


13. PC MC the most competitive market structure

14. PC MC the second-most competitive market structure

15. PC MC the product is homogeneous

2.58 CATEGORIZATIONSet a good example. Match a market structure to each market. Answers will be used more than once.

Types of Competition

Industry Examples

Perfect competition

Monopolistic competition

Oligopoly

Monopoly

1. _______________________________ backpacks

2. _______________________________ wheat

3. _______________________________ automobiles

4. _______________________________ personal computers

5. _______________________________ eggs

6. _______________________________ airlines

7. _______________________________ personal injury law firms

8. _______________________________ breakfast cereals

9. _______________________________ electricity

10. _______________________________ milk

11. _______________________________ athletic footwear

12. _______________________________ water (as a public utility)

13. _______________________________ hamburger stands

14. _______________________________ shampoo

15. _______________________________ cigarettes

2.59 APPLYING KEY CONCEPTSIn the scheme of things. In this exercise, you’ll create a spectrum, representing the power of the individual firm in each type of market we’ve discussed. Arrange them in order from least powerful on the left to most powerful on the right. Use the market types listed below to label each point on the spectrum.

Market Type Bank

monopolistic competition monopolyoligopoly perfect competition


“CREATIVE DESTRUCTION” (II.G)

Up to this point, we have treated markets as though they have one rigid competitive structure and they never change. But in fact, markets evolve constantly. Even without government intervention, monopolies can be effectively dissolved by innovation. Just think about all the different media that have been used for recorded music. In my lifetime alone, I’ve owned the same albums on vinyl, cassette, CD, and now in intangible digital files. Even if you had been the only cassette manufacturer in the world at one point, your monopoly position would now be irrelevant, simply because of innovation.

Innovation is motivated by profit, of course. Entrepreneurs are individuals who try to bring innovation to the marketplace with the ultimate goal of earning a profit. Innovation can come in the form of an incremental improvement in an existing product or service, a new business model, or a new product or service that replaces something else altogether.

Joseph Schumpeter was an economist credited with popularizing the term “creative destruction”: the way markets evolve through innovation. What he meant was that innovation is a creative process; it requires new, original ideas. But it is also an inherently destructive process, because bringing a new product to market often means destroying the market for an existing product. Schumpeter suggested that even when there is only one seller in a market (a monopolist), that seller has to act as though it is competing with others, because eventually, profits will attract others to enter the market.

In modern times, pharmaceutical companies are a good example of this. After spending years developing a new drug, companies will secure patents to create legal monopolies for themselves. Even though the company that creates a new drug begins as the only seller, without patents competitors would enter the market quickly. Sure enough, as soon as those patents expire, we see generic drugs reach the market, increasing supply and decreasing the market price. In the interim, then, the company with the patent does its best to develop brand loyalty—and the next generation of the drug.

2.60 TRUE/FALSE Tell me lies, tell me sweet little lies... Some of the statements are true. Others are false. Circle the correct option. If it’s false, make it true and explain why the statement is wrong. An example has been provided.

T F Example: When Alex realized the patient had shot himself with a bazooka, the hospital declared a Code Yellow and called in the pep squad.

Black bomb

Individual firm is least powerful

Individual firm is most powerful


T F Joseph Schumpeter was an economist who coined the term “profit maximization.”

T F When Schumpeter spoke of destruction, he was referring to existing products or services that were “destroyed” by commercialization.

T F An entrepreneur is a person who works to commercialize new ideas or products.

T F The development of CDs to replace cassette tapes is an example of innovation.

MARKET FAILURES (II.H.1-4)

So far in this workbook, we have used perfectly competitive markets as a model because they yield the greatest socially desirable outcome. But that model doesn’t tell the whole story, because markets don’t exist in isolation. We have been overlooking market failures. A market failure is an instance in which a market yields an undesirable social outcome, or it fails to produce the optimum social outcome.

Externalities are a form of market failure. An externality is a consequence of market activity that affects people or firms outside of that market. When there is a positive externality, the market unintentionally benefits people who are not participating in the market. When there is a negative externality, the market unintentionally harms people who are not participating in it.

For example, when a new airport is built in a small town, the airport will directly benefit the airlines and passengers who use it. It will also have a positive indirect effect on local businesses, which will benefit when travelers from the airport become new customers. If local businesses are not involved in paying for the new airport, the increased business they receive is a positive externality. Education is another example of a positive externality. In addition to the benefits to an individual, having an education tends to make people able to support themselves better and to contribute to society more. Society receives an unintended benefit from each person’s education. Pollution is a common example of a negative externality.

Economists have spent a great deal of time thinking about what to do about externalities (particularly the negative ones). One such economist was Ronald Coase, who eventually won a Nobel Prize for his work on the role of law in dealing with externalities. Coase proposed that people and firms can negotiate to manage externalities amongst themselves, ultimately leading to a more efficient outcome for everyone as a whole. This happens regardless of whether one side has a legal right to a certain outcome. This, in a nutshell, is the original Coase Theorem. It has been used as a theoretical basis for policymaking to deal with externalities. One of the requirements of the Coase Theorem is that there can be no transaction costs, or costs incurred in the bargaining process. In reality, of course, some negotiations require a considerable amount of lawyers’ fees, time, paperwork, and other costs. In his later research, Coase recognized that transaction costs are often substantial, and he argued for how legal rules could be constructed in such a way as to maximize efficiency.

The Coase Theorem is probably easiest to understand with a simple example, such as what happens between neighbors who have different lifestyles.

For instance, I live in a condo on the 10th floor of a tall building. Because each unit is privately owned,


there isn’t anyone in charge to tell me or my neighbors how to behave. My downstairs neighbor is a traveling nurse. She works out-of-state for months at a time and keeps a condo in my building for the occasional week when she is between jobs. When she’s home, she seems to be as popular as Paris Hilton (or at least that’s how it sounds from upstairs). I have a different lifestyle, at least for the time being. This summer, I’m writing this workbook, and I’m doing most of it on my couch, 10 stories above the world—but only one story above “Paris.” If I want to get work done when she’s having company, it’s almost impossible. But the Coase Theorem suggests that it’s not hopeless.

The Coase Theorem holds that even though there is no rule about the noise level, Paris and I can find a solution that will make us both better off. I could offer to pay her to be quiet when I’m home working. As long as I’m paying her less than I get paid to write, I should be better off by paying her something. Alternatively, if her social life is that important, she could consider paying me for the right to be loud. I might use part of the money for very expensive noise-canceling headphones, and then I would just deal with the noise and consider it a bonus payment. The most efficient solution is to figure out who would have to pay the least to make the other person happy enough to consider the situation resolved. Maybe it would take $50 for Paris to take the party elsewhere, but it would take $500 for her to convince me to keep working through the noise. If that’s the case, I should pay $50 and she should leave. Then I’ll finish this workbook and we’ll all be happy.28

When people can’t be left to negotiate their own externalities, sometimes government intervention can help. A tax on the market activity that causes an externality can help discourage people from doing it. For instance, if you had to pay a tax of $10 per gallon of gasoline, you’d probably be far less likely to want to drive to school. That would be a way to help manage greenhouse gas emissions. We have already seen how a tax affects market equilibrium, so you should be able to recognize that a tax on gasoline would hurt both buyers and sellers.

Another option is a quota, or a limit on the quantity of the market activity that causes the externality. There have been a few bills going through Congress lately about how to manage climate change. One of the proposed solutions is a “cap-and-trade” program, which essentially sets a quota for CO2 emissions, and then allows firms who under-pollute to sell their rights to firms who pollute beyond their quotas.

2.61 MATCHING Left sock, right sock. Match the word on the left with its description on the right. Use each letter only once.

a. market failureb. Joseph Schumpeterc. quotad. externalitye. transaction costf. government

interventiong. Ronald Coaseh. positive externalityi. tax

1. _____ a restriction on the amount of a market activity that can occur in order to minimize the externalities it creates

2. _____ occurs when the market yields an undesirable social outcome3. _____ the alternative to managing externalities privately4. _____ coined the term “creative destruction”5. _____ a way to increase the price of an activity in order to mitigate the

externalities it causes6. _____ unintentional harm of those who are not market participants7. _____ proposed that externalities could be managed by private

negotiations as long as certain conditions were met8. _____ an unintentional benefit of a market activity to someone who

28 I’m being hard on “Paris” here for the sake of making an example, but I feel bad about it. I’ve actually met her and she was very friendly and smart—and not named Paris. I’ve withheld her name in order to protect her identity and the possibility that we could someday be friends. You have to be careful about messing with people who know where you live.


j. negative externalityk. negotiate

does not participate in the market9. _____ can be high enough to prevent efficient outcomes 10. ____ a consequence of market activity that affects those who do not

participate in the market

2.62 THINK FAST!Like it’s Yom Kippur. Write a brief response to the following prompt.

What is the Coase Theorem?

PROPERTY RIGHTS (II.H.5-7)

Another form of market failure exists when there are problems with assigning property rights. Sometimes, it’s easy to tell who owns a good and who has the right to decide who else can use it. That’s true of anything we buy in a store, like a pair of shoes or a cell phone. But for other things, like parks and fresh air, it can be much more difficult to decide who should have ownership.

The Tragedy of the Commons occurs when everyone in a community has free access to a sharedresource, such as a park. Suppose it’s a community of farmers and they all bring their livestock to the commons to graze. No problem: at first everyone is happy to have a place to feed their own cow. But over time, the commons get abused. Farmers start littering and they’re bringing their animals too often, not leaving enough time for grass to grow. Eventually, because no one is responsible for maintaining it, the commons is destroyed. An economist would tsk tsk and say that if you want the commons to be maintained, someone has to own and protect it. In other words, privatization is the solution.

Economists have identified two major characteristics of goods that can be privatized:

� excludability

� rivalry of consumption

Excludability means that people can be prevented from accessing or using a good. It is easy to prevent a law-abiding person from entering a store. It is much more difficult to exclude someone from enjoying a sunset or hearing the music from an outdoor concert.

Rivalry of consumption means that as one person consumes more of a good, less of it is available for others to use. Clearly, food is a rival good. If your coach brings in a dozen donuts and then eats eleven of them, most of your team will not eat any donuts. Fish, wildlife, and parking spaces are all rival goods. By contrast, satellite TV signals are not rival. When I’m watching Glee, you and your whole team can watch it, too, and there will still be plenty of Glee to go around.

Goods can be excludable, rival, both, or neither. The table below summarizes the differences.

TypesofGoods

Rival Not Rival


ExcludablePrivate Goods

donutsCollective Goodsepisodes of Glee

Not Excludable

Common Resourcespublic parking spaces

Public Goodsnational defense

2.62 LISTING The fundamenta-list approach. Write a few short responses to the following prompts.

1. List two characteristics of goods that can be privatized.a.

b.

2. List four different kinds of goods, based on their ownership.

a.

b.

c.

d.

2.63 THIS OR THATDon’t worry, you’ll sort it out. Indicate whether each item below is excludable or not excludable.

Excludable Not

1. the ocean

2. a pizza

3. a sunset

4. national security

5. cable TV

6. satellite radio

2.64 THAT OR THISStop! Break it down... Indicate whether each item below is rival or not.

Rival Not

1. a pizza

2. music from an outdoor concert

3. parking space


4. national security

5. cable TV

6. satellite radio

INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT (II.I)

At the start of this workbook, you learned that economics is a study of decision-making. For this last section of Microeconomics, we’ll look at some of the mechanisms that aid the collective decision-making of groups.

An institution is a mechanism that governs the voluntary behavior of individuals in a group. An institution could be a formal or informal set of rules about the relationships between people, or groups of people. It’s an abstract and broad concept, and probably easiest to understand through a few examples. Marriage is an institution; people enter into a marriage voluntarily, and even unmarried people have some idea of how married people are supposed to behave toward their spouses. Private property is also an institution. We have formal and informal rules about respecting private property. Markets, in some sense, are also institutions. Ultimately, all of these institutions have the effect of governing the behavior of individuals and organizing behaviors into predictable, manageable patterns.

An organization also governs the behavior of individuals, but with formal rules and more rigid structures. An organization consists of some sort of general arrangement among a group of individuals. It pursues the shared goals of its members.

As you know, economists assume that people are rational and that they act in their own self-interest. The implication is that people rationally and voluntarily choose to participate in institutions and organizations because they expect that doing so will somehow make them better off.

Government is another means of managing the collective decision-making of people. Governments can impose mandatory taxes in order to fund activities that are expected to improve social welfare. By comparison, organizations can collect dues, but a member can avoid paying dues by leaving the organization. You and I can’t really leave the U.S. government in order to get out of paying taxes, except by moving to another government. Governments can also use force to maintain order. For many people, knowing that a government entity has the option to use force is enough get them to comply with government orders. Of course, there are many noteworthy exceptions. Governments can also provide support to many social institutions. For instance, although marriage is a voluntary institution, the government has a system for handling the legal aspects of divorce and for organizing the transfer(and taxation) of wealth among spouses.

Since organizations and governments are run by human beings, they are subject to the rational, self-interested behaviors of the people who manage them. For example, elected leaders sometimes pursuestrategies to improve the welfare of their constituents, at the expense of the greater good. This practice is called pork barrel politics. In a related practice, legislators will sometimes trade votes. By offering a vote to help a colleague pass a bill, a law-maker can secure a vote for a bill of his own down the road. In this case, both individuals end up voting for something that may not be in the interest of the greater good. The practice of trading political favors is sometimes called logrolling. It can result in a costly and inefficient political process.

Lawmakers are not the only ones guilty of acting in their own self-interest at the expense of the greater good. Special-interest groups often retain lobbyists to pursue measures that will benefit themselves, at


the expense of the rest of the population. There are numerous examples of this type of rent-seeking behavior, and it is not uncommon that special-interest groups will spend a lot of money to oppose other special interest groups over such matters.


III. MacroeconomicsThis workbook section covers section III of the curriculum outline. If you are using USAD guides, please note that it roughly follows pages 56 to 99 of the

USAD Economics Resource Guide.

INTRODUCTION

In this section, we turn our focus from the individual to the aggregate. In macroeconomics, we examine the behavior of the economy as a whole. Rather than isolating each individual person, firm, or market, as we did in microeconomics, we now look at the cumulative effects when every individual interacts simultaneously. For this curriculum, most of our macroeconomic analysis is focused on measuring and understanding the aggregate behavior of the U.S. economy, but of course, the principles we use here may be applied to any national economic system.

ECONOMIC GROWTH & LIVING STANDARDS IN THE U.S. (III.A.1)

Let’s start with some basic terminology. You’ve probably heard of “GDP” or gross domestic product before. GDP is mentioned all the time in the news, and it’s been a major concern in the U.S. economy over the past few years because it hasn’t been as large as many people would have liked it to be. GDP is the total value of all final goods and services produced within an economy over a specified period of time. GDP is so important because it is a standard measure of a nation’s productive output, and it is the primary measure of the size of an economy. It also lends itself to another important measure. If we take everything that a nation produces in a year (total GDP), and divide it by the total population, we get GDP per capita. GDP per capita is an estimate of how much an average person can consume in a year.

You might be thinking, “Hey, shouldn’t GDP per capita be a measure of how much an average person produces?” That’s not a bad guess, but GDP per capita would be misleading in that sense because there are plenty of people who don’t work (which means they don’t really produce anything we can measure). If you want to know how much the average person produces, you need to know the average labor productivity—or the total GDP divided by the total number of employed workers (the labor force) in an economy.

All three of these measures are used to understand how much relative prosperity a country enjoys and how quickly its economy is growing. If GDP is increasing every year, an economy is expanding somehow. Of course, if the population is growing, we should expect output to grow, too (since more people should mean more workers to produce goods). But in times of economic prosperity, the growth in GDP will outpace the growth in population. Also, in periods of rapid technological progress, the growth in output may significantly outpace the growth in population (meaning average labor productivity will increase).


3.01 SHORT ANSWER Who you callin’ short? Write a short answer to each of the following questions regarding the measurement of economic growth and living standards in the U.S.

1. What does GDP stand for?

2. What is GDP?

3. What does GDP per capita tell you about an economy?

4. What does average labor productivity tell you about an economy?

SNAPSHOT OF THE U.S. & OTHER ECONOMIES (III.A.1, CONTINUED)

Section III of the Economics Resource Guide presents a quick snapshot of the U.S. economy, up through 2007 and 2008, comparing it to other economies around the world. You should definitely make it a point to know that information, as it will give you a frame of reference as you’re working through the material. In addition, we’ve taken the liberty of providing you with some more current information about the U.S. below. The next few exercises are based on the data in both sources.

Snapshot of the U.S. Economy (2009 estimates)29

Gross Domestic Product: $14.26 trillion30

GDP per capita: $46,000Labor force: 154.2 million

29 Data obtained from CIA World Factbook: https://www.cia.gov/library/publications/the-world-factbook/geos/us.html30 GDP expressed at purchasing power parity in 2009 U.S. dollars.


3.02 FILL IN THE BLANK (pp. 56-58)

Money in the bank. The number bank below provides key figures relating to the economic growth and living standards in the U.S. since 1900. Fill in the sentences with the number that best fits each blank. Each number will be used once. An example has been completed for you.

NUMBER BANK32 258 154 43,0001 14 1999 5

46,000 4 11 8

1. Jessica first started writing for DemiDec in 1999 . That was over 11 years ago,

which is why Jessica is beginning to feel old.

2. As of 2008, production per person in China was about ___________ percent as large as in the U.S.

3. Since 1900, total real output in the U.S. has increased by a factor of nearly ___________

4. In 2008, the average output per person in the U.S. was just over $___________ per year.

5. Since 1900, population in the U.S. has increased by a factor of roughly ___________

6. Since 1900, average output per person in the U.S. has increased by a factor of nearly ___________

7. As of 2008, output per person was about ___________ per year in Ghana. That was only slightly

more than ___________ percent as large as in the U.S.

8. As of 2009, average consumption per person was just over $___________ per year in the U.S.

9. In 2009, U.S. GDP was just slightly more than $____________ trillion.

10. In 2009, the U.S. population was just over ___________ million.

3.03 RANKING (p. 59)

One is the loneliest number...” Each question below lists economic indicators for different countries. Rank them from highest to lowest, with “1” representing the largest value. Note: All rankings are as of 2007.

Example: Which TV show does Jessica watch most often?2 The Living Dead1 In Business with Margaret Brennan3 Glee

1. Which of the following countries had the highest GDP?United KingdomBrazilGermanyNigeria

2. Which of the following countries had the highest GDP?


ChinaMexicoJapanEgyptFrance

3. Which of the following countries had the highest GDP per capita?

GermanyUnited KingdomFranceJapanUnited States

4. Which of the following countries had the highest GDP per capita?

EgyptChinaGhanaNigeriaIndia

3.04 LISTING (p. 59)

Be sure to check it twice. Write a list of countries in response to each prompt below. Note: All rankings are as of 2007.

1. List, in order of greatest to least, the six countries with the greatest life expectancy at birth.

a.

b.

c.

d.

e.

f.

2. List the seven countries that have adult literacy rates of about 99 percent.

a.

b.

c.

d.

e.

f.

g.

3. List, in order of greatest to least, the six countries with the greatest incidence of internet usage among the population.

a.

b.

c.

4. List, in order of greatest to least, the five countries with the greatest GDP per capita.

a.

b.

c.

d.


d.

e.

f.

e.

RECESSIONS & EXPANSIONS (III.A.2)

Economic activity tends to fluctuate over time. There are some periods in which productivity (and other business activity) increases for several consecutive months. There are other periods in which business activity decreases for several months. Together, these fluctuations form a cycle, which economists refer to as the business cycle.

The business cycle consists of periods of economic expansion and periods of economic contraction. Expansionary periods are commonly defined as periods in which GDP increases for at least two consecutive quarters (six months). When an expansionary period ends, the level of business activity is said to “peak.” Following a peak, an economic downturn begins. A downturn is simply a downward change in the direction of the business cycle over time. A contraction in the cycle is called a recession. By definition, a recession occurs when there is a sustained decrease in GDP for at least two consecutive quarters. The end of a recession is a trough in the cycle. You’re probably familiar with the term “depression;” a depression is like a severe recession, but it lasts for a long time (years, rather than quarters) and it’s marked by substantial unemployment.

If we plot GDP over time, we can actually see the cycle; during expansionary periods, GDP increases from one month to the next; during contractionary periods, GDP decreases. The graph below is a sketch to illustrate these concepts (it is not based on any actual data from a real-life economy).

The Business Cycle

Rea

l GD

P p

er Q

uarte

r

Time (in Quarters)

contraction

expansion

peak

trough

Although the level of economic activity fluctuates, the long-term trend is an increase in GDP. In other words, even though there are short-term decreases in business activity, economic growth occurs over time.


3.05 DIAGRAMMINGIt’s not polite to call names. Label each part of the business cycle, below.

3.06 TRUE OR FALSE“I want the truth!” Determine whether each statement below is true or false. For true statements, circle “T.” For false statements, circle “F” and then add any necessary corrections to make them true.

1. T F A recession is a sustained decrease in business activity, lasting at least four consecutive quarters.

2. T F The business cycle results from natural fluctuations in levels of business activity.

3. T F By definition, economic growth is a sustained increase in an economy’s factors of production.

4. T F To measure economic growth, economists watch for increases in Gross Domestic Product.

5. T F The end of a recession is a trough in the business cycle.

MEASURING GDP (III.B.1.A-D)

Earlier in this workbook, you learned that GDP is a measure of economic output. A more precise definition is this: GDP is the market value of all final goods and services produced within a country during a specified period of time. Let’s look closely at each part of this definition:

Typically, the “market value” of a good or service is simply its price. In the U.S., the market value is expressed in terms of current U.S. dollars. Since everything is measured in market prices, a single airplane (which is very expensive) contributes more to GDP than a single automobile (which is relatively less expensive).

A good or service is “final” if it is ready for the consumer without adding any other goods and without undergoing any additional steps in the production process. For example, cars and planes are both final goods; you could buy a finished car or plane and drive (or fly) it off the lot the same day, without adding more parts. However, if you bought a steering wheel, you would still need all the other car parts before you could drive it

Time

GDP


anywhere31. In this example, the steering wheel is an intermediate good; it is going to contribute to the production of a final good. If an economy produces only one airplane and one car in a year, its total GDP for the year is equal to the market value of the plane and the car combined. If we were measuring GDP and we counted the steering wheel and all the other car parts before the car was assembled, and then counted the assembled car and the assembled airplane, we would probably overstate the value by slightly less than the price of the car (since you need labor to assemble all those car parts, and the cost of the labor is included in the price of the car). That would be an example of double-counting, one of the challenges of macroeconomic measurement.

If you start to think about it, you will realize that there are some goods that contribute to a lot of other goods. For example, factory equipment is used to make a lot of different goods, even though the equipment doesn’t actually become part of any one good. Buildings and equipment like this are called capital goods. We include them in GDP in the year they’re produced.

As you know, the “D” in GDP stands for “domestic,” which means that GDP only counts the goods and services that are produced within a country’s borders. If I had spent my summer in Spain writing this workbook, and had then published it there, it would not be part of the United States’ GDP, even though I am an American citizen.32

In order for our measure of GDP to be meaningful, we have to assign some relevant timeframe to it. You will often see news reports of GDP per quarter. Another common timeframe, which we used earlier in this workbook, is annual GDP. It is particularly important to specify the time period when you are calculating the growth rate in GDP from one period to the next.

3.07 SHORT ANSWER “Riddle me this...” Write a short answer to each of the following questions about the measurement of GDP.

1. How can we determine the market value of a final good?

2. Why can’t we include intermediate goods in the calculation of GDP?

3. Why doesn’t U.S. GDP include goods produced by Americans living abroad?

4. How do we account for capital goods when we calculate GDP?

31 Unless you had a vivid imagination, of course. Then you could probably drive without even buying the steering wheel. 32 And furthermore, that would have probably defeated the purpose of spending the summer in Spain


3.08 MATCHING—REVIEW Not as fashionable as it used to be. Match the letter of the term in the column on the left to a description in the column on the right. An example has been completed for you.

a. GDP per capitab. average labor productivityc. business cycled. capital goode. troughf. intermediate goodg. alpacah. labor forcei. recessionj. final goodk. GDP

_____ 1. consists of expansions and contractions in economic activity

_____ 2. in 2009, equal to about $14.26 trillion in the U.S.

_____ 3. a measure of what an average person consumes in a year

_____ 4. not counted in GDP

_____ 5. in 2009, equal to about 154.2 million in the U.S.

_____ 6. occurs at the end of a contractionary period

_____ 7. a species of camelid, often mistaken for the llama

_____ 8. a sustained decrease in GDP, lasting at least two consecutive quarters

_____ 9. goods that are used to produce other goods but counted in GDP when they’re first produced

_____ 10. a measure of what an average worker produces in a year

_____ 11. ready for consumption and eligible for inclusion in GDP

WHAT GDP MEASURES—AND WHAT IT DOESN’T (III.B.2)

GDP is a measure of economic prosperity, but it isn’t a perfect measure. It doesn’t tell you who is doing all the work, what sort of work they’re doing, how hard they’re working, or what sort of environment they’re working in. It’s just a high-level aggregate. Scholars often point out three other shortcomings of GDP:

1) It is difficult to measure: We’ve already looked briefly at the problem of measuring GDP. It can be difficult to decide whether a good is final or intermediate, or to accurately determine when it was produced. One example of such a good is national defense. Some might view a secure border as a finished good, an end product in itself, but others will argue that it’s an intermediate good, which is necessary for the production of all other goods and services.

2) It excludes goods and services that are not bought and sold in markets: Sometimes people simply trade favors without any exchange of cash. For example, if your neighbor is an orthodontist who needs to file taxes and you’re a tax accountant who needs braces, you might decide to help one-another. GDP will not include either of your services because there is no cash transaction to record the exchange (and besides, we don’t measure GDP in terms of tax returns).

3) It ignores harmful externalities: As you know, an externality is an unintended consequence of market activity that affects those who are not participating in the market. GDP does not capture the environmental costs of producing goods from limited resources, or releasing pollutants into the atmosphere during the manufacturing process33.

3.09 EXCLUSIONS

33 This is the point of cap-and-trade programs, something about which your author has spent a bit of time thinking. Sadly, those are beyond the scope of this workbook.


Uninvited guests. Each of the following economic measures is accompanied by a list of goods and services. In each group, at least one good or service should not be included in the measure. Identify any that don’t belong and cross them out. An example has been completed for you.

Example Characteristics

Attractiveness of a date (to Jessica)

intelligence, sense of humor, credit score, number of argyle sweater vests, athleticism, willingness to watch Glee34

Measure Goods and Services

GDP 1. new construction equipment, lumber, new homes, new home furnishings U.S. GDP 2. Ford vehicles, Chevrolet vehicles, Chrysler vehicles, Ford bumpersU.S. GDP 3. Fords, Chevrolets, GMs, Toyotas

2009 U.S. GDP 4. produce harvested in 2009, grapevines planted in 2009 (for winemaking), 2007 Cabernet Sauvignon bottled in California in 200935

GDP 5. an old apartment building, labor to renovate the building, paint and lumber used in the renovation process

U.S. GDP 6. pollution in the U.S. resulting from driving Japanese cars, pollution in Japan resulting from producing Japanese cars, Japanese cars, American cars

Japan GDP 7. pollution in the U.S. resulting from driving Japanese cars, pollution in Japan resulting from producing Japanese cars, Japanese cars, American cars

Canada GDP8. Canadian healthcare; prescription drugs manufactured in Canada;

prescription drugs manufactured in Canada and illegally resold in the U.S.; prescription drugs manufactured in the U.S. and legally obtained in Canada

GDP 9. power used to run a factory, power used to run a home refrigerator, a replacement car battery, solar panels on the roof of a private residence

GDP 10. bottled water in a vending machine, water used by Dole to make fruit juice, water on a waterslide at a water park, a rain puddle

3.10 LISTING Feeling listless? Write a list in response to the prompt below.

1. List the three main criticisms of GDP as a measure of the quality of life in an economy.

a.

b.

c.

3.11 EITHER OR Choose Your Own Adventure. Circle the choice that best completes the sentence. An example is provided.

34 Perhaps you think I’m joking. Just wait until you’re my age. 35 FYI, the vintage on a bottle of wine corresponds to the year in which the grapes are harvested. Better quality wines are often aged in barrels for more than a year, then bottled before they are released for sale.


Example: Eclipse is the (WORST, THIRD) installment in the Twilight saga.

1. Externalities such as pollution (ARE, ARE NOT) included in the calculation of GDP.2. Non-market activities (ARE, ARE NOT) included in the calculation of GDP.3. GDP per capita is a measure of how much an average person in an economy (PRODUCES,

CONSUMES).4. Average labor productivity is a measure of how much an average person in an economy

(PRODUCES, CONSUMES). 5. (GDP, GDP PER CAPITA) is often used as an indicator of the quality of life in an economy. 6. All else being equal, a country with a (HIGH, LOW) adult literacy rate is thought to have a better

quality of life.7. All else being equal, a country with a (HIGH, LOW) incidence of internet use among its

population is thought to have a better quality of life.8. The efforts of stay-at-home moms are (INCLUDED IN, EXCLUDED FROM) the calculation of

GDP.9. GDP is said to be difficult to measure because (IT FAILS TO ACCOUNT FOR INFLATION,

IT HAS POTENTIAL TO DOUBLE-COUNT).10. Illegal activities are (INCLUDED IN, EXCLUDED FROM) the calculation of GDP.

OTHER WAYS TO MEASURE GDP (III.B.3-4)

We can calculate GDP in a couple of different ways. Each approach aims to avoid double-counting, of course. And no matter how you calculate it, GDP is GDP; every approach should arrive at the same total.

In the expenditures approach, GDP is calculated as GDP = Consumption + Investment + Government Spending + (Exports Sold—Imports Bought). In other words, we measure it as the sum of different kinds of expenditures. This equation is usually notated in the form of Y = C + I + G + X, where Y represents GDP and X represents net exports.

The “C” component has three smaller parts:

1) Consumer durables, which are long-lived consumer goods, such as automobiles, which we can reasonably expect to use over the course of multiple years;

2) Consumer non-durables, which are consumer goods that have to be replaced more quickly, typically in less than a year. Food is an obvious example of a non-durable. Clothing is also a non-durable good. Of course, there are plenty of us who will hang onto a favorite jacket or pair of boots for multiple seasons, maybe even multiple years, but economists recognize that there is also a whole fashion industry, which thrives on making those boots look out-of-date a few months after they’re purchased; and

3) Services, which are things you pay for without getting anything tangible in return. For example, an economics lecture is a valuable service.

In this context, “investment” has a different meaning from what you may be accustomed to hearing elsewhere. As a component of GDP, “I” includes the expenditures of businesses on final goods and services and the expenditures of consumers on the purchases of new homes and residential buildings. Investment has three parts:

1) Residential fixed investment, or the purchases of new houses and residential buildings;

2) Business fixed investment, or the purchases of buildings, machinery, and equipment by businesses; and


3) Inventories, which are purchases of goods added to business inventories, but not yet sold. Once goods are sold, they become part of consumer goods, so we count them as “C”. The “I” part just captures the economic value of the goods that are ready for sale but have not yet made it to “C.36”

Government spending includes the purchases of final goods and services by local, state, and federal governments. It is not quite the same as all expenditures by those entities, however, since some government spending is not used for goods or services. The federal government spends a lot of money on Social Security payments, but that money is just a transfer payment. It’s collected as a tax on the wages of current workers (which are counted as part of other expenditures), and then redistributed to current recipients. Since Social Security beneficiaries don’t provide a good or service in exchange for the payments they receive, the federal government isn’t really buying goods or services with those payments—so we exclude them from GDP. Another government spending component, which is excluded from GDP but incurred at all levels of government, is interest on government debt. Again, goods and services are not received in return for those payments, so they don’t count in GDP, either.

Net exports has two parts. First, the money that foreigners spend on our domestic goods and services is added to GDP. That part is exports. Then, the money that our businesses and consumers spend on foreign goods and services is subtracted, since they’re already counted in the GDP of other countries. That part is imports.

Regardless of how we measure GDP, it’s still just GDP. The expenditures approach arrives at the same result as the income approach. So if GDP is measured by expenditures, or production, or income, we should be able to use these values interchangeably. This is an important identity in macroeconomic analysis:

GDP = Income = Expenditures = Production

3.12 CATEGORIZATION Sort it out. Identify which component of GDP—if any—is represented by each item below. An example has been completed for you.

C I G X Neither Example: the purchase of a new iPad

C I G X Neither 1. the purchase of an old home

C I G X Neither 2. the sale of American-made iPads to German consumers

C I G X Neither 3. the purchase of a new apartment building

C I G X Neither 4. the purchase of a new public school building

C I G X Neither 5. the interest payments on U.S. Treasury bills

C I G X Neither 6. income tax preparation for an individual

C I G X Neither 7. Amazon’s inventory of Kindles at the end of the year

C I G X Neither 8. Social Security payments

C I G X Neither 9. the purchase of a new home

C I G X Neither 10. the purchase of a new BMW by an American

36 Oh, I “C”! –Robb


3.13 LISTING Almost as fun as making a playlist. Write a list in response to each prompt below, relating to the expenditures approach to GDP measurement.

1. What are the four components of GDP under the expenditures approach?a.b.c.d.

2. What are the three components of the consumption portion of GDP?

a.b.c.

3. What are the three components of investment?a.b.c.

4. What are the two components of net exports?a.b.

3.14 THINK FAST! I don’t have all day. Write the equation that summarizes the income approach to GDP measurement.

3.15 MATCHING Like chocolate and peanut butter. Match the letter of each component of U.S. GDP on the left with an example on the right. Some letters will be used more than once.

a. residential fixed investmentb. importsc. government spendingd. servicese. consumer non-durablesf. inventoriesg. consumer durablesh. exportsi. business fixed investment

_____ 1. sale of web-based math lectures to private schools in India_____ 2. stuffed alpacas bought from South America _____ 3. a new DemiDec global headquarters building_____ 4. purchase of a new Lincoln Navigator for your Decathlon

team, using private funds_____ 5. purchase of Cram Kits by public U.S. high schools

_____ 6. the purchase of a new fridge for your team by your parents_____ 7. economics books on the shelf at Borders at year’s end_____ 8. purchase of a new home for your coach (using private

donations)_____ 9. the purchase of a new dormitory at a U.S. public university

_____ 10. the purchase of private economics tutoring


INFLATION (III.B.6)

The price level is the aggregate of the prices of all goods and services in an economy. When the price level increases, everything is more expensive.

Inflation is an increase in the price level. When there is inflation, all goods and services, in general, become more expensive. To some economists, inflation is defined as a sustained increase in the price level—rather than a temporary one—lasting for at least two consecutive quarters. The inflation rate is the percentage by which the current price level has increased from the previous price level. We calculate the inflation rate as follows:

You’ll notice that we often hear about inflation in the news. That is because when there is rapid inflation, a host of other economic problems may soon follow. For that reason, inflation is something we have to watch closely.

3.16 SHORT ANSWER Without the “short,” it’s just strawberry cake. Write a short answer to each of the following questions.

1. What is inflation?

2. What is the price level?

THE CONSUMER PRICE INDEXA price index is a number that indicates the average price of a market basket or a representative sample of goods, relative to the average price of the same basket at another time. If a price index changes, we know that the prices of the goods in the basket have changed—even though the selection of goods has not.

To create a price index, we have to establish a base year, or starting point. The average prices of the goods in the basket are represented by an index of 100 in the base year. When inflation occurs in subsequent years, the value of the index will increase. For example, if the index is 105, then we know that the average price of the goods in that year’s basket is 105 percent of the average price in the base year. Prices have increased by five percent.

The Consumer Price Index (CPI) is the best-known price index. It represents changes in the prices of goods and services consumed by households. The market basket used to determine the CPI contains over 2,000 goods and services, lumped into about 200 categories (such as cereal, rent, airfare, television, etc.) The categories are divided into major groups, which include food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Each month, the Bureau of Labor Statistics gathers current price information about each item and uses those data to determine numerous versions of the CPI.

The CPI-U is the CPI for urban consumers. It is the most comprehensive CPI figure, the one most often quoted as “the CPI” in the media. The CPI-U represents the spending patterns of about 87 percent of the population. The CPI-W is based on the spending patterns of just Urban Wage Earners and Clerical Workers. The CPI-W population is part of the CPI-U population, representing about 32 percent of the population.

price levelyear � price levelprevious yearinflation rateyear = price levelprevious yearx 100 %


The Producer Price Index (PPI) is based on a market basket of producer goods, or factors of production commonly bought by manufacturers.

The CPI (and its cousins) and the PPI are all compiled by the Bureau of Labor Statistics. You can see current CPI, PPI, and other price index data for yourself if you visit www.bls.gov.

We use the CPI as an economic indicator. Changes in the CPI indicate changes in the health of the economy. We also use it to filter the effect of inflation out of various economic measurements.

The CPI is the most common measure of the rising cost of living, but it is not entirely accurate. One problem is that the “market basket” is old, and not often updated. The goods in the basket do not necessarily represent the goods households are buying. Should iPods be part of the CPI? Another problem is that the basket approach does not allow for substitution. In real life, if the price of a good goes up, we are likely to buy a substitute. Yet another problem is that the changes in the total price of the market basket are assumed to be solely caused by changes in the price level. In actuality, the quality of some of the goods may increase, and the increase in quality may result in a justifiable price increase, unrelated to inflation.

3.17 APPLYING KEY CONCEPTSShort and sweet. Write a brief response to each of the following questions.

1. Suppose the price level for 1997 in the CPI is 160. By what percent did the price level rise between the base year and 1997?

_______

2. Suppose the price level for 2001 in the CPI is 277. By what percent did the price level rise between the base year and 2001?

_______

3.18 MATCHINGYou can’t strike these matches. Match the letter of each term with its definition.

a. CPI-U b. double-countingc. nominal GDPd. deflatione. GDP per capitaf. PPIg. inflationh. indirect taxesi. cost-pushj. GDPk. real GDPl. stagflationm. the expenditures approachn. net exportso. demand-pullp. BLSq. CPI, PPI, GDP

1. _______ equal to GDP divided by the deflator2. _______ C + I + G + X3. _______ inflation that results from demand in excess of supply4. _______ a rise in prices during a time of high unemployment5. _______ sum of goods and services produced in an economy in a year6. _______ measures of inflation7. _______ a general rise in price levels8. _______ subtracted, in the income approach9. _______ exports sold, minus imports bought10. _______ measures of GDP need to avoid this11. _______ inflation that results from rising production costs12. _______ commonly used as a measure of quality of life13. _______ GDP, inflated14. _______ compiles the CPI and the PPI15. _______ a decrease in the overall price level16. _______ the price index most commonly used17. _______ consists of a market basket of production commodities

REAL GDP (III.B.5)

We measure GDP using the current dollar values of goods and services. If prices increase, even when productivity has not increased, GDP will appear to have also increased. For that reason, economists differentiate between


nominal GDP, or GDP expressed in current-year dollars, and real GDP, or GDP that has been adjusted for inflation. The GDP deflator is the price index we use to convert nominal GDP to real GDP. To determine real GDP, we simply divide nominal GDP by the GDP deflator.

A change in GDP can be misleading because we have no way of knowing for certain whether a price increase is the result of inflation or whether it actually indicates a change of quality. Real GDP is a more accurate measure of output than nominal GDP, since it attempts to filter out one of those effects.

3.20 CHARTINGPie, anyone? The pie chart below represents U.S. GDP. Each “piece” of the pie is one of the transaction categories we use to calculate GDP in the expenditures approach (C, I, G, or X). Begin by looking closely at each piece to estimate about what percent of the GDP pie it might represent. Next, label each piece with an appropriate transaction category and its corresponding percent of total U.S. GDP (example: “X, 55%”).

3.21 FILL-INThe best part of a jelly donut. Complete each statement below by filling in the missing words or phrases.

1. GDP = __________________ + Investment + Government Spending +

__________________ This is the __________________ approach to measurement.

2. In the income approach to GDP, subsidies, __________________ and __________________

must be subtracted from the subtotal to find the national income.

3. __________________ is considered a better measure of the quality of life in an economy than

just GDP, though it is not as good as GDP adjusted for Purchasing Power Parity (PPP.)

4. GDP does not account for __________________ or __________________

3.22 EXCLUSIONSOne of these things is not like the other. In this exercise, you’ll see groups of items that are somehow related. In each group, one item does not belong. Cross out the imposters, explaining why it doesn’t belong.

Nominal GDPReal GDP = GDP Deflator


Ex: Bristol PalinJohn HammKurt WarnerJennifer Grey

Explanation: The group consists of contestants from the Fall 2010 series of �Dancing With the Stars,� a reality show on ABC which features celebrities and B-listers who apparently would like to be bigger celebrities. John Hamm of �Mad Men� is more of an A-lister.

1. consumptionrentsinvestmentgovernment spending

Explanation:

2. employee compensationinterestprofitsindirect taxes

Explanation:

3. government spendingnon-market activitiesunreported activitiesexternalities

Explanation:

4. investmentconsumptionquality changesnet exports

Explanation:

5. YCGX

Explanation:

6. value-addedincomeexpendituresexternalities

Explanation:

7. non-market activitiessubsidiesquality changestransactions without money

Explanation:

8. raw goodsintermediate goodsfinal goodstransfer payments

Explanation:

UNEMPLOYMENT (III.B.7)

The labor force includes anyone at least 16 years of age, who works for pay or profit either full-time or part-time. It also includes anyone who is actively seeking a job. By definition, an “employed” person has some sort of job. An “unemployed” person does not have a job, but is making a persistent effort to find one. If a person has no job and is not really trying to find one, then that person is simply “without a job,” not “unemployed.”


By definition, the labor force is comprised of the employed and the unemployed. The labor force participation rate (LFP) for any group (such as civilians or people of a certain gender) is the percentage of that group that is in the labor force. For example, the civilian LFP is equal to the total number of civilians who are in the labor force, divided by the total number eligible for inclusion in the labor force. The unemployment rate is the percentage of the labor force that is unemployed. The employment rate is the percentage of the labor force that is employed.

Labor Force = Unemployed + Employed

Full employment is typically defined as a condition in which 96 percent of the labor force is employed (or four percent is unemployed). Some economists think that an unemployment rate of four percent is natural. An economic system that is operating at its natural unemployment rate is operating at full employment. At full employment, a nation is capable of attaining its potential GDP.

The unemployed can be divided into four basic categories:

frictional people “between jobs”

structuralpeople who lose their jobs when large-scale changes in the economy (such as new technologies or new trade partners) cause their skill sets to fall out of favor

cyclical people who lose their jobs during economic downturns

seasonalpeople whose skills are only desirable (and employable) at certain times of the year

There are also underemployed workers, who have jobs but who are not working up to their potential. These individuals are problematic when it comes to measuring unemployment. Suppose you just finished law school but you can’t find a job as a lawyer. If you take a job selling surfboards, you are officially “employed,” as far as macroeconomic measures are concerned. But, as a lawyer, you’re still unemployed. Underemployed workers are one reason why we have to dig deeper into the statistics to understand how people are really doing.

# Group Members in the Labor ForceLabor Force Participation

Rate(group)= # Total Group Members

# UnemployedUnemployment Rate = # in Labor Force

# EmployedEmployment Rate = # in Labor Force


3.23 CATEGORIZATIONCount me in. Indicate on each line whether the described person is “IN” or “OUT” of the labor force.

1. _____ Curt teaches AP Physics at a magnet high school. He teaches for about 30 classroom hours each week. He also spends an additional 30 hours each week grading homework assignments and tests, and preparing to give lectures. He earns a salary of $40,000 per year. Regardless of how many hours he works, Curt’s salary does not change.

2. _____ Jason is a 14-year-old fry cook at a fast food restaurant. To get the job, he lied about his age. He works about 20 hours each week and he earns $7.00 per hour.

3. _____ Bridget is 21. She used to be a cocktail waitress, but quit because she believed she had “too much seniority” to work on slow nights in the bar. Now, when her parents ask her how she plans to pay bills, she says she’s “trying to find a job.” While it’s true that her friends have seen her reading classified ads, it is also true that they have often heard her say, “I’m not gonna work there!” It’s been several months since Bridget has actually considered a job.

4. _____ Connor is the manager at the bar where Bridget used to work. He is a 24-year-old Irish-American national. At the bar, his responsibilities include bartending and hiring, as well as preparing the schedule that Bridget once resented so much. Connor works about 35 hours per week. He earns a manager’s salary plus any tips he makes while bartending.

5. _____ Brett is 22. He was delivering pizza one night when he received a call, telling him his National Guard unit was being sent to Afghanistan. Before Brett left, his manager at the pizza place told him he’d still have a job when he returned. After nine months away, Brett is still in Afghanistan.

3.24 MORE CATEGORIZATION Got work? Indicate whether each person below is unemployed, underemployed, or not part of the labor force by writing the appropriate letter in each blank.

a. unemployed b. underemployed c. not part of the labor force

1. _____ Amos has a degree in Music Performance. He waits tables in a resort hotel.

2. _____ Drew is a studio artist waiting to be discovered. That’s about all he does: he waits.

3. _____ Anne has just finished her degree in Advertising. She would like to work for a large advertising firm, but has not found a job yet. In the past four weeks, she has submitted her résumé and portfolio to over 20 firms. She has already had interviews with three of them.

4. _____ Marie was once the CFO for a multinational corporation called Sandwiche’s 37 Inc. After Sandwiche’s Inc. merged with Plural Freshman Corporation, Marie found herself wealthy and without a job. She is now sunning on a private island near Sri Lanka.

5. _____ Craig once zipped through his actuarial exams in record time, becoming one of the nation’s top actuaries by age 25. Now he zips through a parking lot, delivering hamburgers on roller blades.

6. _____ Joe says he doesn’t work because his wife, Suzanne, is better at it than he is. He does not cook nor clean because he thinks she does that better, too. He divides his time between a local café, where he plays board games with pseudo-intellectuals, and a tanning salon, where he works on “his color” and flirts with the employees.

3.25 FILL-IN

37 My team and I did in fact see a menu near Benson, Arizona, on which ‘sandwiches’ was spelled ‘sandwiche’s.’ Yu’m. – Chris


Because filling in is better than filling out. Complete each formula below by filling in the blanks.

1. Labor Force = ___________________________ + _______________________2. Unemployment Rate = ________________________________________________3. Female Labor Force

Participation Rate=

________________________________________________

3.26 APPLYING KEY CONCEPTSUse SPF 60. In each problem, you’ll find fictitious data. Use it to calculate various economic measurements.

1. Country: DecalonTotal population: 100,000Total population over age 16: 65,000Employed men: 30,000Employed women: 20,000Unemployed men: 5,000Unemployed women: 5,000People without jobs over age 16: 5,000

a. Number of people in the labor force: ______________

b. Number of employed people: ______________

c. Number of unemployed people: ______________

d. Unemployment rate: ______________

e. Employment rate: ______________

f. Female labor force participation rate: ______________

2. Country: DemilonTotal population: 50,000Total population over age 16: 32,000Employed men: 10,000Employed women: 18,000Unemployed men: 1,500Unemployed women: 500People without jobs over age 16: 2,000

a. Number of people in the labor force: ______________

b. Number of employed people: ______________

c. Number of unemployed people: ______________

d. Unemployment rate: ______________

e. Employment rate: ______________

f. Male labor force participation rate: ______________

3.27 CATEGORIZATIONUnemployment Anonymous. In this exercise, you’ll meet laborers who are out of work. Read each laborer’s story, and then identify his/her category of unemployment. For each laborer, write “frictional,” “seasonal,” “cyclical,” or “structural,” as appropriate.

1. Meet Juan, formerly a rotary telephone repairman. Now that everything is going cellular—or for that matter, digital—Juan’s skills are obsolete. When he’s not out looking for a job, he spends his days folding comic strips into finger puppets.

Juan’s type of unemployment is ___________________________.

2. Elisa had a great job as an accountant in a global firm. Then there was the Incident. Suffice it to say that Elisa jammed a paper shredder; the following day, she handed in her resignation. New job offers are pouring in, but Elisa is trying to hold out for “the one.” When she finds it, she’ll go back to work.

Elisa’s type of unemployment is ___________________________.


3. Megan was a model of designer Swiss watches (she’s got some good-looking wrists). When the stock market crashed, everyone who could afford those watches stopped buying them. Her boss has told her that as soon as sales pick up again, she can come back to work.

Megan’s type of unemployment is ______________________________.

4. Steve was a server in a coffee shop in a tourist hotspot in the southwest. When the tourism industry took a dive, the coffee shop was forced to cut back. Steve was let go. He loved the regulars at his old job. Every morning, he practices pouring coffee without dripping on the table, hoping he’ll be rehired soon.

Steve THINKS his type of unemployment is __________________________________.

5. Meet Bruce, ex-owner of Bookworm Bungalow, a used book store. When the Kindle arrived in town, everyone stopped reading real books, let alone old ones. Bruce has had to close his shop. He’s been applying for jobs and he’s had a few interviews, but no one will hire him. Books are all he knows.

Bruce’s type of unemployment is ____________________________.

6. Kyle is a ski instructor in Flagstaff, Arizona. Normally, Flagstaff is one of the ten “snowiest” cities in the U.S. This year, however, there have been fewer than three inches of precipitation. Flagstaff tourism has taken a dive. Kyle is accustomed to being unemployed in the summer, but not to living on welfare, too.

Kyle’s unemployment is ___________________________.

THE CIRCULAR FLOW MODEL OF THE ECONOMY (III.C.1-2)

We can divide the economy into three sectors. We’ll begin by discussing two of them. The household sectorconsists of private individuals (or families, etc.) who live in households. The household sector consumes goods and services. The business sector comprises firms, which are businesses that produce goods and services.

In the product market, firms produce goods and services and sell them to households. To produce those goods and services, firms obtain resources (including labor, capital, and land) from households in the factor market. Together, these two markets comprise the real flow, or the circular flow of resources, goods, and services.

The Real Flow

In the product market, households spend money on the goods and services they buy from firms. In the factor market, firms spend money on the resources they buy from households. Together, these aspects of the two markets comprise the money flow, which is the circular flow of money through households and firms in an economy. The money flow moves in the opposite direction of the real flow. Firms’ money payments for resources are called resource payments; households’ payments for goods and services are revenues to firms.

Firms Households

Households buy goods & services from firms in the

PRODUCT MARKET

Firms buy resources from households in the

FACTOR MARKET


The Real Flow and the Money Flow Combined

The portion of the money flow that passes through the product market is the total spent on goods and services. The portion that passes through the factor market is the total income that households collect.

Now we add a third sector, the government sector. The government does not have a clear role in consumption or production, so in this diagram, we’ve placed it inside the circular flow. The main economic activities of the government include regulation and taxation. When we add government to the circular flow, the circle becomes a veritable web. The government sector collects taxes from both sectors (represented by black arrows pointing toward the government) and redistributes the funds to both sectors (shown with black arrows pointing away from the government). It also establishes regulations to limit or encourage production or consumption. In this capacity, the government can effectively increase or decrease the size of the real flow in certain industries.

The Circular Flow Model of the Economy

With the three sectors in place, we can see how each is dependent on the other two. For example, households spend money directly to buy goods and services from firms. They pay taxes to government, which then redistributes funds to other households and firms. And they also save money, and their savings become the deposits that fund investment when businesses, government, and other households borrow money from banks. This all happens in the financial markets, which we will cover in greater detail, later in this workbook.

International trade further complicates the flow. When we import goods from other countries, the goods enter the real flow but money leaves the money flow. In economics jargon, the money spent on an import is a leakage. Similarly, when we export goods to other countries, there is an injection into the money flow.

Firms Households

In the PRODUCT MARKET

money is spent by households and collected by firms

In the FACTOR MARKET

money is spent by firms and collected by households

Firms HouseholdsGovernment

Imports

Exports

flow of funds

flow of goods and services


3.28 DIAGRAMMINGWin, lose, or draw. This simple circular flow model of the U.S. economy has been started for you. Your task is to complete it. Follow the list of instructions below.

1. Label each sector.

2. Label each market.

3. Draw arrows to represent the money flow between the sectors.

4. Draw arrows to represent the money flow to and from foreign countries.

5. Draw arrows to represent transfer payments.

3.29 SHORT ANSWERS…One sign your date is not very interested in you. For each item, briefly respond in the blanks provided.

1. In the circular flow model, which sector is on the demand side of the product market?

__________________________________

2. In the circular flow model, which sector is on the demand side of the factor market?

__________________________________

3. Which sector owns the resources?

_____________________________

4. Which sector is responsible for regulation and taxation?

_____________________________

5. When the real flow is clockwise in the model, in what direction does money flow?

__________________________________

6. Supply-side economics suggests that the circle starts in which sector?

__________________________________

7. What is Say’s Law?

___________________________________________________

___________________(sector)

____________________(sector)

____________________(sector)

____________________(market)

____________________(market)


WHAT DETERMINES HOW MUCH AN ECONOMY PRODUCES? (III.C.2)

The circular flow model demonstrates the strong relationship between production and consumption: households supply labor to the firms that produce goods and services, which households and other firms will eventually buy. This is why we make such a big deal about GDP; since GDP is a measure of productivity, it’s a proxy for how much an economy can consume, which means it can give us some idea of how people live within an economy.

Ultimately, the amount an economy can consume depends on how much it can produce. To be more precise, it can be shown that consumption actually depends on average labor productivity, or the average amount of GDP produced by each worker in the labor force. Between countries, many of the differences in GDP per capita (a measure of the standard of living) result from differences in average labor productivity (a measure of output).

For every economy, output—and especially average labor productivity—is a function of the following factors:

1) physical capital, which includes factories and industrial equipment;2) human capital, or the education and skill set of the workforce;3) natural resources, which includes all endowments in the environment that can be used for production;4) technology, or the knowledge about production processes that enables an economy to convert natural

resources into finished goods; and5) the regulatory and political climate, which can help or hinder growth depending on its ability to enforce

property rights, spur competition, deter corruption, and otherwise foster a thriving marketplace.

3.30 LISTING List-en carefully. Write a list in response to the following prompt.

1. List the five factors that determine how much an economy can produce.

a.b.c.d.e.

3.31 THIS OR THAT Choose wisely. Circle the choice that best completes the sentence. An example is provided.

Example: (Simon Cowell, Paula Abdul) used to give good luck jewelry to contestants on American Idol.

1. All else being equal, an increase in an economy’s capital stock should (INCREASE, DECREASE, HAVE NO EFFECT ON) output.

2. All else being equal, an increase in an economy’s money supply should (INCREASE, DECREASE, HAVE NO EFFECT ON) output.

3. All else being equal, if a country fails to invest in maintaining a decent education system, its productivity will eventually begin to (DECREASE, INCREASE).

4. All else being equal, improvements in technology should (DECREASE, INCREASE) the productivity of an economy.

5. All else being equal, if two countries differ widely in terms of their GDP per capita, they are most likely to have differences in (UNEMPLOYMENT, AVERAGE LABOR PRODUCTIVITY).


SAVINGS, INVESTMENT, AND THE FINANCIAL SYSTEM (III.D)You learned in the previous section that physical capital is one of the critical determinants of an economy’s productivity. For this reason, it presents an important economic challenge: in order to keep an economy growing, physical capital has to be growing, too, which means that someone has to be investing in it. It’s a challenge because money that is invested in the future can’t be spent on things we need or want now, in the present.

To economists, “investment” means spending money to purchase (or build) new physical capital. Investment could mean building a new addition to a factory in order to support more production volume. In modern times, investment might also mean spending $200 million to build a wind farm, which can be used to supply power to factories. In either case, a firm that wishes to invest has to borrow money in the financial markets. In the circular flow model, you saw that households lend money to firms, and firms invest that money in their physical capital. This flow is not as direct or simple as it appears in the circular flow model. Rather, households deposit their savings with financial institutions, who then lend money to firms (and to other households).

In this context, saving has a precise meaning. To an economist, saving means waiting until the future to consume some portion of current income. In other words, you are saving whenever you make more money than you spend in a given period of time. Saving is inversely related to consumption. In theory, if you lived on your sister’s couch and she paid all your bills, you could save 100 percent of your income. (You would just consume it later, once she kicked you off the couch.) But although you can only save 100 percent of your income, you can actually consume more than 100 percent of it, since you have the option to borrow money. Suppose you make $200 one day and you decide to take a road trip. You borrow $20 from your sister to put gas in your car and then spend $200 on your trip. Even though you only made $200, you spent $220; you managed to consume 110 percent of your income.

3.32 SHORT ANSWERS…Your best bet if you’re ever being questioned in court. Briefly respond in the blanks provided.

1. What does “saving” mean to an economist?

2. What does “investment” mean to an economist?

3. What is the relationship between household saving and household consumption?


DEBT AND EQUITY FINANCING (III.D.1)In the next section, we’re going to cover the stock market and the bond market. But before we get there, it mightbe helpful for you to understand a little bit about how companies raise money in general.

When a company needs cash for investment, it has two options: it can either issue debt or equity. Debt is some form of a loan, where the lender gives money to the company for a specified period of time and in return, the company agrees to repay the money with interest. It can be very similar to the sort of loan that many private individuals use to buy homes and cars. There are all different kinds of debt.

The other way companies can raise money is to sell equity. Equity represents ownership in a company, or at least partial ownership, which means that an equity investor has a right to the future profits of a company. To obtain equity financing, a company issues shares of ownership (or shares of “stock”) in exchange for cash.

DEBT AND EQUITY FINANCING: TWO WAYS FOR COMPANIES TO GET CASH

DEBT EQUITY

� Company issues bonds or takes out loans

� Lenders can be banks or private individuals� Lenders receive principal and interest payments� If the company sells, lenders are repaid before

the company owners get any money from the sale

� Company sells shares of stock to investors

� Investors receive no interest payments� Investors become partial owners in the company� If the company sells, equity investors will share

the proceeds of the sale with other owners, after all debts have been repaid

To understand the difference between debt and equity, it might be helpful to consider an example. Suppose a company has 5,000 shares of stock outstanding and it wishes to obtain $1 million to build a new building.

To use debt financing, the company would borrow the money and pay it back monthly over the course of three years, with a little extra for interest. Let’s just assume that with interest, the monthly payments work out to about $32,000 per month. Over the life of the loan, the company will pay a total of about $1.2 million back to the lender (36 payments of just over $32,000). From the lender’s perspective, this is a pretty good deal. If the company finishes the new building but then fails to pay back the entire loan, the lender can take possession of the building and sell it to another company. In the meantime, it will receive payments of principal and interest.

Or, the company can use equity financing. Suppose the company has two owners, who each have 2500 shares of stock, for a total of 5000. They do some research and determine no one will put $1 million into their company—with no guaranteed return—unless they get the equivalent of about 15 percent ownership in the company. That means they are going to have to issue about 1,000 shares of stock, for a total of 6,000, in exchange for that $1 million. That’s a price of $1000 per share. If the company goes this route, they won’t have to make any monthly payments. However, the new investors will own 16.7 percent of the company (1,000 out of 6,000 shares). If the investors expect the company to do really well, this is a pretty good deal. They can wait until the company becomes more profitable, and then sell their stock. Suppose they wait until the company is worth a total of $10 million. If they sell their 16.7 percent interest then, they might get about $1.67 million for it.38

One of the important differences between debt and equity investors is the amount of risk involved (from the perspective of the investor). Equity holders usually expect to receive a better return on their investment thanbondholders receive, since they take on considerably more risk. A debt investor has no stake in the ownership of a company; no matter how profitable or successful a company is, a debt investor will only be repaid the money it lends plus some interest. On the other hand, an equity investor owns a piece of the whole company. If the

38 Okay, this is really oversimplified—so oversimplified I can’t resist the urge to write a footnote. In real life, these equity investors have a minority interest, which means they don’t have the ability to control decision-making in the company. Any reasonable investor would expect a discount on the stock for lack of control, so the owners probably couldn’t get the full $1.67 million. Regardless, it wouldn’t make sense to issue stock to build a building unless you had absolutely no proven cashflow and the building was critical to your ability to turn a profit. But I digress…


company does well, it can be sold and after all of its debts are repaid, equity investors will keep what’s left, which might be much more than what they originally invested in the company. By the same token, if a company does poorly, the equity investor has a greater risk of losing its entire investment.

3.33 THINK FAST!What are a company’s two primary means of raising money for investment?

FINANCIAL MARKETS (III.D.1, CONTINUED)

Financial markets broadly encompass all the institutions that facilitate saving and borrowing within an economy. In the U.S., financial markets include the markets for stocks, bonds, futures, options, and foreign currencies. In this workbook, we focus on the bond market and the stock market.

One means of obtaining debt financing is to sell bonds in the bond market. Individuals, households, and even other companies can buy bonds. When you buy a bond, you give cash to the issuing company and in return, you receive some kind of certificate that guarantees that the company will repay everything you lent it (what you paid for the bond) plus interest. You might get all of your money back in one lump sum after a few years, or you might get periodic interest payments over time, with a final payment when the bond matures. When you buy a bond, you are essentially making a loan to the company. The original amount you lend is called the principal.

Of course, companies don’t always perform as well as they hope to. When you buy a bond, there is a chance that the issuing company will not be able to repay you, which means you will lose your money. You get interest payments because your loan has some risk. That is, the interest is meant to compensate you for the risk you’re taking. Companies that are very stable and have a long history of repaying their debts tend to pay lower interest rates on their bonds. Riskier companies, who appear to be more likely to encounter financial trouble—or who are currently having financial trouble—tend to have to pay higher interest rates in order to issue debt in the bond markets.

In general, when a borrower fails to repay a debt, we say the borrower has defaulted.

As you learned in the previous section, a share of stock represents a piece of a company’s equity. Shares of stock in public companies are first sold in primary markets, when companies first issue equity and receive cash in exchange. Later, the same shares of public companies are freely traded in secondary stock markets such as the New York Stock Exchange (“NYSE”). (We call companies “public” when anyone in the public can buy and sell their shares fairly easily, without having to have some inside connection to the other owners of a company.)

You’ve probably heard of the “NASDAQ,” which is short for the National Association of Securities Dealers Automated Quotation System. The NASDAQ is one of the major organized stock exchanges in the U.S. The other two major exchanges are the NYSE and the American Stock Exchange (AMEX).


3.34 TRUE OR FALSE Truth hurts. Some of the statements below are true. Others are false. For each one, indicate “T” or “F” and then make corrections to make the false statements true. An example has been provided.

T FLil Wayne

Example: In 2010, Lady Gaga spent eight months in jail for having been in possession of normal clothing on her tour bus.

a gun his

T F 1. Financial intermediaries include the markets for stocks, bonds, futures, options, and foreign currencies.

T F 2. A borrower is in default if he fails to repay a debt.

T F 3. The three major stock exchanges in the U.S. are the NASDAQ, the Dow, and the AMEX.

T F 4. If a bond has a high interest rate, the issuing company is a low default risk.

T F 5. Debt investors tend to require higher rates of return than equity investors.

T F 6. In a stock exchange, a company can sell new shares of its equity.

T F 7. The original amount of a loan is called the principal.

T F 8. Stock represents a share of ownership in a loan.

T F 9. Companies make periodic interest payments to equity holders.

T F 10. If a company is sold, its equity investors keep all of the proceeds from the sale.

FINANCIAL INTERMEDIARIES (III.D.2)

Financial intermediaries are third parties who help facilitate the transfer of money between savers and borrowers. They include banks (and similar depository institutions), investment funds, and contractual savings institutions. In this workbook, we will focus mainly on banks and certain investment funds.

Banks are depository institutions—which is to say that they accept deposits (savings) from households and businesses and they pool the funds from those deposits in order to make loans to other households and businesses. Credit unions, savings and loan associations, and mutual savings banks are all forms of depository institutions. The differences between them and commercial banks have mostly to do with who makes a profit, who gets to borrow and deposit funds, and how the institutions are regulated. One of the important features of commercial banks in the U.S. is that deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”), which means households don’t incur any risk by “lending” their savings to banks.


Investment funds buy stocks and bonds using the pooled savings of multiple households and businesses. To raise money, an investment fund sells shares (similar to the way in which a company issues equity). The idea is that by pooling more money than what a private individual can save alone, the investment fund has access to larger financial instruments and the risk is spread among all of the fund’s investors. Also, investment funds are professionally managed, which means that the individuals who own shares of the funds get to benefit from the expertise of the fund manager, rather than having to do their own market research all the time. A mutual fund is one type of investment fund.

3.35 WORD BANKFill in the _______. The word bank below provides key terms relating to financial markets and financial intermediaries. Complete the sentences below by writing in the term that best fits each blank. Each term can only be used once and you will not need to use all 12 terms.

WORD BANK

financial intermediaries stock financial instruments mutual fund

maturity depository institutions primary insurance

secondary bond principal contractual savings institutions

1. A public company first sells shares of its equity in a ______________________________ market.

2. Banks, credit unions, and savings and loan associations are all examples of

_____________________________________________.

3. In its simplest form, interest is calculated as a percentage of the

_________________________________ amount of a debt.

4. The NYSE and other stock exchanges are examples of ________________________________

markets.

5. One of the reasons that people are comfortable making deposits in commercial banks is the

_______________________________ provided by the FDIC.

6. Investors in a(n) ____________________________ enjoy the benefits of having a professional

manager for their investment as well as access to large ________________________________.

7. Banks, investment funds, and ______________________________ are three types of financial

intermediaries.


8. ________________________________ are third parties that facilitate the transfer of funds from

savers to investors.

9. Companies can issue bonds for sale in a _________________________________ market.

10. A debt reaches ___________________________________ at the end of its contractual term.

A FEW MORE WORDS ABOUT INTEREST (III.D)

Before we can really get into how financial intermediaries and financial markets come together, we will first need to take a step back to clarify a few things about interest. As you know, interest is the cost of borrowing money. We usually express interest in the form of an annual interest rate. An interest rate is a percentage of a principal, or the amount borrowed. For example, if you borrow $1000 at 10 percent annual interest, then the principal is $1000 and the interest rate is 10 percent. After one year, you’ll owe 10 percent more than you borrowed, or a total of $1100 ($1000 + (.10($1000)).

Lenders make money by giving loans and charging interest on those loans. Like everyone else, lenders worry about inflation. If a bank is waiting to collect money from a borrower, unexpected inflation can lower the value of the loan when it is finally repaid. For that reason, banks intentionally set interest rates high enough to compensate for inflation.

The stated interest rate on a new loan is the nominal interest rate, which includes the real rate and an inflation premium. When you take out a loan, the bank doesn’t mention the inflation premium or the real rate; they simply offer you the funds if you agree to repay them at some nominal rate. You sign a form to agree to repay the loan at the nominal rate.

During an inflationary period, we can approximate the real interest rate on a loan by subtracting the inflation rate from the nominal interest rate.

Many loans have flexible interest rates, which are designed to automatically adjust in response to economic conditions. These rates are usually determined by adding some fixed premium to the prime rate. The prime interest rate is the rate banks charge for short-term loans to their most credit-worthy corporate customers. The prime interest rate is published in the Wall Street Journal.

Interest rates do not only affect borrowers and lenders. They also affect people who are saving money. When you deposit funds into a savings account, you earn interest on your deposits because you are effectively lending your money to your bank. In this sense, interest acts as an incentive for you to spend money in the future, rather than the present. As you know, when you borrow money, you have to pay interest for the use of the funds you borrow. In this sense, a low interest rate might act as an incentive for you to spend money in the present, rather than the future, and a high interest rate might discourage you from borrowing and spending money in the present.

Interest rates influence how we allocate resources among present and future uses. When interest rates change, they affect the balance of saving and borrowing in the economy. Banks raise interest rates to discourage borrowing or encourage saving, and they lower rates to encourage borrowing or discourage saving.

3.36 SHORT ANSWERSome prefer “vertically challenged.” Write a brief response to each of the following prompts.

Real Interest Rate = Nominal Interest Rate � Inflation Rate


1. Why is inflation bad for lenders?

2. What is the relationship between the real interest rate and the nominal interest rate?

3.37 SENTENCE COMPLETIONPicky, picky, picky. Pick the word or phrase that best completes each statement below. Circle your answer choices.

1. Interest rates are usually expressed as a(n) [ANNUAL, QUARTERLY] percentage of a principal amount.

2. The [NOMINAL, REAL] interest rate is adjusted for inflation.

3. Some adjustable interest rates are pegged to the [PRIME, REAL] interest rate.

4. Inflation can [INCREASE, DECREASE] the value of outstanding loan balances.

5. The prime rate is published in [THE WALL STREET JOURNAL, THE ECONOMIST].

COORDINATING SAVINGS AND INVESTMENT DECISIONS IN FINANCIAL MARKETS (III.D.5)

Interest is the price of borrowed money, and it is also the incentive to lend or save it. So just like any good or service, money has a price. As it turns out, we can use a simple supply and demand model to predict how rational people will respond to changes in interest rates.

Suppose we let the interest rate, i, represent the “price” of money. And suppose we say that people who want to borrow funds are demanding money; that is, the quantity of money demanded for loans is the “quantity demanded” of money. People borrow money to make investments. Naturally, if the interest rate is high, then money is expensive to borrow, so people are unlikely to want to borrow very much of it; and if they can’t borrow, they’re unlikely to invest. On the other hand, when the interest rate is low, people will probably be more willing to make new investments; they can use money inexpensively. The graph of the relationship between investment and the interest rate is a familiar one. Just like the demand curve for any good or service, the demand curve for money—that is, the graph of the investment function—is downward-sloping.

Now consider another way to use money. Some people borrow money to make investments, but some people deposit it in banks in order to earn interest. When savers deposit their money, they supply banks with the funds to make loans to people who demand money. For simplicity, we can say that money-saving and money-supplying are nearly the same thing. When the interest rate is high, savers can earn more interest by saving more money, so they’re likely to want to deposit money in banks. Banks are likely to want to make loans because they can earn so much interest on them. On the other hand, when the interest rate is low, savers don’t stand to gain as much from saving, so they are unlikely to want to save as much. Banks don’t earn as much interest on loans, so they are


unlikely to make as much money. This relationship has a familiar graph. Not surprisingly, the supply curve for money—the graph of the savings function—is upward-sloping.

Demand for Loanable Funds Supply of Loanable Funds

This market is called the loanable funds market. As with any good or service, the “market price” of money is set where the supply and demand curves intersect. In the loanable funds market, the real interest rate is set at the intersection of the investment and savings curves.

The Loanable Funds Market

3.38 WORD BANKFollow the reserve requirement. Use the terms in the bank to complete each sentence, below. You will not need to use every term in the bank.

WORD BANK

borrow investment savesavings real nominal

exchanged demanded suppliedprime

1. In the loanable funds market, people who _____________________________ money are the suppliers.

2. In the loanable funds market, people who _____________________________ money are the people who demand it.

3. The graph of the _____________________________ function is a downward-sloping curve.

I

i

M

Si

M

I

Si

M

real interest rate


4. The graph of the _____________________________ function is an upward-sloping curve.

5. When the interest rate is high, the quantity _____________________________ of money is low.

6. When the interest rate is high, the quantity _____________________________ of money is high, too.

7. The _____________________________ interest rate is determined at the intersection of the savings and investment curves.

AGGREGATE SAVINGS AND INVESTMENT (III.D.3)

With some algebraic trickery, it can be shown that the sum of all savings in an economy (S) is equal to the sum of all investment (I), provided there are no imports or exports, and no one is borrowing from or lending to other countries. As you know, “savings” in this context means money that is earned in the present but not spent in the present.

When we say that S = I, we are referring to aggregate savings, which includes government savings as well as the savings of private households. In the expenditures approach to GDP measurement, you learned that “G” represents government spending. For government, income is generated through taxation (“T”). In order to have government savings, taxes have to be larger than government spending (T—G must be positive). A budget surplus exists if the government is saving. In the U.S., that hasn’t happened for a while (at least not at the federal level). In recent years, we’ve had a budget deficit, or an excess of government spending over taxation.

INTERNATIONAL CAPITAL FLOWS IN AN OPEN ECONOMY (III.D.4)

It’s important that you understand that the identity “S = I” only holds true in a closed economy; that is, it works if there are no imports or exports and no one is borrowing from or lending to other countries. In reality, however, neither of those conditions is true in the U.S. The U.S. is an open economy, which means that we trade relatively freely with other economies. We also invest in other economies and we allow foreigners to invest in ours.

We can measure an economy’s net capital outflow as the difference between domestic investment in foreign assets and foreign investment in domestic assets. In other words:

net capital outflow = domestic purchase of foreign capital - foreign purchase of domestic

capital

One form of international capital flow is foreign direct investment (FDI), which is simply the purchase of foreign assets. Sometimes large firms will open foreign branches or subsidiaries of their own companies and that kind of spending is an example of FDI. Another form of international capital flow is portfolio investment, or the purchase of the debt or equity (bonds or stock) of foreign companies.

In an open economy, net capital outflow (NCO) is always equal to net exports (NX). With some algebra, it can be shown that in an open economy, domestic savings (S) is equal to domestic investment (I) plus NCO (or NX, since they’re equal). You should memorize this identity:

S = I + NCO

3.39 SHORT ANSWERJust get to the point already. Write a brief response to each of the following prompts.


1. Under what condition does the identity S = I hold true?

2. What is net capital outflow?

3. What are two primary forms of international capital flow?

4. Write the identity that explains the relationship between savings, investment, and net capital outflow in an open economy.

5. What is the difference between FDI and portfolio investment?

MONEY (III.E.1-3)

As far as economists are concerned, money is anything we can use to buy resources, goods, or services, or to repay debts. We use money in order to trade more easily and avoid the extreme complexity of barter. We also use it to help us compare the relative values of goods and services. And of course, we borrow, save, and invest with money. Currency is a common medium of exchange used as money.

Commodity money is something, such as gold, that is intrinsically valuable, but that can also be used as money. By contrast, fiat money is paper currency that is accepted as money because a government has declared it legal tender; by law, it must be accepted in payment of debts. Fiat money has no intrinsic value. It can only be used as money. Coins such as pennies or quarters are referred to as fractional currency because they represent a fraction of the value of the unit of currency; that is, a quarter is worth one-fourth of a U.S. dollar.


Money serves three functions. First, it serves as a medium of exchange. If you give money to someone, she will probably be willing to give you a resource, good or service in exchange for it. Second, money serves as a store of value. That is, unlike an ear of corn or a gallon of milk, money won’t spoil over time. If you have a five-dollar bill today, and you choose to hold onto it for a week, then you can spend it at the end of the week and it will still be worth five dollars (assuming there has been no inflation). And finally, money functions as a unit of account (or a “standard of value”). We express the prices of resources, goods, and services in terms of our medium of exchange; in other words, we express prices in terms of money.

Good money must have some essential physical properties. It must be durable, scarce, and easy to transport. Also, it must be divisible, in the way that a dollar may be divided into 100 cents.

WHAT YOU NEED TO REMEMBER ABOUT MONEY

3

functions:

4

essential physical properties:

� medium of exchange� store of value� unit of account

� durability� scarcity� ease of transport� divisibility

Some coins are made of precious metals, and their value is determined by their metal content. These coins are debased when their precious metal content is decreased by adding in non-precious metals. Debasement allows unscrupulous rulers to make more currency from the same amount of precious metal.

3.40 TRUE OR FALSEDare to tell the truth. Determine whether each statement below is true or false. For true statements, circle “T.” For false statements, circle “F” and then add any necessary corrections to make them true.

1. T F Silver is an example of fiat money.

2. T F Commodity money has no intrinsic value.

3. T F Anything can be money, as long as people will accept it in exchange for resources, goods, or services, or in repayment of debts.

4. T F Good money must be durable, abundant, and easy to transport.

5. T F Money functions as a medium of exchange, a store of value, and a unit of account.

3.41 CATEGORIZATIONWhat’s your function? Indicate which function of money is described in each problem below.

Ex.: John wants a new car and he owns a painting. The car dealership doesn’t want his painting. He sells his painting for money, and then spends that money on the car he wants. John didn’t have to barter because he used money as a medium of exchange.

1. John couldn’t express the value of the car he wanted in terms of paintings, nor could he express the value of the painting he had in terms of cars. But he was able to express the value of both goods in terms of money. In this sense, money functioned as a


______________________________.

2. Mark bought a house for $200,000. Five years later, he sold it for $280,000. Although the house is not money, Mark used it as a

______________________________.

3. Suppose we can express the value of any DemiDec product in terms of flashcards. Flashcards serve which function of money?

______________________________

3.42 FILL-INAcademic dentistry. Fill in the blanks in the sentences below.

Ex. An economics workbook would be a better form of money than a boat because a workbook is easier to transport.

1. A coin is a better form of money than a house because it has the essential physical property of

________________.

2. Silver is a better form of money than gravel because silver has the essential physical property of

________________.

3. A coin would be a better form of money than a white rose because silver has the essential

physical property of _______________________________.

4. The U.S. dollar is a good form of money, in part, because it is _________________________;

it can survive a run through a washing machine39.

5. Dollar bills are a better form of money than water because they are _____________________.

6. A stone could be a better form of money than a rare orchid because a stone is more

____________ than an orchid; but a rare orchid could be a better form of money than a stone

because a rare orchid is more ______________ than a stone.

DEFINITIONS OF THE MONEY SUPPLY (III.E.2, CONT’D)Anything can be money, as long as people will accept it in return for resources, goods, or services, or in repayment of debts. By that definition, what one person sees as “money” may not be “money” to someone else. Of course, most of us would agree that cash can be safely called “money.” But as it turns out, only 25 percent of the transactions we make every day actually involve paper currency and coins. About 70 percent of our daily transactions involve demand deposits—the money we keep in checking accounts. That other five percent has to come from somewhere, right? And if people are accepting something in return for goods and services, then it must be money, right?

The money supply is the total quantity of money in an economy. Just as there is uncertainty over how to define money, there is uncertainty over how to measure the money supply. The Federal Reserve keeps track of a few

39 Just like DemiDec Dan’s passport.


money aggregates, or definitions of the money supply. Each definition differs from the others according to its liquidity, which is the ease with which an asset can be converted into cash.

DEFINITIONS OF THE MONEY SUPPLY

M1

� the most liquid conventional definition

� consists of paper currency and coins, traveler’s checks, and demand deposits

� demand deposits make up the majority of M1 assets

M2

� the second-most liquid money aggregate

� some economists think M2 is the most useful definition of the money supply

� includes everything in M1, as well as deposits in savings accounts, money market deposit accounts, money market mutual fund shares, small certificates of deposit (CDs), overnight repurchase agreements, and overnight Eurodollars (a small-denomination CD has a value of less than $100,000)

M3

� includes everything in M2 as well as large-denomination CDs, long-term repurchase agreements, Eurodollars, and shares of institutional money market mutual funds.

� as of 2006, no longer tracked by the Federal Reserve

L

� the broadest and least liquid definition of the money supply (think of “L” as standing for last resort)

� includes everything in M2, as well as savings bonds, government securities, commercial papers, and deeds

3.43 CHARTINGIt’s money in the bank. Or is it? The pie chart below represents the portion of day-to-day transactions we make with each type of money.

1. Begin by looking closely at the chart to estimate what portion of the circle is represented by each piece of the “pie.”

2. Label each piece with the appropriate form of money. Your labels will include “Demand Deposits,” “Paper Currency and Coins,” and “Other Forms of Money.”

3. Finally, complete the labels by writing what percentage of daily transactions is accounted for by each piece of the pie.

3.44 DIAGRAMMING


The chicken or the egg? The diagram below represents definitions of the Federal Reserve’s money aggregates. In the boxes, write “M1,” “M2,” or “M3,” where appropriate. On the lines, write the components of each definition of the money supply.


3.45 CATEGORIZATIONOne of these things is not like the others. In this exercise, you’ll see groups of items that are somehow related. In each group, one item does not belong. Identify the impostors and cross them out. Then explain how the remaining three are related.

Ex: economistwriterbartendertelemarketermusicianfinancial analyst

Explanation:The group consists of occupations I’ve had since high school. I’ve never been a telemarketer, though, and that’s probably for the better... unless, of course, I could interest you in—just kidding.

1. paper currencycoinsdemand depositsovernight Eurodollars

Explanation:

2. standard of valuestore of valuemeasure of wealthmedium of exchange

Explanation:

3. durabilityaccountabilityscarcityportability

Explanation:

4. money market depositsM1government securitieslarge-denomination CDs

Explanation:

5. includes M1second-most liquid money

groupincludes long-term repurchase

agreementsthe most useful money supply

measurement

Explanation:


6. includes paper currencyincludes commercial paperincludes M2most liquid money aggregate

Explanation:

3.46 MATCHINGMatch-ismo. Match the letter of each term in the column on the left to the MOST ACCURATE description in the column on the right.

a. liquidityb. fiat moneyc. M1d. money aggregatee. commodity moneyf. fractional currencyg. moneyh. Li. money supplyj. scarcityk. demand depositsl. legal tender

1. _______ something that must be accepted for payment of any debts

2. _______ a definition of the money supply3. _______ the least liquid definition of the money supply4. _______ the ease with which an asset can be converted to an

economy’s medium of exchange5. _______ the physical property of precious metal coins that

deteriorates when the coins are debased6. _______ money that has no intrinsic value7. _______ anything that people will accept in return for resources,

goods, or services, or in repayment of debts8. _______ something that is worth a portion of the value of a unit

of currency9. _______ the narrowest definition of the money supply10. _______ something that is intrinsically valuable, but can also be

used as money11. _______ the quantity of money in an economy12. _______ funds that must be made available to the depositor on

demand

3.47 LISTINGThe fundamenta-list approach. Complete each list below.

1. List five uses for money.

a.

b.

c.

d.

e.

2. List three functions of money.

a.

b.

c.


3. List four essential physical properties of good money.

a.

b.

c.

d.

4. List four components of the M1 definition of the money supply.

a.

b.

c.

d.

5. List six components of M2 not included in M1.

a.

b.

c.

d.

e.

6. List four components of M3 not included in M2.

a.

b.

c.

d.

THE FEDERAL RESERVE SYSTEM, BANKS, AND THE SUPPLY OF MONEY (III.E.3)

The Federal Reserve System was established as the central bank of the U.S. when the Federal Reserve Act of 1913 was passed. It was designed as a “decentralized” central bank because at the time, centralized banking power was a divisive political issue. The Federal Reserve has six functions:

1) to determine and conduct monetary policy2) to supervise and regulate financial institutions3) to lend to banks and other financial institutions4) to act as a bank for the U.S. government5) to issue currency and coins6) to provide certain financial services, such as clearing checks

The “Federal Reserve” consists of 12 districts, each with its own bank. District banks can issue currency. There are also 25 branch banks, which are smaller than the district banks.

The Federal Reserve is operated by a seven-member Board of Governors. Everyone on the board is appointed to a 14-year-term by the U.S. president, but the terms are spaced two years apart. This way, no president can appoint the entire board while in office. By law, no two board members can hail from the same district. The Chairman of the Board of Governors is appointed from within the board. The Chairman serves a renewable 4-year term. The current Chairman is Ben Bernanke, who succeeded Alan Greenspan.

The members of the Board are part of the 12-member Federal Open Market Committee. The other five members of the FOMC are presidents from the 12 districts. The president of the New York district has a permanent seat on the FOMC.

The Federal Advisory Council is a committee of 12 prominent commercial bankers. Each member represents one of the 12 Federal Reserve Districts. The Council meets with quarterly with the Board of Governors to voice


concerns about banking policy.

3.48 FILL-INNumber crunch. Complete each statement below.

1. There are ________ members of the Board of Governors of the Federal Reserve.

2. There are ________ branch banks in the Federal Reserve System.

3. The Federal Reserve System is comprised of ________ districts.

4. The Chairman of the Board of Governors is appointed to a renewable ________-year term, but the other

members of the board each serve ________-year terms.

5. The Federal Open Market Committee has ________ members.

6. The maximum number of members of the Board of Governors from the same district is ________.

7. The Federal Advisory Council meets _______ times per year with the Board of Governors.

8. There are ________ members in the Federal Advisory Council.

9. The Federal Reserve System has ________ district banks.

10. _____ members of the Federal Open Market Committee are not members of the Board of Governors.

3.49 DIAGRAMMINGThe Federal Reserve. Below is a diagram of the Federal Reserve System. Label each part, using the terms listed below.

Board of GovernorsMember Banks

12 District BanksFederal Open Market Committee

25 Branch (“Federal”) BanksFederal Advisory Council


THEFED


FRACTIONAL RESERVE BANKING (III.E.3, CONT’D)The U.S. has a fractional reserve banking system, in which only a fraction of the money deposited into a bank actually remains there. The rest is loaned out with interest so that banks can earn a profit. The portion of a deposit that a bank is required to keep is the required reserve, and it is expressed as a mandatory percentage of deposits. That percentage is the reserve ratio, and it is set by the Federal Reserve.

We use the fractional reserve banking system to generate money without even having to print it. When a person makes a deposit at a bank, the bank holds onto the required reserve of it. For instance, if a person deposits $1000, and the reserve ratio is 10 percent, then the bank is required to keep $100 on hand. To make money, the bank will then lend the remaining $900 to someone else. Now suppose that person deposits all $900 in another bank. That bank will have the same reserve ratio, so it will keep $90 and lend the other $810… to someone who will deposit it in another bank. And the process will continue.

We can use the simple money multiplier to estimate approximately how much money will be generated by a change in a component of the money supply. The simple money multiplier is just the inverse of the reserve ratio. For example, if the reserve ratio is 10 percent, or 1/10, then the simple money multiplier is 10. If we increase the amount of cash in the hands of the public by $100, and the simple money multiplier is 10, then the money supply will increase by $1000, or 10 x $100.

Of course, not everyone spends or deposits every penny they earn, so this simple multiplier generally overstates the “real” multiplier. But it’s a useful guide for understanding why banks can have so much power over the size of the money supply.

3.50 APPLYING KEY CONCEPTSPractice makes perfect. In this exercise, you’ll put the fractional reserve banking system into practice at its most basic level. Answer each question below.

1. If the reserve ratio is 10%, what is the simple money multiplier?


3. If the reserve ratio is 33⅓%, what is the simple money multiplier?



6. If the simple money multiplier is 10, what is the reserve ratio?



1simple money multiplier = reserve ratio


9. Suppose a Federal Reserve representative knocks on your door one day and hands you $1000. You head to the bank to deposit it. If the reserve ratio is 25%, how much money can be created from your deposit?

10. In #9, if the reserve ratio were 33⅓%, how much money could have been created from your deposit?

MONETARY POLICY (III.E.3, CONT’D)The Federal Reserve System works to pursue the macroeconomic goals of the United States by determining and implementing monetary policy. Monetary policy describes any policy action to influence the health of an economy by manipulating its money supply.

The Federal Reserve uses three main tools to influence the money supply. They are summarized in the following table and described in greater detail in the paragraphs that follow.

HOW THE FED INFLUENCES THE MONEY SUPPLY

POLICY TOOL ACTION EFFECT ON THE MONEY SUPPLY HOW IT WORKS

open market operations

buy injects cash into the economy

sell pulls cash out of the economy

discount rate

creates a disincentive for banks to borrow (and lend) money

makes loans less expensive for banks, encouraging them to borrow (and lend) more

reserve requirement

allows banks to lend more of their deposits

forces banks to lend less of their deposits

One tool is open market operations, which is the buying and selling of government securities. This is the most useful tool of the Federal Reserve, and the one that is most often used. When the Federal Reserve buys a government security (such as a long-term government bond) from a bank, it puts money into the bank. The bank, in turn, has more money on hand (although it has equally less value in assets), so it will then use that money to make loans. As you know, when a bank makes a loan, the loaned funds will be deposited at another bank, where the excess reserves can be lent out again, then deposited. The excess reserves from that deposit will be lent out again, and then deposited again, and so forth. The Federal Reserve will buy government securities to increase the money supply or sell government securities to decrease the money supply.

Another tool of the Federal Reserve is to raise or lower the discount rate. The discount rate is the interest rate the Federal Reserve charges to member banks when it lends them money. If the Federal Reserve wants to encourage banks to borrow money, then it can lower the discount rate. If banks borrow, they’ll have more money


on hand, so they’ll make more loans, which will eventually increase the money supply. Similarly, to discourage banks from borrowing, the Federal Reserve can raise the discount rate. The Federal Reserve will lower the discount rate to increase the money supply or raise the discount rate to decrease the money supply. This tool is not used very often because its results are difficult to predict. When the Federal Reserve alters the discount rate, it may hope to affect banks’ willingness to borrow, but it can’t actually control it. By contrast, when the Federal Reserve buys or sell securities, it can control exactly how much money it is manipulating.

The third tool of the Federal Reserve is to raise or lower the reserve requirement. If the Federal Reserve raises the reserve requirement, then banks will have less excess reserves available to make loans. If the Federal Reserve lowers the reserve requirement, then banks will have a greater percentage of deposits available to make loans. Of course, the reserve requirement is simply the inverse of the simple money multiplier; if the reserve ratio increases, then the money multiplier will decrease. The Federal Reserve will lower the reserve requirement to increase the money supply or raise the reserve requirement to decrease the money supply. As it turns out, the Federal Reserve rarely changes the reserve requirement, because doing so could have a tremendous and hard-to-control effect on the economy.

3.51 IN BRIEFShort answer. Write a brief response to each of the following questions.

1. What is monetary policy?

________________________________________________

2. What are the three main tools the Federal Reserve uses to influence monetary policy?

________________________________________________

3. What are open market operations?

________________________________________________

________________________________________________

4. What is the discount rate?

________________________________________________

5. Which monetary policy tool does the Federal Reserve use most often?

________________________________________________

3.52 APPLYING KEY CONCEPTSThis way up. In part A, you’ll see what happens to something that can affect the money supply. Respond by drawing an arrow to show whether the related item will increase or decrease. In part B, you’ll read about something that happens, which will influence the money supply. Respond by drawing an arrow to show howthe related item will be affected.

Part A.

IF GOES THEN GOES


Ex: Number of hours you study economics with your team Likelihood you’ll medal in economics

1. reserve requirement money multiplier

2. money multiplier money supply

3. reserve requirement money supply

4. discount rate likelihood banks will borrow from the Federal Reserve

5. loans the Federal Reserve makes to banks money supply

6. reserve requirement money supply

7. discount rate money supply

8. reserve requirement excess reserves

Part B.

IF THEN GOES

Ex: You don’t study economics Your chance of impressing the judges who interview you

9. the Federal Reserve buys a government security money supply

10. the Federal Reserve raises the discount rate money supply


11. banks borrow more money from the Federal Reserve money supply

12.a government plane flies over L.A. and drops cash on the citizens of L.A., who then go make deposits at their banks

loans made by banks in L.A.

13.people suddenly panic about the banking system and withdraw all of their deposits from banks

money supply

14. fractional reserve banking as we know it is outlawed money supply

BANK RUNS (III.E.4)

One of the risks of a fractional reserve banking system is that if banks suddenly had to give back all of the deposits they have accepted, they would be unable to do so (since they are only required to keep a fraction on hand). It’s a rare occurrence, but not an impossible one.40 A major economic event can cause a level of public shock that is sufficient to induce a bank run, or a sudden rush of demand for deposits. If a bank is unable to return deposits immediately, it risks losing the public’s faith—which could mean losing its depositors. In the U.S., the Fed has a responsibility to support banks by lending cash in the event of a bank run.

3.53 THINK FAST!Write a brief response to the following prompt.

What is a bank run?

MONEY AND INFLATION IN THE LONG RUN (III.E.5)

Like everything else, money has a price, which is determined by the interaction of supply and demand. In the short run, when there is an increase in the demand for money, its price goes up; when there is an increase in supply, its price goes down (assuming all else is equal). In the market for money, the “price” is really the value of money, or how much you can get in exchange for it. When demand for money increases, money becomes more valuable. You can get more for your money. When the Fed takes a step to increase the money supply, money becomes less valuable.

It is important to note that the market for money is not exactly the same as the market for loanable funds that

40 Truer words were never spoken. While I was proofreading this passage in the fall of 2010, there was a bank run in Ireland. Go figure.


you saw earlier in this workbook. In the market for money, demand is driven by people’s desire for liquidity in their wealth, or the ability to easily convert it to cash. If you didn’t need cash on a day-to-day basis, you could store your wealth in the form of investments in works of art, buildings, oil reserves, and homes. But because we need cash, or something much like cash (such as a debit card or check card) for almost everything we do, it’s not convenient to store all of our wealth in the form of Van Gogh and Picasso paintings.41,42

The Fed has the ability to influence the money supply, either indirectly through its oversight over banks or directly through its operations in the open market. In the short run, an increase in the money supply may cause people to act as if they simply have more money, which is to say they’ll start demanding more goods and services. But in the long run, increases in the money supply eventually just lead to inflation. Although demand for goods and services will increase in the short run, the supply does not change. Eventually, all prices will have to rise.

The graph below illustrates the market for money. The money supply is represented by the vertical line. Demand is the downward-sloping curve. The vertical axis represents the value of money, or how much you can get for a dollar. The horizontal axis represents the quantity of money. In the graph on the right, you can see that when the Fed increases the money supply (causing the supply curve to shift to the right), the value of money falls even though there is more money in the economy.

The Market for Money

THE VELOCITY OF MONEY (III.E.5, CONT’D)

The velocity of money is the number of times, on average, that money will change hands within an economy (how many times a typical dollar bill will be spent). We can calculate the velocity of money (V) as the quotient of nominal GDP divided by the money supply (M):

velocity of money = nominal GDPmoney supply

Since nominal GDP is equal to the value of all goods and services that are bought and sold in the economy, it is

41 And anyway, it would be difficult to figure out how many gallons of gas you should get for your signed “Wheatfield with Crows” if all of the gas stations were quoting in terms of “Starry Night.” 42 The art museum robbery was foiled when the thieves had no Monet to buy Degas to make their Van Gogh. –Robb

1/P 1/P

Q Q

ValueofM

oney

ValueofM

oney

Inthelongrun,anincreaseinthesupplyofmoneywillreducethevalueofmoney

D D

S1 S2S1


also equal to the total amount of money that is spent in an economy over the same time period. We can calculate nominal GDP as the product of the price level (P) and real GDP (Y). Substituting (P x Y) for nominal GDP and rearranging the terms in the equation above, we get the following identity:

V x M = P x Y

Using this identity, it’s easy to see that algebraically, an increase in the money supply must increase the price level or real GDP. Otherwise, it has to be offset by a decrease in the velocity of money. You learned previously that the things that actually increase real output (Y) are labor, technology, capital, and natural resources, we can more or less rule out the possibility that an increase in M would increase Y. That means an increase in the money supply will either raise P (as you know) or lower V.

Economists sometimes talk about the neutrality of money in the long run. Money is said to be neutral because in the long run, any change in the money supply will only lead to a proportionate change in the price level.

3.54 TRUE OR FALSE Can you handle the truth? Some of the statements below are true. Others are false. If it’s false, make it true and explain why the statement was wrong. An example has been provided.

T F Example: Writing workbooks late at night makes Jessica more productive during the regular workday.

much less

T F 1. In the market for money, supply is driven by people’s desire for liquidity.

T F 2. Convertibility refers to the ease with which an asset can be converted into cash.

T F 3. In the long run, any change in the money supply can be expected to result in a proportionate change in the price level.

T F 4. An increase in the money supply can result in a long-run increase in real GDP.

T F 5. The volume of money is the number of times, on average, that it changes hands within an economy over a specified period of time.

T F 6. In a graph of the market for money, the vertical axis represents the real interest rate.

T F 7. When the money supply increases, money becomes more valuable.

T F 8. When the price level falls, money becomes more valuable.

T F 9. When the price level rises, the money supply increases.

T F 10. In the U.S., the federal government has a few monetary policy tools that it can use to influence the money supply.


3.55 SHORT ANSWER Short and sweet. Write a brief response to each of the following prompts.

1. What is the equation for the velocity of money?

2. How can we rearrange the equation for the velocity of money to show how changes in the money supply affect the price level or the velocity of money?

3. Why can’t the money supply be used to create long-run increases in real GDP?

MORE ON INFLATION (III.E.6)

There are three main reasons why inflation is a challenge for economists: 1) It reduces the value of money people already have. Even though future salaries can be adjusted to

compensate for price increases, the money you’ve already made won’t receive the same benefit. 2) It distorts pricing. Eventually, we expect all businesses to adjust their prices (and the wages they pay to

employees) to compensate for inflation. But when some prices have been adjusted and others haven’t, some goods and services may appear to be relatively over- or under-priced compared to goods and services of equal value.

3) It creates uncertainty about the future. A lot of financial decisions, including decisions about how much to save or spend, and when to invest, are made on the basis of people’s expectations about the future prices of goods and services. Inflation makes those decisions more risky.

3.56 LISTING List-en up. Write a list in response to each prompt below.

1. List the five factors that determine economic output.

a.

b.

c.

2. List the three reasons why inflation can be bad for the economy.


d.

e.

a.

b.

c.

AGGREGATE SUPPLY & AGGREGATE DEMAND (III.F.4)

Aggregate output is comprised of all the goods and services produced in an economy. Real GDP is a measure of aggregate output.

In the same way that a consumer demands units of individual goods and services, the demand of all consumers for all goods and services comprises the demand for aggregate output. Similar to the demand relationship you’ve already seen, aggregate demand is the relationship between the quantity demanded of aggregate output and the price level, or the average price of all the goods and services produced in an economy. The aggregate demand curve graphically represents the relationship between the price level and the quantity demanded of real GDP.

Aggregate supply is the relationship between the price level and the quantity of real GDP that producers are willing and able to supply. This relationship is graphically represented by the aggregate supply curve.

Equilibrium occurs at the point where aggregate demand equals aggregate supply, or the intersection of the aggregate demand curve with the aggregate supply curve. This point is the equilibrium level of real GDP and price in the economy.

3.57 APPLYING KEY CONCEPTSMean curves. In this exercise, you’ll see how shifts in aggregate demand and aggregate supply can cause changes in the business cycle.

1. A recession is marked by a decrease in real GDP. One way this can happen is if aggregate demand decreases. Draw a new aggregate demand curve, reflecting the change that would cause a recession.

2. Stagflation is a combination of stagnation and inflation: prices are rising but real GDP is not growing. This happens when there is too little aggregate supply available to satisfy aggregate demand. Draw a new aggregate supply curve,

Pric

e Le

vel

Real GDP

AD AS

Equilibrium


reflecting the change that causes stagflation.

AGGREGATE SUPPLY & AGGREGATE DEMAND (III.F.4, CONT’D)

Aggregate supply does not function exactly like the supply curve of a single market. Aggregate supply is limited by an economy’s capacity to produce. At some point, suppliers simply do not have the capacity to produce any more. If aggregate demand continues to increase past this point, the price level will rise, but equilibrium real GDP will not increase. For this reason, many modern models of the economy give the aggregate supply curve a kinked shape. This kink represents the full utilization of a society’s resources.

The Aggregate Supply Curve

If the aggregate demand curve intersects the aggregate supply curve at any point below suppliers’ capacity to produce, equilibrium falls below the economy’s full employment of resources. Another way to look at it is to think of the vertical aggregate supply curve as a long-run model, whereas the upward-sloping version represents the short-run response of producers to changes in the price level.

The aggregate demand curve is shaped like the demand curve for a single market; the price level is inversely related to the quantity demanded of real GDP. However, the reasons for the shape are somewhat different.

First, there is the wealth effect, which basically means that at lower prices domestic consumers feel wealthier, since they can use the same amount of money to buy more things. The wealth effect is sort of like the aggregate version of the relationship between price and quantity demanded that we see in the market for a single good or service. Also, foreign exchange has an effect on aggregate demand because lower domestic prices encourage foreigners to demand more domestic goods. And finally, interest rates can affect the shape of the aggregate demand curve, too. When prices are low, people need less money to buy the same amount of things, which means they’re more inclined to save. And as you know, when people save more, the supply of loanable funds increases, which lowers interest rates and encourages borrowing. Businesses and households borrow money in order to spend it, which means they want to buy more goods and services.

Pric

e Le

vel

Real GDP

AD AS

Pric

e Le

vel

Real GDP

AD AS

Pric

e Le

vel

Real GDP

AS


The aggregate demand curve will shift in response to changes in foreign income, changes in consumers’ expectations of future income, or changes in consumers’ expectations of future prices. Also, changes in exchange rates, income distribution, and government policy can cause the curve to shift.

The aggregate supply curve shifts when total output increases or decreases. Taxes can increase or decrease aggregate supply by affecting suppliers’ willingness or ability to produce. The price of resources can cause the curve to shift, too, by affecting suppliers’ willingness or ability to produce. Changes in the quality or composition of the labor force will affect suppliers’ productivity, therefore causing the curve to shift. Finally, changes in the capital base, which can increase or decrease the economy’s productive capacity, can cause the curve to shift, too. If the aggregate supply curve shifts to the left, the society experiences stagflation: higher price levels with lower output.

3.58 UPS AND DOWNSOn point4433. In this exercise, you’ll see what happens to a factor that affects aggregate supply or aggregate demand. Your job is to demonstrate how aggregate supply or aggregate demand is affected by drawing an arrow that points in the appropriate direction.

Ex: Number of dropped calls: Number of friends to whom I recommend my cell phone carrier

1. The size of the capital base: Aggregate Supply:

2. Foreign income: Aggregate Demand:

3. Resource costs: Aggregate Supply:

4. Taxes Aggregate Supply:

5. Consumers’ expected future income: Aggregate Demand today:

6. Income taxes: Aggregate Demand:

43 Earlier in this DemiDec summer, I learned about a rare foot injury that dancers sometimes suffer when dancing on point. I fractured a small bone in my foot and as my doctor was going over the results of the MRI with me, he asked how long I’d been dancing on point. Uh, since… never? He was surprised to learn that I had injured myself while running barefoot. I was surprised to learn that he had actually looked at me and thought, “Yep, this woman is probably a ballerina.”


7. Income taxes: Aggregate Demand:

8. Resource costs: Aggregate Supply:

THE KEYNESIAN MODEL (III.F.6-7)

John Maynard Keynes (pronounced like, “John walks with two canes”) was a British economist who, among other things, offered a now well-known explanation for short-run fluctuations in economic activity. Keynes suggested that at any time, there is some level of potential output (potential GDP) and some possible output gap, the difference between the actual level of GDP and the potential output if all resources are fully utilized.Potential output increases because of investment in technology, increases in the population, and increases in an economy’s capital stock.

In this view, any variation in economic output can be explained as a change in the output gap, for better or worse. The gap may widen if actual output stays constant but potential output increases; or it may widen if potential output stays constant but actual output falls because of underutilized resources. In the Keynesian model, most short-run fluctuations can be explained—and addressed -- in terms of divergences in actual and potential output. For example, in a recession, there is an output gap because resources are not being used. This is why unemployment is highest during recessions.

Going back to the aggregate supply and demand curves from the previous section, you can think of the vertical long-run supply curve as potential output. Any difference between that curve and the point at which the aggregate demand curve intersects the upward-sloping short-run AS curve is essentially the output gap. If there is no output gap, all three curves intersect at the same point, as in the graph below.

The Keynesian Model of Aggregate Supply and Aggregate Demand

In the Keynesian model, recessions or other short-run fluctuations occur when there are shocks to AD or AS. In the short run, these shocks can alter the price level and create output gaps, as shown in the graph below. In the long run, consumers and suppliers will change their expectations about the price level and in response, both AD and AS will adjust accordingly.

Price

Level

ASSR

AD

ASLR


Short-Run Effects of Shocks to Aggregate Supply and Aggregate Demand in the Keynesian Model

3.59 EITHER OR The People’s Choice. Circle the choice that best completes the sentence. An example is provided.

Example: (Bill Gates, Mark Zuckerberg) is the subject of The Social Network.

1. In the Keynesian model, the (SHORT-RUN, LONG RUN) aggregate supply curve is vertical.2. An economy’s (POTENTIAL OUTPUT, OUTPUT GAP) increases because of improvements in

technology.3. An economy’s (POTENTIAL OUTPUT, OUTPUT GAP) increases when there is a recession.4. An economy’s (POTENTIAL OUTPUT, OUTPUT GAP) increases when there is an increase in

the population.5. An economy’s (POTENTIAL OUTPUT, OUTPUT GAP) decreases when unemployment

decreases.

3.60 LISTING It’s not just for grocery shopping anymore. Write a list in response to the prompt below.

1. List the three factors that can affect an economy’s potential output in the Keynesian model.

a.

b.

c.

Y Y

Ashocktoaggregatesupplyraisesthepricelevelandcreatesanoutputgap.

Ashocktoaggregatedemandlowersthepricelevelandcreatesanoutputgap.

Price

Level

Price

Level

ASSR

AD

ASLRASSR

AD

ASLRASSR*

outputgap

AD*

outputgap


INFLATION & THE KEYNESIAN MODEL (III.F.7)

The Keynesian model assumes that people (both consumers and suppliers) anticipate some level of inflation all the time. Indeed, in your own life, you’ve probably noticed that prices have risen more often than they have fallen. That means that full employment equilibrium is possible at any expected level of inflation. For example, if something causes a short-run increase in aggregate demand, the price level will rise and there may be a temporary output gap. Eventually, AS will shift upward in response to the higher prices until real GDP equals potential output again. We get an output gap when a shock causes an unexpected change in the price level.

3.61 SHORT ANSWER Because brevity is the soul of wit. Write a brief response to each of the following prompts.

1. How did Keynes explain short-run fluctuations in economic activity?

2. In the Keynesian model, at what price level is full employment equilibrium possible?

3. In the Keynesian model, what are the two components of the output gap?

STABILIZING THE ECONOMY (III.F.8)

Some economists and politicians believe that when there are short-run fluctuations in economic prosperity, there should be some form of government intervention to mitigate the damage. This is not a universal view by any means. And among those who believe in government intervention, there is considerable debate about how to use the available policy tools to help ease the market back to equilibrium. For economists, the debate is not only about how to manage the crisis, but also whether to do anything at all. Some economists take the view that in the long run, government intervention can do more harm than good.

In this workbook, you’ve already learned about monetary policy, the set of tools the Federal Reserve uses to manage the money supply with the longer view toward influencing economic activity. By way of review, the monetary policy tools of the Fed are open market operations, changes in the discount rate, and changes in the reserve ratio. In the Keynesian view, you have also learned the argument that changes in the money supply have no effect on long-run output—although they can certainly shake things up in the short run. That seems to be the view of the authors of the current Decathlon curriculum44.

44 As well as the primary author of this workbook.


As an alternative to monetary policy, or in addition to it, we can also use fiscal policy to influence economic prosperity. Fiscal policy broadly refers to the actions of government entities (mainly federal and state) to encourage or discourage spending or investment. Government spending is a direct fiscal policy measure which can spur economic activity. For example, the American Recovery and Reinvestment Act of 2009 sanctioned billions of dollars of federal funding for various projects throughout the country, and those projects in turn created jobs for unemployed workers who then (presumably) were able to spend their new income and help businesses stay open45. Taxation is an indirect measure; by cutting taxes, the government can effectively leave consumers and businesses with more money to spend, which is thought to have the effect of stimulating aggregate demand (through an increase in consumption or investment, or both).

Those in favor of government intervention to curb short-run economic fluctuations typically argue that fluctuations in either direction have significant costs. People lose jobs in a recession. If the economy overheats, people lose money to price increases.

Those who oppose the use of fiscal policy to stabilize the economy tend to argue the following:1) Any intervention requires information, which takes time to collect. For example, we have to know how

much to increase consumer spending, which means we first have to know how far it has decreased. That kind of data is difficult to measure, and it takes months to be able to observe and quantify it.

2) Any policy action takes time to implement. There is always a risk that the economy could repair itself before the policy measure takes effect—which would mean the policy measure could actually makethings worse.

3.62 WORD BANKLike paint-by-number, but without the paint. Or the numbers, for that matter. The word bank below provides key terms relating to the Keynesian model and the views of different economists about short-run economic stabilization. Fill in each sentences with a term from the bank. You will not need to use every term.

WORD BANK

time fiscal policy debt benefits

costs taxation monetary policy regulation

1. Increased government spending is an example of ______________________________ to

stimulate aggregate demand.

2. Those who advocate using government intervention to manage short-run economic fluctuations

argue that there are substantial __________________________________ involved when output is

too low or when prices are too high.

3. Open market operations are an example of ___________________________ to manage short-run

fluctuations in economic activity.

45 For example, your beloved author spent a year working economics research that was funded (indirectly) by ARRA grants. Hooray for fiscal policy.


4. The problems with fiscal policy, according to its critics, have to do with

________________________________ -- both to collect information and to implement policy

measures.

5. One fiscal policy tool that can indirectly influence economic activity is

________________________________.


About the AuthorJessica Raasch has a last name that rhymes with “Gosh.” She has been writing for DemiDec off and on since 1999, after a chance run-in with DemiDec Dan himself during her senior year of high school. In those days, she was everything you’d expect from a winning Varsity—obsessive, under-slept, irrationally choosing to neglect her other studies in order to spend more time with her team—and nothing you’d expect from a future economist. Since then, it has been said that Jessica’s life has moved in parallel with that of Alan Greenspan. Like Ms Raasch, Mr. Greenspan began his college years as an aspiring clarinetist before dropping out of music school and enrolling in an economics program. Although Jessica has not yet stood before the Federal Reserve Board as its honorable Chairwoman, she has had the privilege of standing before a few fine teams of high school students as their guest economics coach—and she has treasured those opportunities.

After college, Jessica went to work for a large public accounting firm, doing work that involved a mix of finance, accounting, and economics. When the market tanked, one of her former professors recruited her to join his economics research institute. She spent the next year there, studying the economics of climate change policy, labor supply issues, and development agencies in Arizona. She was considering a PhD in economics, so that year was a good opportunity to gauge just how many tweed coats she would need to buy in order to fit in among her future colleagues. Jessica has since ruled out academia, at least for now, and has returned to the long, tweed-less hours of private enterprise. For the summer of 2010, Jessica was finance professional by day, economics writer by night. Most of this workbook was writtenlate at night from her 10th floor balcony, overlooking the city lights of downtown Phoenix.

About the EditorChris Yetman is said by some to be more legend than man. Standing at an impressive 6”2, his literal shadow is cast over us all, while the shadow of his accomplishments proves to be even more fearsome. The Yeti has taught AP Calculus for 20 years at Canyon Del Oro High School and keeps all of his secrets tucked away in a thick, hoary beard. The beard has swelled recently, seeing as it’s had to make room for 11 years of Academic Decathlon coaching knowledge. He is a notorious thief of self-esteem, with warrants out for his arrest in all 50 states (and The District of Columbia.) It is rumored that he once made Kanye West cry. He loves living in Tucson, Arizona, because the only things that rival his power are the large mountains that frame the city. Those who know him (including his wife, two sons, and gaggle of decathletes) say that he absolutely lives up to the hype. Those who don’t know him aren’t as sure, but all can agree on the fact that he will one day shut himself in a Las Vegas hotel, and in a Howard Hughes-esque style, grow his fingernails to match the length of his beard.


Answer KeyI. BASIC ASSUMPTIONS OF ECONOMICS

1.01 FILL-IN1. lunch 2. scarcity

3. scarce 4. air

5. opportunity cost

1.02 THINK FASTwe weigh the benefits of an alternative against the costs

1.03 APPLYING KEY CONCEPTS1. a few ounces of fries and soda 2. a few bucks 3. proximity to snow

1.04 THINK FASTthe incremental difference between option and another

1.05 LISTINGa) scarcity is everywhere b) nothing is free c) people are rational d) trade is good

1.06 EXAM PRACTICE1. You should have underlined “trade-off” and “opportunity cost.” The correct answer is a. 2. You should have underlined “opportunity cost” and “chose not to.” The correct answer is d.

1.07 FALSE1. One of the basic assumptions of economics is that trade is usually always beneficial for someone everyone involved. 2. When you give up one thing in order to have another, you make a trade trade-off. 3. The rationality assumption means that economists expect people to respond to incentives in unpredictable predictable ways. 4. If something is given away for free, it cannot can still be scarce. 5. People are forced to make economic decisions because they are irrational resources are scarce.

1.08 THIS OR THAT

Rational Irrational Explanation

(the itsy-bitsy spider) × The itsy-bitsy spider makes himself better off by going where he can find water when he’s thirsty.

(Jill) × Jill makes herself better off by removing herself from the situation that scares her.

Jack× Jack tries to make himself better-off by making Jill better-off

(removing the scary tree), presumably in the hopes that Jill will then fall for him and he will have more of what he values, too (more Jill).

(Jill’s mom) ×

Although Jill’s mom is making herself better off in the short run (getting more shoes), she’s making herself worse-off in the long run (failing to save for retirement). This behavior is irrational. You could argue that she likes shoes now more than she likes her future financial health (in which case, her choice would be rational). However, keep in mind that she is a financial planner, so we can assume she values her future financial stability more than the average shoe-shopper. Also, if you get into advanced economics, you will learn that what Jill’s mom is actually doing is called “hyperdiscounting” the future—which is a predictable but irrational behavior.

(Jack) ×

Jack is being irrational because he’s not using cost-benefit analysis. By improving his speech, he makes himself slightly better off (up to 50 points closer to winning). However, it will cost him more time to raise his speech score from 950 to1000 than it will to raise his Economics score from 650 to 700. (If he studied economics, he would know that


already!)

(Jill) ×

Jill is making herself worse-off in two ways: she’s depriving herself of the thing she values in the near-term (seeing the movie), and she’s damaging her team’s chances of winning at regionals by not helping her teammate prepare for Econ. Jill is letting her emotions get in the way of both victory and vampires. You could argue that she is being rational if she sees value in making her point to Jack. By proving her point (to her own detriment), she’d actually be making herself better-off. But that’s a bit of a stretch, particularly because it’s not clear whether Jack will actually see her point.

1.09 CATEGORIZATION1. N2. P

3. N4. P

5. P

1.10 EXAM PRACTICEYou should have underlined ought. You should have placed an asterisk by “*If the price increases, then the quantity demanded will increase.*” The correct answer is c.

1.11 THIS OR THAT1. Not2. Pareto-efficient

3. Not4. Pareto-efficient

5. Not6. Pareto-efficient

1.12 CATEGORIZATION1. macro 2. micro

3. micro 4. macro

5. micro

1.13 MATCHING1. j2. k3. f4. e

5. m6. c7. h8. a

9. i10. l11. g12. b

II. MICROECONOMICS

2.01 THINK FAST!1. All the buyers and sellers of a particular good or service.

2.02 LISTING1. large number of buyers2. large number of sellers3. very similar products4. buyers and sellers have access to pricing information

2.03 THIS OR THAT

Good or Service Perfectly Competitive Not Reason

DemiDec Economics Workbooks × There is only one seller.gasoline xcopper xDroidTM Incredibles x There is only one manufacturer (so ultimately, only one seller).bananas xsoftware x There are large differences between each product.Microsoft Office x There is only one manufacturer (ultimately, only one seller).cell phones x There are large differences between each product.cars x There are large differences between each product.notebook computers x There are large differences between each product.

2.04 FILL-IN 1. law of demand, decreases 2. increases 3. curve, point on the curve

2.05 GRAPHING


2.06 FILL-IN 1. quantity demanded 2. quantity demanded

3. demand 4. quantity demanded

5. quantity demanded 6. demand, quantity demanded

2.07 CATEGORIZATION1. answer: price drops

explanation: all affect demand, but a price change affects quantity demanded.2. answer: the price of a complementary good increases

explanation: all result in an increase in demand, but when the price of a complementary good increases, demand decreases.3. answer: change in price

explanation: a price change does not affect demand, but quantity demanded.4. answer: change in price

explanation: a price change does not affect demand, but quantity demanded.

2.08 UPS AND DOWNS 1. ↑ 2. ↓ 3. ↑ 4. ↓ 5. ↑ 6. ↓ 7. ↑ 8. ↓ 9. ↓ 10. no change

2.09 IN BRIEF 1. the quantities of a good or service that consumers are willing and able to buy at any given price. 2. the quantity of a good or service that consumers are willing to buy at a given price 3. the income effect, the substitution effect 4. the price of a good and the demand for its substitute are directly related; as the price of a good rises, the demand for a substitute rises. 5. the price of a good and the demand for its complement are inversely related; as the price of a good rises, the demand for its

complements will fall.

2.10 GRAPHING1. 2. 3.

4. 5. 6.

2.11 MATCHING1. f2. i3. e

4. j5. k6. g

7. b8. c9. a

10. h11. d

2.12 SENTENCE COMPLETION 1. supply, positively 2. falls

3. curve, point on a curve 4. right, positive

5. along

Demand Curve for Toasters

05101520253035404550

0 10 20 30 40 50 60

Quantity Demanded

Pric

e

Q

D1

P

0

D2 D1

Q

P

0

D2 D1

Q

P

0

D2

D1

Q

P

0

D2

D1

Q

P

0

D2Q

D1

P

0

D2


2.13 GRAPHING

2.14 IN BRIEF1. the quantities of a good or service that producers are willing and able to produce and make available for sale at each possible price 2. the quantity of a good or service that producers are willing and able to produce and make available for sale at a given price 3. positively

2.15 UPS AND DOWNS 1.↑ 2.↓ 3.↓ 4.↑ 5.↑ 6.↑ 7.↓ 8.↓ 9.↑ 10.↓

2.16 GRAPHING1. 2. 3.

2.17 SENTENCE COMPLETION1. demand, increase 2. demand 3. decrease, demand 4. increase, demand 5. Supply

2.18 GRAPHING1.

yes, increases, increases

2.

yes, increases, decreases

3.

yes, indeterminate, decreases

4.

yes, indeterminate, increases

2.19 CHARTINGChanges in Equilibrium no supply ↑ supply ↓ supplync demand no change

no changeP ↓Q↑

P ↑Q ↓

↑demand P ↑Q ↑

P ?Q ↑

P ↑Q ?

↓ demand P ↓Q ↓

P ↓Q ?

P ?Q ↓

2.20 THINK FASTThe market clears.

2.21 MATCHING1. g2. b3. j

4. d5. h6. a

7. c8. f9. e

10. i

2.22 GRAPHING

Supply Curve for Toasters

05101520253035404550

0 10 20 30 40 50 60

Quantity Supplied

Price

P

D S

Q

P

D S

Q

P

D S

Q

P

D S

Q

Q 0

S1

P

S2

Q

S2

P

0

S1

Q

S2

P

0

S1


2.22 SENTENCE COMPLETION 1. elastic 2. inelastic 3. unit elastic

4. responsiveness 5. cause, effect 6. how responsive x is to incremental changes in y

2.23 APPLYING KEY CONCEPTS 1. a. 10 b. 55 c. 5 d. 12.5 e. 45.5% 2. a. -20 b. 90 c. 2 d. 29 e. 322%

2.24 CATEGORIZATION 1. e 2. u 3. i

4. i 5. i 6. e

7. e 8. i 9. e

10. e

2.25 WORD BANK1. unit elastic 2. elastic 3. inelastic, inferior 4. inelastic

5. unit elastic, normal 6. substitutes 7. independent 8. complements

9. substitutes 10. inferior 11. normal 12. elastic

13. inelastic

2.26 IN BRIEF1. the two goods are substitutes 2. the two goods are complements 3. the two goods are independent 4. how responsive X is to incremental changes in Y 5. how responsive demand is to incremental changes in consumer income 6. how responsive quantity demanded is to incremental changes in price 7. luxury goods 8. inferior goods

2.27 UPS AND DOWNS 1. 2. 3. 4. 5. 6. 7. 8.

2.28 LISTING (in no particular order) 1. the availability of substitutes, the price of a good as a proportion of consumer income, time horizon, the presence of consumer necessity, and the relevant market definition 2. the ease of entry and exit for sellers, the scarcity of inputs, time

2.29 SENTENCE COMPLETION 1. price-elastic 2. price-inelastic, price-elastic 3. less

4. price-elastic 5. Less

2.30 THINK FAST! When there is a change in market equilibrium, the side of the market that has the greater price elasticity will have a smaller change in surplus. Alternatively, When there is a change in market equilibrium, the side of the market that is more price-inelastic will suffer a greater loss of surplus.

2.31 GRAPHING


consumersurplus

producersurplus

D

P

exchange price

exchange quantity Q

S


A decrease in resource costsWhich surplus is most affected by the change?

consumer surplus

A number of buyers are expecting to get raises within the monthWhich surplus is most affected by the change?

producer surplus

Suppliers are expecting input prices to riseWhich surplus is most affected by the change?

consumer surplus

Someone discovers a better way of making a productWhich surplus is most affected by the change?

producer surplus

The price of a complementary good increasesWhich surplus is most affected by the change?

consumer surplus

2.31 GRAPHING Term DefinitionExample: “Journey” 1. a distance to be traveled 2. the theme of New Directions’ performance at Regionalselasticity a measure of the responsiveness of one variable to a change in anotherprice-elasticity of demand a measure of the responsiveness of quantity demanded to a change in priceprice-elasticity of supply a measure of the responsiveness of quantity supplied to a change in priceincome-elasticity of demand a measure of the responsiveness of quantity demanded to a change in consumer income

cross-price elasticity of demand a measure of the responsiveness of the quantity demanded of one good to a change in the price of another good

normal good a good for which quantity demanded increases in response to an increase in consumer income; a good for which YED is positive

inferior good a good for which quantity demanded decreases in response to an increase in consumer income; a good for which YED is negative

complement a good for which quantity demanded increases in response to a decrease in the price of another good (or vice versa); a good for which the cross-price elasticity of demand is negative

substitute a good for which quantity demanded decreases in response to a decrease in the price of another good (or vice versa); a good for which the cross-price elasticity of demand is positive

2.32 THINK FAST!Total revenue is highest at the point where price-elasticity of demand is exactly equal to 1.

2.33 TRUE/FALSE 1. F—If demand is a straight, downward-sloping straight line, price-elasticity changes constantly along the curve.2. T3. F - If the price-elasticity of demand is exactly equal to 1, any change in price will decrease total revenue.4. F - If the price-elasticity of demand is 0, an increase in price will not affect total revenue.5. F - Total revenue is equal to price times quantity exchanged.6. T7. T8. F - If consumers have several close substitutes from which to choose, a decrease in price will increase total revenue.9. F - An increase in the price of a life-saving medication is likely to increase total revenue.

D1

P

Q

S1 S2

D1

P

Q

S1

D2

D1

P

Q

S1S2

D1

P

Q

S1 S2

D1

P

Q

S1

D2


10. F- As you move along the demand curve from left to right, total revenue tends to increase and then decrease.

2.34 THINK FAST!1. A price control is a form of government intervention in which a legal maximum price or minimum price is established.

2.35 APPLYING KEY CONCEPTS:1. price floor, surplus, q4—q2 2. price ceiling, shortage, q5—q1 3. price floor, p3

2.36 SENTENCE COMPLETION 1. minimum, above 2. maximum, below

3. surplus 4. shortage

2.37 GRAPHING EVENT & RESPONSE GRAPHA tax of $0.10 per minuteWhich side of the market bears the greater tax burden?

buyers

Market for Cell Phone Minutes

A tax on hospital bedsWhich side of the market bears the greater tax burden?

sellers

Market for Hospital Beds

A tax on text messages to American IdolWhich side of the market bears the greater tax burden?

buyers

Market for Text Messages to American Idol

2.38 TRUE/FALSE1. F—When a tax is imposed, the market price of a good will increase by less than the amount of the tax.2. T3. F—A tax usually has the effect of reducing the exchange quantity.4. T5. F—Price-elasticity can be used to predict which side of the market will bear the greater tax burden.

2.39 APPLYING KEY CONCEPTS 1. 5 units of milk2. 75 units of clothing3. 10 units of toothbrushes

4. 20 units of grain5. 2 units of food

2.40 IN BRIEF 1. Mexico. 2. Decalon 3. Spain 4. Peru (If the relative price of a pound of beef is 30 potatoes, then the relative price of a potato is 1/30 lb. of beef in Peru. In Spain,

the relative price of a potato is 1/3 pound of beef. )

2.41 APPLYING KEY CONCEPTS 1. a) 3 pieces of clothing b) 3/5 pieces of clothing c) 1/3 car

d) 5/3 cars e) Germany f) Germany

g) U.S. h. U.S.

D1

P

Q

S1

S2

S2

D1

P

Q

S1

S2

D1

P

Q

S1

S2


2. a) 5 pounds of fish b) ½ pound of fish c) 1/5 pound of cheese

d) 2 pounds of cheese e) France f) France

g) Japan h) Japan

2.42 IN BRIEF 1. absolute advantage 2. country A should specialize in the good in which it has a comparative advantage. 3. Although the country has an absolute advantage, if its relative price of either good is different from the relative prices in another

country, then both countries stand to benefit from trade.

2.43 CASE STUDY1. 502. 253. 600

4. 3005. yes

2.44 THINK FAST!The most important goal of a firm is to maximize profit.

2.45 DEFINITIONS

Term Definition

opportunity cost for a firm, the value of the next-best opportunity to produce and sell something else; generally, the value of the next-best alternative

accounting profit the difference between total revenues and total costs

economic profit equal to the difference between total revenues and total costs, minus any opportunity costs.

2.46 CATEGORIZATION 1. f2. f3. v

4. f5. f6. f

7. f8. v9. v

10. f

2.47 MATCHING 1. c2. f3. a

4. j5. g6. h

7. e8. b9. d

2.48 IN BRIEF 1. a large number of each 2. there are no barriers to entry or exit 3. demand is perfectly price elastic 4. the product is homogenous 5. everyone has free and equal access to information about everything 6. The seller is a price taker. The seller must sell at the market price.

2.49 MATCHING 1. l2. a3. j

4. b5. c6. g

7. f8. d9. i

10. h11. k12. e

2.50 IN BRIEF 1. there is only one seller, but a large number of buyers 2. technically, a new seller can’t enter, because the market would no longer be a monopoly 3. a firm can set its price however high or low it chooses, in the interest of maximizing profit; there is no competition and so there are

no available substitutes 4. a monopoly firm aims to keep the market to itself, to maintain the monopoly 5. X-inefficiency, welfare loss due to monopoly, contrived scarcity

2.51 THINK FASTA monopolist will produce at the point where marginal revenue equals marginal cost.

2.52 FILL IN THE BLANK1. profit2. marginal revenue3. price

4. quantity exchanged5. perfect competition6. producer surplus

7. consumer surplus8. welfare los


2.53 THINK FASTThe Sherman Act was the first piece of federal legislation that addressed monopolies. The Act made it a crime to engage in anti-competitive behavior.

2.54 LISTING1. legislation, such as the Sherman Act 2. judicial action, led by the Anti-trust division 3. regulation

2.55 IN BRIEF1. typically, only a few sellers but a large number of buyers 2. very difficult; the barrier to entry are very high 3. the products are homogenous or only slightly differentiated 4. each seller has to sell at the price at which other sellers are selling; there is little price movement in an oligopoly 5. to try to maintain the oligopoly 6. collusion; pressuring legislators to regulate firms in the industry such that regulations are too difficult for a new entrant to satisfy

2.56 IN BRIEF 1. a large number of each 2. fairly easy; there are few barriers to entry or exit 3. the products are very similar, but each seller tries to capture market power by differentiating his product 4. branding and advertising

2.57 CATEGORIZATION 1. MC2. PC3. MC4. PC

5. MC6. PC & MC7. MC8. PC

9. PC & MC10. PC11. MC12. PC

13. PC14. MC15. PC

2.58 CATEGORIZATION1. 1.mc 2. 2.pc 3. 3.o 4. 4.mc

5. 5.pc 6. 6.o 7. 7.mc 8. 8.o

9. 9.m 10. 10.pc 11. 11.mc 12. 12.m

13. 13.mc 14. 14.mc 15. 15.o

2.59 APPLYING KEY CONCEPTS

2.60 TRUE/FALSE1. F—Joseph Schumpeter was an economist who coined the term creative destruction.2. F - When Schumpeter spoke of destruction, he was referring to existing products or services that were “destroyed” by innovation.3. T4. T

2.61 MATCHING1. c2. a3. f

4. b5. i6. j

7. g8. h9. e

10. d

2.62 THINK FASTThe Coase Theorem holds that as long as private property rights are clearly defined and transaction costs are low, people (or firms) can negotiate to manage externalities and eventually reach a more efficient social outcome.

2.62 LISTING1. excludability, rivalry of consumption 2. common resources, public goods, private goods, collective goods

2.63 THIS OR THAT1. NOT2. EXCLUDABLE

3. NOT4. NOT

5. EXCLUDABLE6. EXCLUDABLE

Individual firm isleast powerful

Individual firm is most powerful


2.64 THAT OR THIS1. RIVAL2. NOT

3. RIVAL4. NOT

5. NOT6. NOT

III. MACROECONOMICS

3.01 SHORT ANSWER1. gross domestic product2. the total value of all final goods and services produced within an economy over a specified period of time3. how much the average person in an economy consumes4. how much the average worker produces

3.02 FILL IN THE BLANK1. 19992. 53. 324. 43,000

5. 46. 87. 258, 18. 46,000

9. 1410. 154

3.03 RANKING

1. 2, 3, 1, 42. 4, 3, 2, 5, 13. 3, 4, 2, 5, 14. 2, 1, 5, 3, 4

3.04 LISTING

1. Japan, Germany, France, United Kingdom, U.S. and South Korea (tied for fifth)2. U.S., Germany, France, United Kingdom, Japan, South Korea, Russia3. South Korea, Japan, U.S., U.K., Germany, France4. U.S., France, Germany, U.K., Japan

3.05 DIAGRAMMING

3.06 TRUE OR FALSE1. 1. F—A recession is a sustained decrease in business activity, lasting at least two consecutive quarters.2. T3. 3. F—By definition, economic growth is a sustained increase in an economy’s capacity to produce.4. T5. T

3.07 SHORT ANSWER1. The market value of a final good is simply its price.2. If intermediate goods were included, they’d be double-counted (since they are also included when we count final goods).3. We don’t include the output of Americans living abroad because GDP is a measure of domestic product—what’s produced in the U.S.4. Capital goods are included in the year in which they are produced—even though they contribute to the production of many other

goods and services for much longer than one year.

3.08 MATCHING—REVIEW 1. c2. k3. a

4. f5. h6. e

7. g8. i9. d

10. b11. j

3.09 EXCLUSIONSYou should have crossed out the following:1. lumber2. Ford bumpers

peakexpansion

downturn recession

upturn

trough

Time

GDP


3. Toyotas4. grapevines planted in 2009 (for winemaking)5. an old apartment building6. Pollution in the U.S. resulting from driving Japanese cars, pollution in Japan resulting from producing Japanese cars, Japanese cars7. Pollution in the U.S. resulting from driving Japanese cars, pollution in Japan resulting from producing Japanese cars, American cars8. prescription drugs manufactured in the U.S. and legally obtained in Canada9. power used to run a factory10. water used by Dole to make fruit juice, water on a waterslide at a water park, a rain puddle

3.10 LISTING1. It is difficult to measure.2. It excludes goods and services that are not bought and sold in markets.3. It ignores harmful externalities.

3.11 EITHER OR1. are not2. are not3. consumes4. produces

5. GDP per capita6. high7. high8. excluded from

9. it has potential to double-count10. excluded from

3.12 CATEGORIZATION1. Neither2. X3. I4. G

5. Neither6. C7. I8. Neither

9. I10. X

3.13 LISTING1. consumption, investment, government, net exports2. consumer durables, consumer non-durables, services3. residential fixed investment, business fixed investment, inventories4. exports, imports

3.14 THINK FAST!Y = C + I + G + X

3.15 MATCHING1. h2. b3. i

4. g5. e6. g

7. f8. a9. c

10. d

3.16 SHORT ANSWER1. an increase in the price level (or a sustained increase, lasting at least two consecutive quarters)2. the aggregate of the prices of all goods and services in an economy

3.17 APPLYING KEY CONCEPTS1. 60% 2. 177%

3.18 MATCHING1. k2. m3. o4. l5. j

6. q7. g8. h9. n10. b

11. i12. e13. c14. p15. d

16. a17. f

3.20 CHARTING

3.21 FILL-IN1. consumption, net exports, expenditures 2. depreciation, indirect taxes

Net Exports5%

Government15%

Investment15%

Consumption65%


3. GDP 4. externalities, non-market activities

3.22 EXCLUSIONS1. answer: rent

explanation: All are used to calculate GDP with the expenditures approach. Rent is not.2. answer: indirect taxes

explanation: In the income approach to GDP calculation, indirect taxes are subtracted to arrive at the total. The others are added.3. answer: government spending

explanation: The group consists of problems with GDP measurement. Government spending, if reported correctly, is not difficult to measure.

4. answer: quality changesexplanation: I, C, & N are part of the expenditures approach to GDP calculation. The measurement of quality changes is a problem with the accuracy of GDP measurement.

5. answer: Yexplanation: In the equation for GDP from the expenditures approach, C, G, and X are added to arrive at GDP. Y is excluded because it is GDP in that equation.

6. answer: externalitiesexplanation: Value added, income, and expenditures are three different approaches to calculating GDP. A problem with GDP measurement is that it does not include the value of externalities.

7. answer: subsidiesexplanation: The group consists of problems with GDP measurement. Subsidies are easily measured, but they must be subtracted from the income approach equation.

8. answer: final goodsexplanation: The group consists of things that are not included in GDP. Final goods are certainly included in GDP.

3.23 CATEGORIZATION1. in2. out

3. out4. in

5. out

3.24 MORE CATEGORIZATION1. b2. c

3. a4. c

5. b6. c

3.25 NUMBER CRUNCH1. unemployed, employed 2. #unemployed, # in labor force 3. # Females in the labor force, # females

3.26 APPLYING KEY CONCEPTS1.

a. 30,000 + 20,000 + 5,000 + 5,000 = 60,000 b. 30,000 + 20,000 = 50,000 c. 5,000 + 5,000 = 10,000d. 10,000 / 60,000) x 100% = 16.7% e. (50,000 / 60,000) x 100% = 83.3% OR 100% - 16.7% = 83.3%f. [(20,000 + 5,000) / 60,000 ] x 100% = 33.3%

2. g. 10,000 + 18,000 + 1,500 + 500 = 30,000h. 10,000 + 18,000 = 28,000i. 1,500 + 500 = 2,000j. (2,000 / 30,000) = 6.7%k. (28,000 / 30,000) x 100% = 93.3%l. [(10,000 + 1,500) / 30,000] x 100% = 38.3%

3.27 CATEGORIZATION1. structural 2. frictional 3. cyclical 4. cyclical 5. structural 6. seasonal

3.28 DIAGRAMMING

3.29 SHORT ANSWERS1. household sector2. business sector3. household sector

4. government sector5. counterclockwise 6. business sector

7. supply creates its own demand

GOVERNMENT(sector)

HOUSEHOLDS(sector)

BUSINESS(sector)

FACTOR MARKET(market)

PRODUCT MARKET(market)


3.30 LISTINGphysical capital, human capital, natural resources, technology, the regulatory and political climate

3.31 THIS OR THAT1. increase2. have no effect on

3. decrease4. increase

5. average labor productivity

3.32 SHORT ANSWERS1. Waiting until the future to consume some portion of current income.2. Spending money to purchase or build new physical capital.3. By definition, money that is not consumed is saved. The two are inversely related.

3.33 THINK FAST!debt and equity financing

3.34 TRUE OR FALSE1. F –Financial markets include the markets for stocks, bonds, futures, options, and foreign currencies.2. T3. F - The three major stock exchanges in the U.S. are the NASDAQ, the NYSE, and the AMEX.4. F - If a bond has a high interest rate, the issuing company is a high default risk.5. F - Debt investors tend to require lower rates of return than equity investors.6. F - In a stock exchange, a equity holders can buy and sell new shares of its equity stock in public companies.7. T8. F—Stock represents a share of ownership in a company.9. F—Companies make periodic interest payments to lenders (or bondholders).10. F—If a company is sold, its equity investors keep all of the proceeds from the sale after all debts are repaid.

3.35 FILL IN1. primary2. depository institutions3. principal4. secondary5. insurance

6. mutual fund7. contractual savings institutions8. financial intermediaries9. bond10. maturity

3.36 SHORT ANSWER1. Inflation can decrease the value of outstanding loan balances.2. The nominal interest rate is the stated rate for a loan; the real interest rate is the nominal rate adjusted for inflation.


3.37 SENTENCE COMPLETION1. annual2. real

3. prime4. decrease

5. The Wall Street Journal

3.38 WORD BANK1. save 2. borrow3. investment

4. savings 5. demanded6. supplied

7. real

3.39 SHORT ANSWER1. S = I in a closed economy.2. Net capital outflow represents the difference between domestic investment in foreign assets and foreign investment in domestic assets.3. The two primary forms of international capital flow are foreign direct investment (FDI) and portfolio investment.4. S = I + NCO5. Foreign direct investment is done with the investor having the intent of being actively involved in the management of the foreign

asset. In portfolio investment, the investor owns only a fractional share of the asset and is not actively involved in its management.

3.40 TRUE OR FALSE1. F—Silver is an example of commodity money.2. F—Fiat money has no intrinsic value.3. T

4. F—Good money must be durable, scarce, and easy to transport.

5. T

3.41 CATEGORIZATION1. unit of account 2. store of value 3. unit of account

3.42 FILL-IN1. ease of transport 2. scarcity

3. durability 4. durable

5. easier to transport 6. durable, scarce

3.43 CHARTING

3.44 DIAGRAMMING

3.45 CATEGORIZATION1. answer: overnight Eurodollars

explanation: All are components of M1, except overnight Eurodollars.2. answer: measure of wealth

explanation: The other three are the functions of money.3. answer: accountability

explanation: The others are the essential physical properties of money.4. answer: government securities

explanation: All are components of M3. Government securities are exclusively a component of L.5. answer: includes long-term repurchase agreements

explanation: The others are all true of M2. While it is true that M3 “includes long-term repurchase agreements,” that is not true of M2.

6. answer: most liquid money aggregateexplanation: The others may all be said of L. L is “the least liquid money aggregate,” not the most liquid.

3.46 MATCHING

Other Forms of Money

5%

Paper Currency &

Coins25%

Demand Deposits

70%

large-denomination CDsEurodollars

savings deposits long-term repurchase agreementspaper currency and coins money market depositstraveler's checks money market mutual funds institutional money marketdemand deposits small-denomination CDs mutual fund shares

overnight repurchase agreementsovernight Eurodollars

M1M2

M3


1. l2. d3. h

4. a5. j6. b

7. g8. f9. c

10. e11. i12. k

3.47 LISTING1. trading, borrowing, saving, investing, comparing the relative value of goods and services 2. medium of exchange, store of value, unit of account 3. durability, portability, scarcity, divisibility 4. paper currency, coins, demand deposits, traveler’s checks 4. savings deposits, money market deposit accounts, money market mutual fund shares, small-denomination CDs, overnight repurchase

agreements, overnight Eurodollars 5. large-denomination CDs, long-term repurchase agreements, Eurodollars, institutional money market mutual fund shares

3.48 FILL-IN1. seven2. 253. 12

4. four, 145. 126. one

7. four8. 129. 12

10. five

3.49 DIAGRAMMING

3.50 APPLYING KEY CONCEPTS1. 102. 53. 3

4. 45. 26. 10%

7. 33 1/3 %8. 20%9. $4000

10. $3000

3.51 SHORT ANSWER1. any action to manipulate the money supply in order to influence the health of the economy 2. open market operations, raising or lowering the discount rate, raising or lowering the reserve ratio 3. the buying and selling of government securities 4. the interest rate the Federal Reserve charges when it lends money to banks 5. open market operations

3.52 UPS AND DOWNS1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

3.53 THINK FAST!A sudden rush of demand for deposits from a bank.

3.54 TRUE OR FALSE1. F—In the market for money, demand is driven by people’s desire for liquidity.2. F—Liquidity refers to the ease with which an asset can be converted into cash.3. T4. F—An increase in the money supply has no long-run effect on real GDP.5. F—The velocity of money is the number of times, on average, that it changes hands within an economy over a period of time.6. F—In a graph of the market for money, the vertical axis represents the value of money.7. F—When the money supply increases, money becomes less valuable.8. T9. F—When the money supply increases, the price level rises.10. F—In the U.S., the Federal Reserve has a few monetary policy tools that it can use to influence the money supply.

3.55 SHORT ANSWER

Federal Open Federal Market AdvisoryCommittee Council

BoardofGovernors

Member Banks

THEFED

25 Federal Banks

12 District Banks


1. velocity of money = nominal GDP / money supply2. M x V = P x Y3. The money supply is not one of the determinants of economic output.

3.56 LISTING1. technology, human and physical capital, natural resources, and the regulatory/political climate2. it reduces the value of money; distorts pricing; creates uncertainty about future pricing

3.57 APPLYING KEY CONCEPTS

1. 2.

3.58 UPS AND DOWNS1. 2. 3. 4. 5. 6. 7. 8.

3.59 EITHER OR1. long-run2. potential output

3. output gap4. potential output

5. output gap

3.60 LISTING1. investment in technology, increases in the population, increases in the capital stock

3.61 SHORT ANSWER1. Any short-run variation in economic activity was the result of a change in the output gap.2. At any expected price level.3. potential output and actual output

3.62 WORD BANK1. fiscal policy2. costs

3. monetary policy4. time

5. taxation

SSEECCTTIIOONN IIVV ((TTHHEE GGRREEAATT DDEEPPRREESSSSIIOONN))

4.01 CHARTING

EconomicIndicators

Real GDP Fell by 27% during the downturn and did not regain 1929 levels until 1939

Employment rates Fell rapidly. Approximately one quarter of the population was unemployed in 1933, and unemployment remained above 9% until 1941

Effects of Depression

In the United States The role of government changed, and political alignments changed with it

Worldwide The depression’s political effects led toward World War II, especially by paving the way for Hitler in Germany

Outcomes on Economic Thinking

Keynesianism Developed when economists tried to explain the Great DepressionAccounting techniques

National income accounting, used for calculating GDP, might not have been developed if the Great Depression had not made it clear that they were necessary

Fiscal and monetary policy

Are informed by historical analysis of the Great Depression, particularly during financial crises

4.02 LISTING1.

a) 20% of American households had flush toilets in 1920; 50% had toilets in 1929. b) 1% of American households had central heating in 1920; 50% had heat in 1929.c) 20% of American households had electric lights in 1920; 68% had electricity in 1929.d) Less than 1% of American households had radios in 1920; 40% had radios in 1929.e) 26% of American households had cars in 1920; 60% had cars in 1929.

2. a) Electric power made it possible to buy and use many appliances.b) By increasing manufacturing efficiency, electricity kept prices low.

Real GDP

Pric

e Le

vel

AD AS

Real GDP

Pric

e Le

vel

AD AS


3. a) Construction costs went down.b) Factory layout became more flexible.c) Conditions for workers improved.d) Production became more efficient.

4. a) Building boomed as car owners moved to the suburbs. b) Businesspeople built shopping centers to cater to car owners.c) Businesspeople created new industries such as gas stations, car garages, and motels.

5. a) While prices were high, overoptimistic farmers borrowed money to make investments they could not pay off later.b) European, Australian, and Argentinean productivity drove prices down in the United States.

4.03 CAUSE & EFFECT

World War I caused destruction of assets across Europe. European countries did not experience steady growth in the 1920s.

The German central bank monetized fiscal deficits, increasing the supply of money. Hyperinflation crippled Germany’s economy.

The German government could not bring expenditures and revenues into balance. Hyperinflation crippled Germany’s economy.

The Dawes Plan pumped foreign capital into Germany in order to counterbalance the outflow of reparations payment.

In 1924, the German economy entered a period of expansion.

In England, major industries went into decline while the Bank of England maintained high interest rates.

England’s economy stagnated, and unemployment stayed steadily high.

4.04 EITHER OR1. 19132. BANKS3. FIRST WORLD WAR4. BONDS

5. 19236. BENJAMIN STRONG7. CUTS8. SURPLUS, CONTRACTION

9. EXPANDED10. ANNA SCHWARTZ11. VALUE OF THE DOLLAR12. STABLE

4.05 DATINGearly September 1929 The stock market hits its peak September 1929 FOMC votes to increase the money supply by purchasing $25 million in bonds per weekOctober 15, 1929 Economist Irving Fisher theorizes publicly that the stock market has reached “a permanently high plateau”October 23, 1929 Irving Fisher states that the stock market has hit its lowest pointOctober 24, 1929 The stock market crashes, and 13 million shares are traded November 1929 Stock prices recover slightlyDecember 1929 Stock prices settle around 34% below their peakJune 1930 Economic weakening prompts the passage of the Smoot-Hawley Tariff, which harms international trade

4.06 FILL IN THE BLANKAugust, crisis, economists, stable, October, consumers, margin, profits, debt, excess, moral, recovery

4.07 SMART ARTChain of Bank Panic

Panic Hits International Finance

Consumers begin to worry that their bank is struggling

�ey rush to the bank to withdraw their

savings

Banks sell offassets to meet

customer demands

�e asset prices fall, and the banks fail under the pressure

Austria's largest bank, Kreditanstalt, fails

Austria's economy struggles so much that the Austrian government abandons the

gold standard

Lenders withdraw loans from other countries with shaky

economies


The Federal Reserve Responds and Creates More Panic

4.08 FALSE1. disaster deposit2. Washington New York3. in from4. deposit insurance the gold standard5. Four Two6. France Britain

7. foreign currency gold8. Herbert Hoover Franklin Roosevelt9. placed the dollar on removed the dollar from10. Agricultural Banking11. 25% 10%12. 1945 1941

4.09 COMPARISON1—D; 2—T; 3—T&D; 4—D; 5—T; 6—D; 7—D; 8—T&D; 9—T; 10—D

4.10 COMPOUND DEFINITIONS1. nominal Not adjusted for inflationa) nominal GDP: Gross Domestic Product measured according to the current value of the dollarb) nominal interest rates: Stated interest rates that do not account for expected inflation2. potential Possiblea) potential output: The highest level of production (output) an economy can possibly produce over time

3. aggregate The sum of several elements, considered togethera) aggregate demand: The sum of goods and services an economy produces at a certain price levelb) aggregate supply: The sum of an economy’s demand for goods and services at a certain price level4. currency Coins and paper money in public usea) currency holdings: The coins and paper money that the public keeps, without spending or depositing itb) national currency: The coins and paper money in use in a certain country

4.11 MULTIPLE CHOICE1—e; 2—a; 3—c; 4—d

4.12 MATCHING1—c; 2—e; 3—h; 4—j; 5—i; 6—d; 7—b; 8—g; 9—a; 10—f

4.13 ANSWERSThe Failures of the Federal Reserve Money Supply

Answer: The Federal Reserve’s failure to act as a lender of last resort for failing banks undermined this.

Answer: In 1928, the Federal Reserve deliberately reduced the money supply because they wanted to inhibit this.

Question: What is consumer confidence? Question: What is speculation in the stock market?Answer: A final source of loanable funds in an emergency; the Fed failed to serve this role as the Great Depression approached.

Answer: When they stopped trusting banks, consumers began increasing these.

Question: What is the lender of last resort? Question: What are their currency holdings?

4.14 IN BRIEF1. Milton Friedman and Anna Schwartz claimed Great Depression was caused by a drastic reduction in the money supply. They attribute

the responsibility for this to the Fed, which could have acted as a lender of last resort to pump money into the banking system.2. Between January 1928 and September 1929, the Fed raised the discount rate from 3.5% to 6% in order to curb excesses in the stock

market. This seems to have had little effect on the stock market, and it probably accounted for a drop in consumer buying and business investment. These spending declines led to a decline in production.

3. Friedman and Schwartz think the Fed should have stepped in to lend money to failing banks, which would have allowed consumers to feel confidence in the banking system. Instead, the Fed stood by while banks failed. Consumers lost confidence and withdrew or held onto their money rather than depositing it into banks.

4. When Benjamin Strong died, leadership of the Federal Reserve reverted to a 12-member panel of Federal Reserve Bank governors. In the absence of a single decisive leader in the midst of crisis, the Fed reverted to inaction.

�e Fed raises the discount rate

Tighter crecit cuts borrowing and spending

Industrial production declines


4.15 THIS OR THATFriedman/Schwartz Critics

The decline in the money supply during the depression resulted from a decrease in demand ×The decline in the money supply during the depression resulted from a decrease in supply ×Interest rates fell until September 1931 ×Real interest rates were higher than they appeared due to inflation ×Bank panics were a sign of the free market’s adjustment to changes in demand ×Canada experienced few bank failures ×The Federal Reserve’s inaction caused the Great Depression ×Benjamin Strong could have averted much of the crisis ×4.16 FINISH THE SENTENCE1. the gold standard2. exchange rate3. local currency

4. capital flows5. reducing the money supply6. foreign lending

7. foreign buyers8. deflation

4.17 CHARTING

Difficulties Returning to the Gold Standard?

Why or Why Not?

Britain YESNo

Britain experienced high inflation during the war, so returning to the gold standard required them to keep interest rates high. This sparked a recession and bumped up unemployment. Even so, Britain only managed to return to the gold standard in 1925.

France YESNo

France could not return to the gold standard at its previous exchange rate, so the country set a new, lower exchange rate. Many economists believe the French set the rates too low. The 1920s brought France trade surpluses and an inflow of gold.

Germany YESNo

Like France, Germany set new, lower exchange rates. Even then, Germany’s reparations obligations created a situation in which Germany had to run a trade surplus or borrow from other countries.

4.18 CAUSE & EFFECTCause Effect

The United States raised interest rates in an attempt to reduce speculation in the stock market.

Capital flows into major European economies declined.

Austria, Germany, and England abandoned the gold standard and adopted floating exchange rates.

The Federal Reserve tightened monetary policy to prevent the gold reserves of the United States from dwindling.

Tight monetary policy brought deflation in the United States. Consumers waited for prices to fall before they spent money.Prices fell in an atmosphere of sluggish spending. Consumer expectations of deflation were reinforced further.Franklin D. Roosevelt expanded the money supply, introduced spending programs, and allowed the value of the dollar to drop.

The economy began to recover.

4.19 COMPARISON1—I; 2—I; 3—M&I; 4—M&I; 5—M&I; 6—M; 7—I; 8—M&I; 9—M

4.20 LABELING1. Attempted to raise prices and wages by limiting extreme competition National Industrial Recovery Act2. Established a federal minimum wage and prohibited child labor Fair Labor Standards Act3. Channeled $500 million in federal money into state and local relief programs Federal Emergency Relief Agency4. Limited cultivated acreage and guaranteed minimum agricultural prices Agricultural Adjustment Act5. Organized industries to draw up voluntary codes which allowed them to set minimum prices, limit output, and establish basic worker protections

National Recovery Administration (the administrative portion of NIRA)

6. Effectively guaranteed the right of collective bargaining National Labor Relations Act7. Established in 1935 for the purpose of creating jobs directly with federal money Works Progress Administration8. Attempted to relieve the hardships of farmers and agricultural workers Agricultural Adjustment Act

4.21 SHORT ANSWERKey points: Some aspects of the New Deal were counterproductive. The NIRA and the AAA restricted output rather than increasing demand. Although this raises prices, it also stunts production; the NIRA and AAA likely slowed recovery rather than stimulating it. Similarly, collecting taxes to fund Social Security removed money from the economy for years before anyone received benefits.

4.22 EITHER OR


1. DEMAND2. INCOMPLETE3. OPPONENTS4. PROPONENTS

5. WORSENED DEPRESSION6. CONSERVATIVE7. SURPLUS8. 1937

9. LOW10. CONTRACTIONARY

4.23 FILL IN THE BLANK1. big government2. expenditures3. consumption

4. rose, fell5. local, federal6. functions

7. power8. free markets9. labor

4.24 TRUE OR FALSE1. True2. False—There are many consensus points between the

monetarist and internationalist perspectives.3. False— It is possible that better policy could have prevented

the initial recession and also stopped it from turning it into the Great Depression.

4. True

5. True6. False—The past can only illuminate today’s problems only

partially.7. False—New innovations in the economy affect its workings

unpredictably.8. True9. True

4.25 DEFINITIONS

Term Definition

1. GDP The sum value of goods and services produced within a given country’s economy within a certain time.2. contraction A decrease in economic activity3. monetary policy The Federal Reserve’s policies for changing the money supply to influence overall demand 4. fiscal policy The use of taxes and government spending to influence overall demand

5. discount rate The rate of interest the Federal Reserve charges its member banks when they need to borrow from it

6. money supply The full amount of money in an economy

7. monetary base The amount of money plus bank reserves in an economy

8. stabilization policy A policy designed to stabilize an economy

9. full-employment budget deficit A hypothetical measure of the deficit or surplus a country would have at full employment

4.26 GROUPINGTerms Explanation

increased manufacturing efficiencynew assembly linesexpanded land cultivationsuburban building boom

Assembly lines, manufacturing efficiency, and the suburban building boom all contributed to prosperity in the 1920s. The expansion of land cultivation, in contrast, left farmers saddled with debt as agricultural prices declined.

Open Market Investment CommitteeFair Labor Standards ActFederal Emergency Relief AgencyWorks Progress Administration

The Open Market Investment Committee led the Federal Reserve during the 1920s. FERA, the WPA, and the FLSA are all New Deal Programs.

BritainAustriaGermanySweden

Britain, Austria, and Germany were all forced to abandon the gold standard in 1934. Sweden was not as strongly affected by the financial troubles around the world.

raising wagesstimulating demandrestricting productionproviding jobs

New Deal policies were designed to raise wages, restricted production, and provided jobs. They were inconsistent at stimulating demand, and many economists now believe the New Deal slowed recovery.

education policyold age insurancelabor marketsagricultural production

The New Deal created a system in which the federal government was responsible for regulating old age insurance, labor markets, and agricultural production. Education policy remained in the hands of the states.

1929194119371931

Economic downturns marked 1929, 1931, and 1937. In 1941, the business opportunities provided by World War II helped the economy back on track toward full employment.

4.27 LABELING1. Co-authored A Monetary History of the United States Milton Friedman & Anna Schwartz2. Claimed in October 1929 that the stock market was on “a permanently high plateau” Irving Fisher


3. Led the Open Market Investment Committee Benjamin Strong4. Argued that an unparalleled drop in the nation’s money supply caused the Great Depression Milton Friedman and Anna Schwartz5. Died in 1928, leaving the Federal Reserve without a single strong leader Benjamin Strong6. Argued Hoover should allow the financial crisis to “purge the rottenness out of the system” Andrew Mellon

4.28 CATEGORIZATIONHelpful Harmful

Created the FDIC Collected taxes to finance Social SecurityAbandoned the gold standard Raised taxes to balance the budgetChanneled money into consumers’ pockets Restricted agricultural productionDeclared a banking holiday Created minimum wage requirements

4.29 ANSWERSThe Beginning of the Great Depression The Shift to Federalism

Answer: The actual downturn that led to the Great Depression began at this time.

Answer: In the early 1930s, state and local governments responded to increases in federal aid by doing this.

Question: What is August 1929? Question: What is lowering expenditures?Answer: Milton Friedman and Anna Schwartz point to this series of events as the turning point between recession and Depression.

Answer: The New Deal concentrated political power here.

Question: What are the bank panics of 1930-1931? Question: Where is Washington D.C.?Answer: Internationalists point to this period as the turning point between recession and Depression.

Answer: The New Deal left the federal government with new power to create these.

Question: What is the summer and autumn of 1931, when Germany, Austria, and Britain abandoned the gold standard?

Question: What are regulations?

4.30 ORDERING3—1920 to 1921—A short recession hits the United States, but the economy bounces back quickly.4—1923—The Open Market Investment Committee is formally established.7—1931—The second wave of bank failures strikes. Kreditanstalt fails, sending European financial markets into crisis.1—1913—The United States establishes the Federal Reserve.6—1930—The first wave of bank failures strikes. 8—1933—The third wave of bank failures strikes, and is ended when Franklin D. Roosevelt restores confidence in the financial system.9—1937—Recovery is interrupted by another recession.5—1929—The downturn that will become the Great Depression begins.2—1914—Major combatants in World War I suspend the gold standard for the duration of the war.10—1941—The United States economy returns to full employment.

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