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Several factors affect the magnitude of the own price elasticity. Knowing these factors can help you make a determination about the likely range of an elasticity in cases where you lack the data needed to estimate it precisely.
Share of Income Devoted to the Product
As a general rule, demand will be more elastic the larger the share of the consumer’s budget required to purchase the item. The rationale here is that the consumer will be more likely to shop around, wait for discounts, or delay making making large purchases until necessary. Demand tends to be more elastic because the consumer stands to capture a large dollar value of additional surplus if he or she can find a better price.
Availability of Substitutes
When substitute products are readily available, demand will be more elastic. Remember from Chapter 1 that two phenomena underpin the law of demand. First, when the price increases, consumers who continue to purchase the product will purchase less. This is a result of the law of diminishing marginal utility. Second, some consumers drop out of the market altogether because participation in this market will no longer provide them with an opportunity for positive consumer surplus at the higher price. When substitute products are readily available, the defection of consumers to lower priced alternatives becomes the driving factor and makes demand very responsive to price changes.
Length of Run
Demand will be more elastic in the long run. The rationale here is that as time passes, consumers have more opportunities to adjust their consumption behavior. One way to model demand over time is to specify quantity demanded in the current time period (period t) as a function of quantity demanded the period before (period t-1). In this case, demand in the short run can be expressed as
$Q_{1}^{t} = \alpha + \beta P_{1} + \gamma Q_{1}^{t-1}$,
where $\alpha > 0$, $\beta < 0$, and $0 \leq \gamma < 1$. In this equation, $\gamma$, the Greek letter gamma, is a habit parameter. As $\gamma$ approaches one, habit formation is very strong and consumption in prior periods has a large impact on consumption today. Moreover, when $\gamma$ is close to one, it will take many periods to converge to the new long-run demand. Demonstration $1$ is designed to help you see this. In the demonstration, you can vary the habit parameter to see the time it takes to adjust from one long-run quantity to another. When the habit parameter is small, adjustment takes place rapidly. When it is large, complete adjustment takes much longer.
Demonstration 4. The habit parameter affects the time to converge to a new point on the long-run demand schedule.
In the long-run, demand at time $t$ will converge to demand at time $(t-1)$. With this in mind, one can set $Q_{1}^{LR} = Q_{1}^{t} = Q_{1}^{t-1}$ in the short run demand equation and solve for $Q_{1}^{LR}$ to get long-run demand as
$Q_{1}^{LR} = \dfrac{\alpha}{1- \gamma} + \dfrac{\beta}{1- \gamma}P_{1}.$
Demonstration $2$, shows the convergence process as time passes. Note that as time goes on, the effect of $Q_{1}^{t=0}$ becomes less and less until it disappears completely. This is an asymptotic process so you do not see complete convergence in the 20 periods represented below. Nevertheless, after 20 periods, there is very little difference between the short-run and long-run demands. You should also be able to verify from Demonstration $2$ that demand is more elastic in the long run than in the short run.
Demonstration $2$. Convergence to long-run demand over time.
Demand at Different Stages of the Market
Many retail food products require fixed proportions of farm products. For example, a pint of blueberries at the retail level requires a pint of blueberries from the farm. A few pints will be damaged in transit from the farm to retail and so offering a certain quantity of blueberries on the retail market may be some fixed proportion ττ of the number of pints from the farm, and ττ may not be equal to one. Nevertheless, there is a clear relationship between the quantity of the farm and retail product. If the assumption of fixed proportions applies, one can express the farm and retail product on the same quantity axis as is done below in Figure $1$.
Figure $1$ shows demand at the farm level and the retail level. The vertical difference between these two demand schedules represents the cost of getting the product from farm to retail. In the case of blueberries, these costs would include things like shipping and stocking. If these costs are independent of the quantity of the farm product being offered for sale at retail, the farm-to-retail markup will be constant. This means that the farm demand will be parallel to the retail demand. This is also shown below in Figure $1$.
What does any of this have to do with elasticity? Well, it can be shown that under certain conditions, the farm demand will be less elastic than the retail demand. Note that the farm and retail demand schedules have the same slope. Let $\beta < 0$ represent this slope. Also note that $Q_{1}^{Farm} = \tau Q_{1}^{Retail}$. Using the point formula one can see that $0 > \beta \times \dfrac{P_{1}^{Farm}}{Q_{1}^{Farm}} > \beta \times \dfrac{P_{1}^{Retail}}{\tau Q_{1}^{Retail}}.$
In other words, $0 > \epsilon_{11}^{Farm} > \epsilon_{11}^{Retail}$ farm demand is less elastic than retail demand. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/03%3A_Elasticities_of_Demand_and_Supply/3.04%3A_Section_4-.txt |
Once you have learned about elasticities on the demand side of the market, it is easy to translate the same concepts over to the supply side. In this course the convention will be to use the symbol $\phi$ (the Greek letter phi) to refer to supply elasticities. Again, subscripts will be used in exactly the same fashion as above for demand elasticities. Moreover, the interpretation of supply elasticities is no different than demand elasticities. For example, the own-price elasticity of supply is defined as
$\phi_{ii} = \dfrac{\% \Delta Q_{i}}{\% \Delta P_{i}}.$
The difference is that $Q_{i}$ is the quantity supplied, making this a supply elasticity as opposed to a demand elasticity.
Ranges for Supply Elasticities
Table $1$ presents some magnitude-based classifications for supply elasticities. Fortunately, there is less to remember about ranges for supply elasticities. The own-price elasticity of supply is always non-negative. This reflects the law of supply. Again, the magnitude of the elasticity shows the responsiveness of quantity supplied to changes in the own-price, and it sometimes makes sense to talk about supply being elastic, unitary elastic, or inelastic. However, the non-negative own-price effect means that revenue to the producing industry always increases as price increases along the supply schedule, regardless of whether supply is responsive (elastic) or unresponsive (inelastic). The sign of the cross-price elasticities will depend on whether the related product in question is a competing product or whether it is a joint product. Finally, economic theory dictates that input price elasticities will be non-positive. If the price of an input used in production increases, the marginal cost of production increases. As explained in Chapter 2, this causes the market supply curve to shift inwards. Table $1$: Classifications based on magnitude of elasticity of supply
Type Range Implication
Own-price $\phi_{ii} >1$ Supply for good $i$ is elastic
Own-price $\phi_{ii} = 1$ Supply for good $i$ is unitary elastic
Own-price $0 \leq \phi_{ii} <1$ Supply for good $i$ is inelastic
Cross-price $\phi_{ij} > 0, i \neq j$ Good $j$ is a joint product for good $i$
Cross-price $\phi_{ij} < 0, i \neq j$ Good $j$ is a competing product for good $i$
Input price $\phi_{iW} \leq 0$ Input price elasticities are non-positive
Calculating Supply Elasticities
The point and arc formulas presented in Table $2$ are nearly identical to those learned for above for the case of demand. The only difference is that quantities supplied are being used in the computations instead of quantities demanded. Again, it is important to emphasize the “all else held constant” provision when using an arc formula. For example, if you are computing an own-price elasticity of supply using the arc formula, you must be confident that the values of any other variables that could shift supply have not changed.
Table $2$. Point and arc formulas for supply elasticities
Type Point Formula Arc Formula
Own-price elasticity $\phi_{ii} = \dfrac{\Delta Q_{i}}{\Delta P_{i}} \times \dfrac{P_{i}}{Q_{i}}$ $\phi_{ii} = \dfrac{Q_{i}^{1} - Q_{i}^{0}}{P_{i}^{1} - P_{i}^{0}} \times \dfrac{P_{i}^{1} + P_{i}^{0}}{Q_{i}^{1} + Q_{i}^{0}}$
Cross-price elasticity $\phi_{ij} = \dfrac{\Delta Q_{i}}{\Delta P_{j}} \times \dfrac {P_{j}}{Q_{i}}, i \neq j$ $\phi_{ij} = \dfrac{Q_{i}^{1} - Q_{i}^{0}}{P_{j}^{1} - P_{j}^{0}} \times \dfrac{P_{j}^{1} + P_{j}^{0}}{Q_{i}^{1} + Q_{i}^{0}}, i \neq j$
Input-price elasticity $\phi_{iW} = \dfrac{\Delta Q_{i}}{\Delta W} \times \dfrac{W}{Q_{i}}$ $\phi_{iW} = \dfrac{Q_{i}^{1} - Q_{i}^{0}}{W^{1} - W^{0}} \times \dfrac{W^{1} + W^{0}}{Q_{i}^{1} + Q_{i}^{0}}$
Elasticity for other supply shift variable $Z$ $\phi_{iZ} = \dfrac{\Delta Q_{i}}{\Delta Z} \times \dfrac{Z}{Q_{i}}$ $\epsilon_{iZ} = \dfrac{Q_{i}^{1}-Q_{i}^{0}}{Z^{1} - Z^{0}} \times \dfrac{Z^{1} + Z^{0}}{Q_{i}^{1} + Q_{i}^{0}}$
Special Cases for Supply Elasticities
It will sometimes be useful to assume that supply is perfectly elastic or that supply is perfectly inelastic. An inverse supply curve with a slope of zero (a horizontal line) corresponds to perfectly elastic supply. What this means is that any quantity can be purchased at the prevailing market price. At first look, this makes absolutely no sense. However, this assumption is appropriate in certain contexts, usually in the case of a buyer who faces a perfectly elastic supply for a product or service. For example, trucking is an important service provided to blackberry marketers. The popularity of blackberries has grown in recent years, so more blackberries are being grown and shipped. The assumption that the blackberry industry faces a perfectly elastic supply for trucking is probably reasonable. Although blackberries shipments have grown, blackberries account for a tiny portion of trucking volume. The fact that more blackberries now need to be shipped has probably not materially affected freight rates. In other words, blackberry marketers can ship all they want at the going rates. As a matter of fact, this assumptions was reflected earlier in Figure 1. By drawing the farm and retail demand schedules parallel to each other, the implicit assumption was that firms in this industry faced a perfectly elastic supply of marketing inputs, the inputs needed to get products from the farm to the consumer.
An inverse supply curve with an infinite slope (a vertical line) corresponds to perfectly inelastic supply. This means that regardless of the price, the quantity supplied is fixed. This assumption may be reasonable in some short to intermediate run contexts in agriculture, especially when we are dealing with fresh and non-storable commodities coupled with production lags. However, it is very important to be careful with this assumption. Just because there is a fixed stock of a certain product does not mean that the supply for that product is perfectly inelastic. Consider, for example, the supply of van Gogh paintings. Van Gogh died in 1890. Consequently, there will never be another van Gogh painting, unless some heretofore unknown paintings turn up in a vault somewhere. Nevertheless, that does not mean the supply of van Gogh paintings is perfectly inelastic. As the prices of van Gogh paintings rise, art collectors and museums are more likely to offer the van Gogh paintings in their collections up for sale and we would expect more Van Gogh paintings to be placed on the market at higher prices and less at lower.
3.06: Section 6-
To this point in the course, you have learned important concepts related to the demand and supply side of the market. The elasticities covered in this chapter reinforce these concepts. Moreover, they allow questions such as those posed in the introductory section to the chapter to be answered with much more precision. Problem sets 2 and 3 represent plausible business decisions that can be answered with elasticities. In problem set 2, you are asked whether you should increase price by a given amount. In problem set 3, you will need to use an advertising elasticity to determine whether to increase advertising expenditures. Later, you will learn that provided you have a precise estimates of demand elasticities, you can answer these types of question much more accurately. In fact, if you have a good estimate of the elasticity of demand facing the firm, you can calculate the actual price that maximizes profits. This will be addressed further in Chapter 7.
In the next chapter, you will put elasticities to work in earnest. Elasticities will be used in models of equilibrium to understand and estimate how markets respond to shocks to demand or supply. You know about demand and you know about supply. It is time to put them together to understand markets. This is the topic of Chapter 4. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/03%3A_Elasticities_of_Demand_and_Supply/3.05%3A_Section_5-.txt |
Problem Set 1: Use the Point Formula for Demand Elasticities.
Exercise $1$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 150 -2P_{1} - 1.5 P_{2} + 0.1M$
$P_{1} = 20$
$P_{2} = 30$
$M = 100$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -0.53$
$\varepsilon_{12} = -0.6$
$\varepsilon_{1M} = 0.13$
Inelastic
Complement
Normal necessity
Exercise $2$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 75-2.5P_{1} - 0.5 P_{2} + 0.5M$
$P_{1} = 30$
$P_{2} = 40$
$M = 200$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -0.94$
$\varepsilon_{12} = -0.25$
$\varepsilon_{1M} = 1.25$
Inelastic
Complement
Normal luxury
Exercise $3$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 150-3P_{1} + 0.5 P_{2} - 0.5M$
$P_{1} = 40$
$P_{2} = 50$
$M = 300$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -4.8$
$\varepsilon_{12} = 1$
$\varepsilon_{1M} = -1.2$
Elastic
Substitute
Inferior
Exercise $4$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 100-2P_{1} + 1.5 P_{2} - 0.2M$
$P_{1} = 50$
$P_{2} = 40$
$M = 200$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -5$
$\varepsilon_{12} = 3$
$\varepsilon_{1M} = -2$
Elastic
Substitute
Inferior
Exercise $5$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 90-2.5P_{1} -0.5 P_{2} +0.5 M$
$P_{1} = 30$
$P_{2} = 40$
$M = 200$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -0.79$
$\varepsilon_{12} = -0.21$
$\varepsilon_{1M} = 1.05$
Inelastic
Complement
Normal luxury
Exercise $6$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 170-2.5P_{1} -1.5 P_{2} +0.1 M$
$P_{1} = 40$
$P_{2} = 30$
$M = 100$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -2.86$
$\varepsilon_{12} = -1.29$
$\varepsilon_{1M} = 0.29$
Elastic
Complement
Normal necessity
Exercise $7$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 100-3P_{1} -0.5 P_{2} +0.5 M$
$P_{1} = 40$
$P_{2} = 20$
$M = 300$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
Answers:
$\varepsilon_{11} = -1$
$\varepsilon_{12} = -0.08$
$\varepsilon_{1M} = 1.25$
Unitary elastic
Complement
Normal luxury
Exercise $8$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 200-2P_{1} +0.5 P_{2} -0.1 M$
$P_{1} = 20$
$P_{2} = 10$
$M = 200$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -0.28$
$\varepsilon_{12} = -0.03$
$\varepsilon_{1M} = -0.14$
Inelastic
Substitute
Inferior
Exercise $9$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 200-2.5P_{1} +1.5 P_{2} -0.5 M$
$P_{1} = 10$
$P_{2} = 20$
$M = 100$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -0.16$
$\varepsilon_{12} = -0.19$
$\varepsilon_{1M} = -0.32$
Inelastic
Substitute
Inferior
Exercise $10$
Given the following:
$\textrm{The demand equation is:} Q_{1}= 60-3P_{1} +1P_{2} +0.1 M$
$P_{1} = 20$
$P_{2} = 30$
$M = 300$
$\textrm{Calculate} \varepsilon _{11}, \varepsilon_{12}, \varepsilon_{1M}$
Is demand for Good 1 inelastic, unitary elastic, or elastic?
Is Good 2 a substitute or complement to good 1?
Is Good 1 inferior, a normal necessity, or a normal luxury?
Answer
$\varepsilon_{11} = -1$
$\varepsilon_{12} = -0.5$
$\varepsilon_{1M} = -0.5$
Unitary elastic
Substitute
Normal necessity
Problem Set 2: Use Elasticities to Determine Whether to Increase Price.
Exercise $1$
Given the following:
Your current quantity is 1000 units.
Your current price is 25 dollars.
Your average variable cost is 15 dollars per unit.
You face an own-price demand elasticity of -3.
What will happen to profit above variable cost if you raise your price by 2 dollars?
Answer
Your current profit above variable cost is 10000 dollars.
Your price will change by 8 percent.
Your new quantity is 760 units.
If you raise price, the profit above variable cost will be 9120 dollars.
Exercise $2$
Given the following:
Your current quantity is 1100 units.
Your current price is 40 dollars.
Your average variable cost is 36 dollars per unit.
You face an own-price demand elasticity of -4.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 4400 dollars.
Your price will change by 2.5 percent.
Your new quantity is 990 units.
If you raise price, the profit above variable cost will be 4950 dollars.
Exercise $3$
Given the following:
Your current quantity is 1120 units.
Your current price is 50 dollars.
Your average variable cost is 40 dollars per unit.
You face an own-price demand elasticity of -5.
What will happen to profit above variable cost if you raise your price by 2 dollars?
Answer
Your current profit above variable cost is 11200 dollars.
Your price will change by 4 percent.
Your new quantity is 896 units.
If you raise price, the profit above variable cost will be 10752 dollars.
Exercise $4$
Given the following:
Your current quantity is 1200 units.
Your current price is 20 dollars.
Your average variable cost is 16 dollars per unit.
You face an own-price demand elasticity of -4.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 4800 dollars.
Your price will change by 5 percent.
Your new quantity is 960 units.
If you raise price, the profit above variable cost will be 4800 dollars.
Exercise $5$
Given the following:
Your current quantity is 1300 units.
Your current price is 50 dollars.
Your average variable cost is 40 dollars per unit.
You face an own-price demand elasticity of -1.5.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 13000 dollars.
Your price will change by 2 percent.
Your new quantity is 1261 units.
If you raise price, the profit above variable cost will be 13871 dollars.
Exercise $6$
Given the following:
Your current quantity is 1200 units.
Your current price is 20 dollars.
Your average variable cost is 16 dollars per unit.
You face an own-price demand elasticity of -0.75.
What will happen to profit above variable cost if you raise your price by 2 dollars?
Answer
Your current profit above variable cost is 4800 dollars.
Your price will change by 10 percent.
Your new quantity is 1110 units.
If you raise price, the profit above variable cost will be 6660 dollars.
Exercise $7$
Given the following:
Your current quantity is 1120 units.
Your current price is 50 dollars.
Your average variable cost is 46 dollars per unit.
You face an own-price demand elasticity of -1.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 4480 dollars.
Your price will change by 2 percent.
Your new quantity is 1097.6 units.
If you raise price, the profit above variable cost will be 5488 dollars.
Exercise $8$
Given the following:
Your current quantity is 1200 units.
Your current price is 25 dollars.
Your average variable cost is 21 dollars per unit.
You face an own-price demand elasticity of -5.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 4800 dollars.
Your price will change by 4 percent.
Your new quantity is 960 units.
If you raise price, the profit above variable cost will be 4800 dollars.
Exercise $9$
Given the following:
Your current quantity is 1050 units.
Your current price is 50 dollars.
Your average variable cost is 40 dollars per unit.
You face an own-price demand elasticity of -5.5.
What will happen to profit above variable cost if you raise your price by 2 dollars?
Answer
Your current profit above variable cost is 10500 dollars.
Your price will change by 4 percent.
Your new quantity is 819 units.
If you raise price, the profit above variable cost will be 9828 dollars.
Exercise $10$
Given the following:
Your current quantity is 1000 units.
Your current price is 25 dollars.
Your average variable cost is 21 dollars per unit.
You face an own-price demand elasticity of -4.5.
What will happen to profit above variable cost if you raise your price by 1 dollars?
Answer
Your current profit above variable cost is 4000 dollars.
Your price will change by 4 percent.
Your new quantity is 820 units.
If you raise price, the profit above variable cost will be 4100 dollars.
Problem Set 3: Use Elasticities to Determine Whether to Increase Advertising.
Exercise $1$
Given the following:
Your current quantity is 1000 units.
Your price is 25 dollars.
Your average variable cost (AVC) is 15 dollars per unit.
Your elasticity of demand with respect to advertising is 0.4.
Your current advertising expenditure is $5,000 and is your only fixed cost. What will happen to profit if you increase advertising by 200 dollars? Answer Your current profit is 5000 dollars. Your advertising will change by 4 percent. Your new quantity is 1016 units. Profit will go down to 4960 dollars (after subtracting the increse in advertising). Exercise $2$ Given the following: Your current quantity is 2000 units. Your price is 40 dollars. Your average variable cost (AVC) is 36 dollars per unit. Your elasticity of demand with respect to advertising is 0.5. Your current advertising expenditure is$5,000 and is your only fixed cost.
What will happen to profit if you increase advertising by 300 dollars?
Answer
Your current profit is 3000 dollars.
Your advertising will change by 6 percent.
Your new quantity is 2060 units.
Profit will go down to 2940 dollars (after subtracting the increse in advertising).
Exercise $3$
Given the following:
Your current quantity is 1500 units.
Your price is 50 dollars.
Your average variable cost (AVC) is 40 dollars per unit.
Your elasticity of demand with respect to advertising is 0.6.
Your current advertising expenditure is $5,000 and is your only fixed cost. What will happen to profit if you increase advertising by 400 dollars? Answer Your current profit is 10000 dollars. Your advertising will change by 8 percent. Your new quantity is 1572 units. Profit will go up to 10320 dollars (after subtracting the increse in advertising). Exercise $4$ Given the following: Your current quantity is 1200 units. Your price is 20 dollars. Your average variable cost (AVC) is 16 dollars per unit. Your elasticity of demand with respect to advertising is 0.5. Your current advertising expenditure is$5,000 and is your only fixed cost.
What will happen to profit if you increase advertising by 250 dollars?
Answer
Your current profit is -200 dollars.
Your advertising will change by 5 percent.
Your new quantity is 1230 units.
Profit will go down to -330 dollars (after subtracting the increse in advertising).
Exercise $5$
Given the following:
Your current quantity is 1300 units.
Your price is 50 dollars.
Your average variable cost (AVC) is 40 dollars per unit.
Your elasticity of demand with respect to advertising is 1.
Your current advertising expenditure is $5,000 and is your only fixed cost. What will happen to profit if you increase advertising by 200 dollars? Answer Your current profit is 8000 dollars. Your advertising will change by 4 percent. Your new quantity is 1352 units. Profit will go up to 8320 dollars (after subtracting the increse in advertising). Exercise $6$ Given the following: Your current quantity is 2000 units. Your price is 20 dollars. Your average variable cost (AVC) is 16 dollars per unit. Your elasticity of demand with respect to advertising is 1.5. Your current advertising expenditure is$5,000 and is your only fixed cost.
What will happen to profit if you increase advertising by 300 dollars?
Answer
Your current profit is 3000 dollars.
Your advertising will change by 6 percent.
Your new quantity is 2180 units.
Profit will go up to 3420 dollars (after subtracting the increse in advertising).
Exercise $7$
Given the following:
Your current quantity is 1500 units.
Your price is 50 dollars.
Your average variable cost (AVC) is 46 dollars per unit.
Your elasticity of demand with respect to advertising is 0.4.
Your current advertising expenditure is $5,000 and is your only fixed cost. What will happen to profit if you increase advertising by 400 dollars? Answer Your current profit is 1000 dollars. Your advertising will change by 8 percent. Your new quantity is 1548 units. Profit will go down to 792 dollars (after subtracting the increse in advertising). Exercise $8$ Given the following: Your current quantity is 1200 units. Your price is 25 dollars. Your average variable cost (AVC) is 21 dollars per unit. Your elasticity of demand with respect to advertising is 0.5. Your current advertising expenditure is$5,000 and is your only fixed cost.
What will happen to profit if you increase advertising by 250 dollars?
Answer
Your current profit is -200 dollars.
Your advertising will change by 5 percent.
Your new quantity is 1230 units.
Profit will go down to -330 dollars (after subtracting the increse in advertising).
Exercise $9$
Given the following:
Your current quantity is 2000 units.
Your price is 50 dollars.
Your average variable cost (AVC) is 40 dollars per unit.
Your elasticity of demand with respect to advertising is 2.
Your current advertising expenditure is $5,000 and is your only fixed cost. What will happen to profit if you increase advertising by 200 dollars? Answer Your current profit is 15000 dollars. Your advertising will change by 4 percent. Your new quantity is 2160 units. Profit will go up to 16400 dollars (after subtracting the increse in advertising). Exercise $10$ Given the following: Your current quantity is 1000 units. Your price is 25 dollars. Your average variable cost (AVC) is 21 dollars per unit. Your elasticity of demand with respect to advertising is 1.5. Your current advertising expenditure is$5,000 and is your only fixed cost.
What will happen to profit if you increase advertising by 300 dollars?
Answer
Your current profit is -1000 dollars.
Your advertising will change by 6 percent.
Your new quantity is 1090 units.
Profit will go up to -940 dollars (after subtracting the increse in advertising).
Problem Set 4: Short-Run and Long-Run Elasticities.
Exercise $1$
Given the following:
The short run demand equation is:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 100 - 2P_{1} + 0.5 Q_{1}^{(t-1)}$
$P_{1} = 35$
$Q_{1}^{(t-1)} =60$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.5$
$Q_{1}^{LR} = 200-4P_{1}$
$\varepsilon_{11}^{SR} = -1.17$
$\varepsilon_{11}^{LR} = -2.33$
$\textrm{In the long-run.}$
Exercise $2$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 100 - 3P_{1} + 0.6 Q_{1}^{(t-1)}$
$P_{1} = 20$
$Q_{1}^{(t-1)} =100$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.6$
$Q_{1}^{LR} = 250-7.5P_{1}$
$\varepsilon_{11}^{SR} = -0.6$
$\varepsilon_{11}^{LR} = -1.5$
$\textrm{In the long-run.}$
Exercise $3$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 150 - 4P_{1} + 0.75 Q_{1}^{(t-1)}$
$P_{1} = 20$
$Q_{1}^{(t-1)} =280$
Answer
$\textrm{Habit parameter}: \gamma = 0.75$
$Q_{1}^{LR} = 600-16P_{1}$
$\varepsilon_{11}^{SR} = -0.29$
$\varepsilon_{11}^{LR} = -1.14$
$\textrm{In the long-run.}$
Exercise $4$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 250 - 4P_{1} + 0.8Q_{1}^{(t-1)}$
$P_{1} = 40$
$Q_{1}^{(t-1)} =450$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.8$
$Q_{1}^{LR} = 1250-20P_{1}$
$\varepsilon_{11}^{SR} = -0.36$
$\varepsilon_{11}^{LR} = -1.78$
$\textrm{In the long-run.}$
Exercise $5$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 120 - 2P_{1} + 0.6Q_{1}^{(t-1)}$
$P_{1} = 40$
$Q_{1}^{(t-1)} =100$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.6$
$Q_{1}^{LR} = 300-5P_{1}$
$\varepsilon_{11}^{SR} = -0.8$
$\varepsilon_{11}^{LR} = -2$
$\textrm{In the long-run.}$
Exercise $6$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 150 - 3P_{1} + 0.8Q_{1}^{(t-1)}$
$P_{1} = 30$
$Q_{1}^{(t-1)} =300$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.8$
$Q_{1}^{LR} = 750-15P_{1}$
$\varepsilon_{11}^{SR} = -0.3$
$\varepsilon_{11}^{LR} = -1.5$
$\textrm{In the long-run.}$
Exercise $7$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 200 - 3P_{1} + 0.75Q_{1}^{(t-1)}$
$P_{1} = 45$
$Q_{1}^{(t-1)} =260$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.75$
$Q_{1}^{LR} = 800-12P_{1}$
$\varepsilon_{11}^{SR} = -0.52$
$\varepsilon_{11}^{LR} = -2.08$
$\textrm{In the long-run.}$
Exercise $8$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 80 - 2P_{1} + 0.6Q_{1}^{(t-1)}$
$P_{1} = 30$
$Q_{1}^{(t-1)} =50$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.6$
$Q_{1}^{LR} = 200-5P_{1}$
$\varepsilon_{11}^{SR} = -1.2$
$\varepsilon_{11}^{LR} = -3$
$\textrm{In the long-run.}$
Exercise $9$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 120 - 3P_{1} + 0.5Q_{1}^{(t-1)}$
$P_{1} = 30$
$Q_{1}^{(t-1)} =60$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.5$
$Q_{1}^{LR} = 240-6P_{1}$
$\varepsilon_{11}^{SR} = -1.5$
$\varepsilon_{11}^{LR} = -3$
$\textrm{In the long-run.}$
Exercise $10$
Given the following:
$\textrm{The short run demand equation is:} Q_{1}^{(t)} = 100 - 2P_{1} + 0.5Q_{1}^{(t-1)}$
$P_{1} = 40$
$Q_{1}^{(t-1)} =40$
What is the habit parameter?
What is the long-run demand equation?
What is the short-run own-price elasticity of demand?
What is the long-run own-price elasticity of demand?
When is demand more elastic, in the short- or long-run?
Answer
$\textrm{Habit parameter}: \gamma = 0.5$
$Q_{1}^{LR} = 200-4P_{1}$
$\varepsilon_{11}^{SR} = -2$
$\varepsilon_{11}^{LR} = -4$
$\textrm{In the long-run.}$
Problem Set 5: Multiple Choice.
Exercise $1$
1. When is demand unitary elastic?
a) When the income elasticity is 1.
b) When the own-price elasticity of demand is -1.
c) When demand is totally unresponsive (inverse demand is a vertical line).
d) All of the above.
Answer
b
Exercise $2$
1. If price goes up by 4 percent and quantity demanded falls by 2 percent then
a) This is a substitute good.
b) This good has an elastic demand.
c) This good is an inferior good.
d) This good has an inelastic demand.
Answer
d
Exercise $3$
1. Suppose that the own-price elasticity of demand is -1. Which statement is true?
a) Profits are maximized.
b) Revenue is maximized.
c) Consumer surplus is maximized.
d) All of the above.
Answer
b
Exercise $4$
1. Suppose the own-price elasticity of demand is -0.75. Which statement is true?
a) An increase in price will decrease revenue.
b) An increase in price will increase revenue.
c) The good in question is a substitute in consumption.
d) The good in question is an inferior good.
Answer
b
Exercise $5$
1. Which of the following elasticity numbers is consistent with a normal good?
a) An income elasticity of demand that is -0.5.
b) An income elasticity of demand that is 0.5.
c) An own-price elasticity of 0.28.
d) Both a and c.
Answer
b
Exercise $6$
1. If an increase in income causes an increase in demand, then we know that
a) The good in question is a normal luxury good.
b) The good in question is a normal necessity good.
c) The good in question is a normal good but we can’t tell whether it is classified as a necessity or a luxury without further information.
d) The good in question violates the law of demand.
Answer
c
Exercise $7$
1. Which demand elasticity number tells you that two products are substitutes in consumption?
a) A cross-price elasticity of -0.5.
b) A cross-price elasticity of 0.5.
c) An income elasticity of 1.5.
d) An own-price elasticity of -0.75.
Answer
b
Exercise $8$
1. One problem with using the arc elasticity formula to compute an own-price elasticity is:
a) It is very hard to compute because you need lots of data points.
b) Actually, there are no problems with using the arc formula to compute elasticities.
c) One must assume that all other factors that affect demand, other than own price, remain the same.
d) If demand has not shifted, the arc formula will often return a positive value for the own-price elasticity.
Answer
c
Exercise $9$
1. Given that a firm has some control over the price it charges (it is not a price taker) and it faces a positive marginal cost, which case would be consistent with profit maximization?
a) It sets its price to make demand inelastic.
b) It sets its price to make demand elastic.
c) It sets its price to make demand unitary elastic.
d) It sets its price so that both demand and supply are in the inelastic range.
Answer
b
Exercise $10$
1. As described in class, the supply schedule for van Gogh paintings:
a) Is perfectly inelastic.
b) Is downward sloping.
c) Maybe quite inelastic but is probably not perfectly inelastic.
d) Is a horizontal line.
e) Choices a and d only.
Answer
c
Exercise $11$
1. Other things equal, in the long run
a) Demand is less elastic than in the short run.
b) Supply is less elastic than in the short run.
c) Demand is more elastic than in the short run.
d) Both demand and supply are less elastic than in the short run.
Answer
c
Exercise $12$
1. Which best describes the concept of elasticity?
a) The responsiveness of demand or supply to own-price or some other shift variable.
b) The idea that demand schedules always slope downwards.
c) The idea that consumer surplus is the area under the demand schedule.
d) The idea that supply schedules always have non-negative slopes.
Answer
a | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/03%3A_Elasticities_of_Demand_and_Supply/3.7%3A_Problem_Sets.txt |
Learning Objectives
• In this chapter you will use material learned earlier in the course to be better understand price determination and the behavior of markets. The chapter starts with a general overview of an equilibrium for a single market and then moves on to a basic framework for predicting the effect of a shock to either the demand or supply side of the market on the equilibrium price and quantity. In most real-world modeling exercises, elasticities are used to characterize an equilibrium in percentage change form. These models are often called “equilibrium displacement models” and are the topic of the second section of the chapter. Again, the emphasis will first be on a single market to keep things simple. The third and fourth sections of the chapter extend the framework to examine the effects of a shock on multiple markets simultaneously. This provides a more realistic treatment of actual markets because a shock to one market will generally reverberate through other related markets. Feedback from these related markets will amplify or diminish the effect in the market experiencing the initial shock. The specific learning objectives for this chapter are as follows:
• Identify an equilibrium in a single market given a supply equation and a demand equation.
• Distinguish between exogenous and endogenous variables.
• Predict the impact of a change in an exogenous variable on the equilibrium price and quantity in a single market.
• Use elasticities to model the impact of an exogenous shock on a market equilibrium.
• Calculate exogenous demand and supply shocks using elasticities. Use these shocks to model changes to an equilibrium.
• Distinguish between partial equilibrium models and general equilibrium models.
• Explain feedback from one market to another within a general equilibrium model.
04: Market Equilibrium and Equilibrium Modeling
In this chapter you will use material learned earlier in the course to be better understand price determination and the behavior of markets. The chapter starts with a general overview of an equilibrium for a single market and then moves on to a basic framework for predicting the effect of a shock to either the demand or supply side of the market on the equilibrium price and quantity. In most real-world modeling exercises, elasticities are used to characterize an equilibrium in percentage change form. These models are often called “equilibrium displacement models” and are the topic of the second section of the chapter. Again, the emphasis will first be on a single market to keep things simple. The third and fourth sections of the chapter extend the framework to examine the effects of a shock on multiple markets simultaneously. This provides a more realistic treatment of actual markets because a shock to one market will generally reverberate through other related markets. Feedback from these related markets will amplify or diminish the effect in the market experiencing the initial shock. The specific learning objectives for this chapter are as follows:
• Identify an equilibrium in a single market given a supply equation and a demand equation.
• Distinguish between exogenous and endogenous variables.
• Predict the impact of a change in an exogenous variable on the equilibrium price and quantity in a single market.
• Use elasticities to model the impact of an exogenous shock on a market equilibrium.
• Calculate exogenous demand and supply shocks using elasticities. Use these shocks to model changes to an equilibrium.
• Distinguish between partial equilibrium models and general equilibrium models.
• Explain feedback from one market to another within a general equilibrium model. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.01%3A_Section_1-.txt |
In a market, demand and supply come together to determine the price and quantity of a product. A market is said to be in equilibrium when the prevailing price causes the quantity supplied to equal the quantity demanded. The term equilibrium suggests a point of stability. Because supply equals demand at an equilibrium, there is no reason for consumers to bid prices up through unmet requests for the product nor is their a reason for producers to bid prices down because of untaken offers of the product. Price is, in this respect, stable.
Consider an example involving a single market. Suppose that the demand for good 1 is given by
\(Q_{1}^{D} = 100 - \dfrac{1}{2} P_{1} + D,\)
where \(Q_{1}^{D}\) is quantity demanded, \(P_{1}\) is price, and \(D\) is a demand shock. \(D\) can be positive, negative, or zero.
Next, suppose that supply for good 1 is given by
\(Q_{1}^{S} = -20 + P_{1} + S,\)
where \(Q_{1}^{S}\) is quantity supplied and \(S\) is a supply shock. Again, \(S\) can be positive, negative, or zero.
To find the equilibrium price, set \(Q_{1}^{S} = Q_{1}^{D}\) and solve for \(P_{1}\) as follows:
\(-20 + P_{1} + S = 100 - \dfrac{1}{2}P_{1} + D \Rightarrow P_{1} = 80 + \dfrac{2}{3}(D-S).\)
Next, substitute this solution for \(P_{1}\) into the supply or the demand equation. If the solution for \(P_{1}\) is correct, you will get the same quantity regardless of which equation you use:
\(Q_{1}^{S} = -20 + 80 + \dfrac{2(D-S)}{3} + S = 60 + \dfrac{2D+S}{3}.\)
\(Q_{1}^{D} = 100 - \dfrac{1}{2}(80 + \dfrac{2(D-S)}{3}) + X = 60 + \dfrac{2D+S}{3}.\)
An equilibrium based on this example is depicted below in Demonstrations \(1\) and \(2\). Note that when there is no demand or supply shock (\(D = S = 0\)), \(P_{1}^{E} =80 \: and \: Q_{1}^{E} = 60\). This is the initial equilibrium depicted in the demonstrations. Use Demonstration \(1\) to add a positive shock to demand. When you do this, the demand schedule shifts to the right by 12 units. This disrupts the equilibrium. At the current price of \$80, only 60 units are supplied but now 72 units would be demanded. Since demand now exceeds supply, the price will be bid up until a new equilibrium price of \$88 is reached which causes the new demand schedule to equate with the supply schedule at a new equilibrium quantity of 68 units. Thus, the initial shock of positive 12 units ultimately resulted in an 8 unit increase in the equilibrium quantity after the market price adjusted to a new equilibrium price.
Reset the demand shock in Demonstration \(1\) to be zero. You will return to the original equilibrium of \(P_{1}^{E} = 80 \: and \: Q_{1}^{E} = 60\). Now use the demonstration to apply a negative shock to demand. This causes demand to shift to the left by 12 units. At the current price of \$80, only 48 units would be demanded after the shock, but suppliers will continue to offer 60 units on the market. Because supply now exceeds demand, the price will be bid down until the market reaches a new equilibrium price of \$72 and a new equilibrium quantity of 52 units. Again the initial shock of negative 12 units ultimately resulted in an 8 unit decrease in the equilibrium quantity after the market price reached a new equilibrium.
Demonstration \(1\). An Equilibrium and equilibrium adjustment resulting from a demand shock.
Demonstration \(2\), is similar except that it allows you to consider the effect of positive or negative shocks to supply as opposed to demand. Spend some time with demonstration \(2\) to visualize the effects of a positive or negative supply shock. As you do, note that a shock disrupts the equilibrium so that supply no longer equals demand. As a result, prices are bid up or down as necessary until a new equilibrium price is determined that matches demand to the new supply schedule. Pay attention to the direction of the quantity and price change in response to the positive and negative supply shocks.
Demonstration \(2\). An equilibrium and equilibrium adjustment resulting from a supply shock.
Exogenous and Endogenous Variables in an Equilibrium Model
In the above example, an equilibrium was found by solving a system of equations. In the case of one market, there are two equations (one supply equation and one demand equation) and two unknowns (the equilibrium price and the equilibrium quantity). These unknown variables are called endogenous variables. They are given this name because they are determined inside the system of equations. The etymology of the prefix “endo” is from a Greek word meaning “within.” In general, the number of endogenous variables in the system will be equal to the number of demand and supply equations. For example, in a model of two markets, there are four equations (two pairs of demand and supply equations) and four endogenous variables (an equilibrium price and quantity in each of the two markets).
Exogenous variables affect the equilibrium but are determined outside of the system of equations. As you might have guessed, the prefix “exo” also has its origin in a Greek word meaning “outside.” In terms of the demand or supply schedules, a change in an exogenous variable causes one or more of the schedules to shift. In the example above, there were two exogenous variables: \(D\) and \(S\). There is no upper limit on the number of exogenous variables that can be included in the system. Exogenous variables will be a subset of those designated in chapters 1 and 2 as demand or supply shift variables. However the term “shifter” and “exogenous” are not synonymous. To be truly exogenous, the shift variable needs to be unaffected by the markets being analyzed in the model. Otherwise, it is not truly exogenous. For example, one could argue that beef and pork are substitutes. If this is true, the price of pork shifts the demand for beef. Nevertheless, it would problematic to assume that the price of pork is exogenous because the price of beef also shifts the demand for pork. In this case, an accurate model would need to encompass the markets for both beef and pork, in which case the prices and quantities of beef and pork would all be endogenous variables in the model.
In many contexts, a change in average consumer income, another demand shift variable, could be treated as exogenous. This is fine so long as it is reasonable to assert that income is dictated by macroeconomic forces that are minimally affected by the market being analyzed. However, there will be cases where income should not be considered exogenous. In fact, income is endogenous in one of the consumer models that will be presented in Chapter 5. In this model, income is determined by the consumer’s allocation of time spent in leisure activities, in the labor force, and in household production. Similarly, in some cases, the supply side of the market will be small enough to not materially affect the price of an input. In such cases, it may be reasonable to assume that input prices are exogenous variables within the model. In others, it will be necessary to formally incorporate input markets into the model and input prices will be endogenous.
A Basic Framework for Identifying the Cause of an Equilibrium Change
Demonstration \(3\). A basic framework for identifying the cause of an equilibrium change.
In regions 1 and 3 of Demonstration \(3\), you can conclude with certainty that demand has shifted. If the new equilibrium lies to the southwest of the initial equilibrium (the region denoted as 1), then demand has decreased (shifted to the left). If the new equilibrium lies to the northeast of the initial equilibrium (the region denoted as 3), then demand has increased (shifted to the right). If a new equilibrium lies in regions 1 or 3, conclusive statements cannot be made about a supply shift. Supply might have shifted but one cannot be sure. To help you see this, use the demonstration to add a negative shock to demand and a positive shock to supply. The new equilibrium point lies in region 1 even though supply has also shifted. Now set the supply shock back to “none”. The resulting equilibrium is still in region 1. In region 1 all you can say with certainty is that demand has decreased. Supply may or may not have shifted. No conclusive statement can be made about supply if you are in region 1.
In regions 2 and 4 of Demonstration \(3\), you know that supply has shifted. If the new equilibrium lies to the northwest of the initial equilibrium (the region denoted as 2), then a conclusive statement can be made that supply has decreased (shifted to the left). If the new equilibrium lies to the southeast of the initial equilibrium (the region denoted as 4), then a conclusive statement can be made that supply has increased (shifted to the right). Again, demand may or may not have shifted if a new equilibrium is observed in regions 2 or 4. However, there is no way for a new equilibrium to be in regions 2 or 4 without there having been a supply shift.
In Demonstration \(3\), you can see the demand and supply schedules. However, the conclusions above can be inferred from this basic framework even if you could not. The framework requires only that the laws of demand and supply apply to the market being examined. Use Demonstration \(3\) to verify the conclusions summarized in Table \(1\). Because you are given example demand and supply schedules in Demonstration \(3\), you may question why some of the directions are marked as ambiguous in the table. For example, a positive demand shock and negative supply shock results in a slight increase in equilibrium quantity given the example schedules in the demonstration. However, another set of example schedules could have been provided that would have shown a decrease in quantity. Note that the ambiguous cases in table \(1\) happen when demand and supply change simultaneously and when the impact of the demand and supply changes on price or quantity offset one another. The actual change in these ambiguous cases depends on the magnitude of the supply shock relative to the demand shock and, as you will see momentarily, on the elasticity of demand and supply.
Table \(1\). Effects of demand and supply shocks on a market equilibrium
Supply Shock Demand Shock Effect on Eq. Price Effect on Eq. Quantity
+ None
None
None +
None
+ + Ambiguous
+ Ambiguous
+ Ambiguous
Ambiguous | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.02%3A_Section_2-.txt |
Recall from Chapter 3, that elasticities are expressed as ratios of percentages. Consequently, to use elasticities to model a market equilibrium, the exogenous demand and supply shocks must also be expressed in percentages. With this in mind, let $\% \Delta S_{i}$ and $\% \Delta D_{i}$ be the percentage exogenous shock to demand and supply in market $i$, respectively. The demand and supply side of the markets can be expressed in change form as follows:
$\% \Delta Q_{i}^{D} = \varepsilon_{ii} \% \Delta P_{i} + \% \Delta D_{i},$
and
$\% \Delta Q_{i}^{S} = \phi_{ii} \% \Delta P_{i} + \% \Delta S_{i} .$
The convention introduced in Chapter 3 is being followed here, where $\phi$ and $\varepsilon$ are used for supply and demand elasticities, respectively. When there is a change from one market equilibrium to another, it must be true that the change in the equilibrium quantity supplied is equal to the change in equilibrium quantity demanded. Thus, it is possible find the percentage change in equilibrium price that would result from the demand and supply shocks by setting $\% \Delta Q_{i}^{S} = \% \Delta Q_{i}^{D}$ and solving for $\% \Delta P_{i}$. Doing this provides
$\% \Delta P_{i}^{E} = \dfrac{\% \Delta D_{i} - \% \Delta S_{i}}{\phi_{ii} -\varepsilon_{ii}}.$
Substituting Equation $1$ back into $\% \Delta Q_{i}^{S}$ or $\% \Delta Q_{i}^{D}$ provides the percentage change in equilibrium quantity:
$\% \Delta Q_{i}^{E} = \dfrac{\phi_{ii} \% \Delta D_{i} - \varepsilon_{ii} \% \Delta S_{i}}{\phi_{ii} - \varepsilon_{ii}}.$
Use of elasticities in modeling equilibria has some clear advantages. First, there is no need to assume that demand and supply are linear. The equilibrium model is a system of equations that is linear in the elasticities even if the underlying supply or demand equations are non-linear. Second, while it is true that equilibrium models in elasticity form provide percentage changes in equilibrium price and quantity, the prevailing equilibrium price and quantity are commonly known. Thus, percentage impacts from these models contain the information needed to assess the economic effects of an exogenous shock on the market. Third, the approach described below can accommodate any number of exogenous shocks and these shocks can occur simultaneously. Finally, the modeling approaches of this section can be extended to real-world situations involving numerous inter-related markets.
Using Elasticities of Supply or Demand from Exogenous Shift Variables
Recall from Chapter 3, that the general definition of an elasticity enables it to be used to forecast a quantity change. This means that if you have the elasticity of demand or supply with respect to an exogenous variable, it can be used to predict a shock to demand or supply as follows:
$\% \Delta S_{i} = \phi_{iZ} \% \Delta Z$
and
$\% \Delta D_{i} = \varepsilon_{iX} \% \Delta X.$
Thus, one way to obtain exogenous supply or demand shocks, $\% \Delta S_{i}$ or $\% \Delta D_{i}$, is to use projected changes in exogenous variables into demand/supply shocks using the elasticities for these exogenous variables.
Convert Potential Quantity Shocks to Percentages
Unfortunately, some shocks do correspond to exogenous variables for which you have elasticity estimates. In these cases it may be feasible to estimate the supply or demand shock in terms of units and then convert those units into a percentage of market quantity. For instance, in the early 2000’s, there was an outbreak of Hoof and Mouth Disease (HMD) in the United Kingdom. According to the BBC, the outbreak resulted in the destruction of more than six million sheep, cattle, and pigs (Bates 2016). The last confirmed case of HMD in the United States was 1929, but HMD is endemic in parts of the world and there is always a risk that it could again become a problem in the United States as well (USDA-APHIS 2013a). In fact, the USDA has an entire agency, The Animal Plant Health Inspection Service, that works closely with Customs and Border Protection to prevent the introduction of HMD and other diseases or pests that could harm US Agriculture (USDA-APHIS 2013b).
Paarlberg, Lee, and Seitzinger (2002) considered the potential effects of an HMD outbreak on meat, poultry and dairy markets in the US. They used supply shocks of -5 percent for beef cattle and milk production, -2 percent for swine production, and -9 percent for lamb and sheep production. These estimates were based on actual livestock reductions observed in the UK outbreak. They also considered demand shocks to account for potential taste changes away from red meats and to account for the fact that discovery of HMD in the US would result in closure of export markets for livestock products. The point to be made here is that in many settings, such as a possible HMD outbreak, modelers may be able to come up with reasonable estimates for supply and demand shocks that can be used for $\% \Delta S$ and/or $\% \Delta D$ and then assess the effect on an equilibrium. A more involved analysis of the potential US market response to an HMD outbreak is provided in Paarlberg et al. (2008). This study provides background on the markets being examined and includes an appendix containing baselines and elasticities used in the equilibrium models. Moreover, the study measures market equilibrium responses to HMD outbreaks of differing levels of severity.
In the Paarlberg, Lee, and Seitzinger (2002) and Paarlberg et al. (2008) studies, the exogenous event was an HMD outbreak and the analyses examined how equilibrium prices and quantities would respond to this event given existing estimates of market elasticities. It is worth pointing out that these authors included markets for feedstuffs in their models. This is because an adjustment to livestock markets would have ramifications on markets for feedstuffs, which would then ripple back into the markets for livestock products. For this reason, it was important to include feedstuff prices and quantities as endogenous variables in the model.
Use Own-Price Elasticities to Convert Changes in Costs or Willingness to Pay Into Quantity Shocks
In other cases, the exogenous shock that needs to be modeled may not have an elasticity nor be easily represented in terms of a percentage of current market quantity. However, if you can estimate the effect as a percentage of the current equilibrium price you can use own-price elasticities to find the shock. This is because an increase in cost is analogous to price decrease for producers. Similarly, an improvement in a quality attribute valued by consumers is analogous to a price decrease for the consumer.
A Supply Shock Problem
Let us consider a supply shock problem. Suppose new biosecurity regulations are proposed to prevent spread of HMD on feedlot operations. Suppose further that the fed cattle market is at an initial equilibrium with a price of $1.25 per pound. It is estimated that it will cost producers$0.03 per pound to comply with the regulations. How will this affect market equilibrium? You know that the regulations will raise costs and this will shift the supply curve to the left resulting in a new equilibrium with a higher price and low quantity (see Table 1 above). The question is, how much higher and lower? To find out, let us first note that the \$0.03 cost increase is 2.4 percent (0.03/1.25 = 0.024) of the current market price. Consequently, the costs resulting from the regulation are analogous to a 2.4 percent reduction in the price that producers receive. Suppose that farm-level supply and demand elasticities are as follows: $\phi_{11} = 2$ and $\varepsilon_{11} = -0.8$. The increase in per-unit costs translates into a supply shock of $\% \Delta S = 2(-2.4) = -4.8 \%$. You can now use Equation $1$ to predict the equilibrium price response as follows:
$\% \Delta P_{1}^{E} = \dfrac{0-(-4.8)}{2-(-0.8)} \approx 1.71.$
From Equation $2$, you get the equilibrium quantity response to be
$\% \Delta Q_{1}^{E} = \dfrac{(2)(0) - (-0.8)(-4.8)}{2-(-0.8)} \approx -1.37.$
A Demand Shock Problem
Suppose that you have access to a study showing that high protein diet fads are growing in popularity and that within a year, consumers will, on average, be willing to pay 3 percent more for chicken. If this study is correct, how would it affect the equilibrium price and quantity of chicken? The study suggests that consumer preferences for chicken with strengthen. Thus, you would expect demand to shift outwards, and the equilibrium price and quantity should rise (see Table 1). The question is by how much? Since consumers are projected to obtain 3 percent more value from chicken, this is analogous to a 3 percent reduction in the price that consumers pay. Suppose that retail level supply and demand elasticities for chicken are as follows: $\phi_{11}= 1.75 \: and \: \varepsilon_{11}= -1.1$. The demand shock is $\% \Delta D = -1.1(-3) = 3.3 \%$. Using Equation $1$, the effect on the equilibrium price is
$\% \Delta P_{1}^{E} = \dfrac{3.3-0}{1.75 - (-1.1)} \approx 1.16.$
From Equation $2$, you get the equilibrium quantity response to be
$\% \Delta Q_{1}^{E} = \dfrac{(1.75)(3.3) -(-1.1)(0)}{1.75- (-1.1)} \approx 2.03.$ | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.03%3A_Section_3-.txt |
So far, the impact of an exogenous shock has been considered for only one market. In many (if not most) cases, this is not a very good assumption. For instance, a shock to the pork market would be expected to have an impact on the beef and poultry markets because these products are substitutes for pork. Moreover, as shown in the Paarlberg, Lee, and Seitzinger (2002) and Paarlberg et al. (2008) studies on HMD mentioned above, something that affects livestock markets would likely affect markets for grain and other feedstuffs. Thus, an initial shock to the pork market will impact related product and input markets. You should account for feedback between these related markets as they adjust to a new equilibrium.
As additional markets are added into an equilibrium analysis framework, the problem becomes more complex. It may not be feasible to model all the related markets. In some cases, the best an analyst can do is assess a single market in isolation. This is called a partial equilibrium model. In a partial equilibrium model, you are ignoring feedback that may result from related markets.
General equilibrium models differ from partial equilibrium models in that they incorporate related markets or economic sectors into the analysis. In a general equilibrium model, feedback from other markets is considered to account for the fact that exogenous shocks occurring in other markets have implications for the market in question.
Classification of a model as a partial equilibrium or general equilibrium can vary a bit in the literature. Specifically, you will sometimes see a model described as partial equilibrium model even though multiple markets are included in the analysis. For example, Paarlberg, Lee, and Seitzinger (2002) and Paarlberg et al. (2008) classify their analyses as a partial equilibrium model, even though their models included markets for meat, dairy, livestock, and feedstuffs. This is because they restrict their focus to a tightly linked group of markets and do not examine the ramifications of an HMD outbreak on other sectors of the economy.
Normally, in a general equilibrium model, the equilibrium quantities and prices in all markets are endogenous. For instance, if you are modeling three related markets, there would be six endogenous variables: three equilibrium prices and three equilibrium quantities. Exogenous variables in a general equilibrium model again reflect any variable outside the system that shifts demand or supply in one or more markets. Note that when markets are related in consumption or production, the price in Market 2 will shift demand or supply in Market 1 and vice versa. However, prices are not exogenous because they are part of the equilibrium and are determined within the system of supply and demand equations that represent all markets included in the model. For this reason, the term “exogenous variable” is much better to use than the term “shift variable” within the context of an equilibrium model. The former implies that the value of the variable is determined outside the system. The latter just implies that the value of the variable causes a shift in one or more of the demand or supply schedules but does not indicate whether the value is determined internally or externally.
Feedback Between Markets in a General Equilibrium Model
To help you visualize feedback between markets, let us consider two markets that are related in demand but are unrelated in supply. This means the goods are either substitutes or complements to one another on the demand side of the market but are neither competing products or joint products on the supply side. Demonstration 4 depicts this situation for the case of substitutes in consumption. Use the demonstration to create a positive supply shock to Market 1. Now let us step through what happened:
1. The positive supply shock to Market 1 causes a decrease in the equilibrium price and an increase in the equilibrium quantity as predicted in Table 1.
2. Because Products 1 and 2 are substitutes in consumption, the lower price in Market 1 causes a leftward demand shift in Market 2, resulting in a lower price in Market 2 as well.
3. The lower price in Market 2 feeds back into Market 1. Because the price in Market 2 is now lower and good 2 is a substitute for good 1, this causes the demand in Market 1 to shift inward and the price in Market 1 to falls further.
A couple of points are worth mentioning here. First, it should be clear that partial equilibrium models may over or understate the true impact of a shock. In the case just examined, feedback from Market 2 amplified the actual effect of the shock to Market 1. In other words, a partial equilibrium model that only included Market 1 would understate the price effect of positive supply shock. Second, in stepping through this example, adjustments to Markets 1 and 2 were presented as a sequential process, as steps 1-3. This was mainly to reinforce the intuition of feedback from Market 2 into Market 1. In reality, steps 1-3 occur simultaneously and the feedback is bidirectional as the markets in the system adjust to the new equilibria.
Take a moment to step through Demonstration \(1\) a second time. This time, create a negative supply shock to Market 1. Notice that prices in both markets increase and feedback from Market 2 to Market 1 again amplifies the price change in Market 1 over what would be observed in a partial equilibrium model.
Demonstration \(1\). Feedback between two markets that are substitutes in consumption but unrelated in supply
Demonstration (2\) provides an example for the case of complements in consumption. Use demonstration 5 to add a positive supply shock to Market 1. Again, you see that feedback from Market 2 amplifies the resulting change in equilibrium price in Market 1. In this case, however, it is for a different reason. The initial supply shock causes the price in Market 1 to fall. Because good 2 is a complement to good 1, this causes demand in Market 2 to increase and results in a price increase in Market 2, which feeds back into Market 1. Demand in Market 1 decreases as a result of the higher price in Market 2 which amplifies the the price reduction. You can repeat the process for a negative shock to Market 1 to see that the resulting price increase in Market 1 is similarly amplified by feedback from Market 2.
The top panels of Demonstrations (1\) and (2\) are very similar. In each case, feedback between the markets amplifies the price change to Market 1. The difference lies in the effects of the initial shock on Market 2. In the case of substitutes, the price change in Market 2 is of the same direction as the price change in Market 1. In the case of complements the price in Market 2 is of the opposite direction to the price change Market 1.
Finally, note that because these markets are unrelated in supply, there is no shift to the supply schedule in Market 2. In fact, this is the only schedule that does not shift as a result of the initial supply shock to Market 1.
Demonstration (2\). Feedback between two markets that are complements in consumption but unrelated in supply | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.04%3A_Section_4-.txt |
In a model with a single market, there are two endogenous variables and two equations. You can find a unique solution for $\% \Delta P$ and $\% \Delta Q$. With multiple markets, there will be two equations (one supply equation and one demand equation) for each market. Solving for the endogenous variables becomes a bit messy unless you use matrix algebra. Let us step through the process of putting a two-market model, such as those depicted in Demonstrations 4.4.1 and 4.4.2 above, into matrix format. In the case of two markets there will be four equations.
$Supply \: in \: Market \: 1: \% \Delta Q_{1} = \phi_{11} \% \Delta P_{1} + \phi_{12} \% \Delta P_{2} + \% \Delta S_{1}$
$Demand \: in \: Market \: 1: \% \Delta Q_{1} = \varepsilon_{11} \% \Delta P_{1} + \varepsilon_{12} \% \Delta P_{2} + \% \Delta D_{1}$
$Supply \: in \: Market \: 2: \% \Delta Q_{2} = \phi_{21} \% \Delta P_{1} + \phi_{22} \% \Delta P_{2} + \% \Delta S_{2}$
$Demand \: in \: Market \: 2: \% \Delta Q_{2} = \varepsilon_{21} \% \Delta P_{1} + \varepsilon_{22} \% \Delta P_{2} + \% \Delta D_{2}$
To express these equations in matrix notation, it is first necessary to make sure terms in these equations are arranged appropriately
• First, get all the endogenous variables on the left side of the equations and all the exogenous terms on the right. There are four endogenous variables in this system. They are $\% \Delta Q_{1}$, $\% \Delta Q_{2}$, $\% \Delta P_{1}$, and $\% \Delta P_{2}$. The exogenous terms are $\% \Delta S_{1}$, $\% \Delta D_{1}$, $\% \Delta S_{2}$, and $\% \Delta D_{2}$.
• Second, there must be place for each endogenous variable in each equation. As shown above, $\% \Delta Q_{1}$ appears only in the supply and demand curves for Market 1 and $\% \Delta Q_{2}$ appears only in the supply and demand equations for Market 2. However, you can add $0 \times \% \Delta Q_{1}$ to the equations to Market 2 and $0 \times \% \Delta Q_{2}$ to the equations for Market 1 so that each endogenous variable has a place in each equation.
• Finally, each endogenous variable must appear in the same order in each equation.
An arrangement that meets all of these criteria is as follows.
$Supply \: in \: Market \: 1: \% \Delta Q_{1} + 0 \times \% \Delta Q_{2} - \phi_{11} \% \Delta P_{1} - \phi_{12} \% \Delta P_{2} = \% \Delta S_{1}$
$Demand \: in \: Market \: 1: \% \Delta Q_{1} + 0 \times \% \Delta Q_{2} - \varepsilon_{11} \% \Delta P_{1} - \varepsilon_{12} \% \Delta P_{2} = \% \Delta D_{1}$
$Supply \: in \: Market \: 2: 0 \times \% \Delta Q_{1} + \% \Delta Q_{2} - \phi_{21} \% \Delta P_{1} - \phi_{22} \% \Delta P_{2} = \% \Delta S_{2}$
$Demand \: in \: Market \: 2: 0 \times \% \Delta Q_{1} + \% \Delta Q_{2} - \varepsilon_{21} \% \Delta P_{1} - \varepsilon_{22} \% \Delta P_{2} = \% \Delta D_{2}$
Notice that each endogenous variable now appears in each equation. In each equation, $\% \Delta Q_{1}$ appears first, $\% \Delta Q_{2}$ appears second $\% \Delta P_{1}$ appears third, and $\% \Delta P_{2}$ appears fourth. It does not matter which endogenous variable appears first, second, third, or fourth so long as the order of these variables is uniform across all equations. In other words, the variable that appears first must be first in each equation, the variable that appears second must be second in each equation, and so forth. Finally, it does not matter the order of the equations. For example, you could have arranged these equations so that both supply equations were listed first followed by both demand equations, if that was your preference. This system of equations as arranged above can be expressed in matrix form as shown below.
$\begin{bmatrix} 1 & 0 & -\phi_{11} & -\phi_{12} \ 1 & 0 & -\varepsilon_{11} & -\varepsilon_{12} \ 0 & 1 & -\phi_{21} & -\phi_{22} \ 0 & 1 & -\varepsilon_{21} & -\varepsilon_{22} \end{bmatrix} \: \begin{bmatrix} \% \Delta Q_{1} \ \% \Delta Q_{2} \ \% \Delta P_{1} \ \% \Delta P_{2} \end{bmatrix} = \begin{bmatrix} \% \Delta S_{1} \ \% \Delta D_{1} \ \% \Delta S_{2} \ \% \Delta D_{2} \end{bmatrix}$
The equations are now in the form $\bf{Ax = b}$, where $\bf{A}$ is the matrix containing zeros, ones, and the elasticities of demand and supply; $\bf{x}$ is the vector of endogenous variables; and $\bf{b}$ is the vector of exogenous shocks. The solution to this system of equations is given by $\bf{x = A^{-1}b}$. Demonstration $1$, provides an example of two markets like those in depicted graphically above in Demonstrations 4.4.1 and 4.4.2. The markets in the demonstration are related in demand but not in supply. The demonstration permits you to examine a supply shock in Market 1. Like the demonstration above, you can see the role of feedback from Market 1 to Market 2 when the supply shock occurs. Take a moment to verify that you understand how the matrices in Demonstration $1$ are constructed given the data provided. Notice also that the effects of the supply shock conform to those you analyzed above in Demonstrations 4.4.1 and 4.4.2.
Demonstration $1$. An exogenous supply shock in a two market system. The markets are related in demand but unrelated in supply.
Given the following:
$\phi_{11} = 1.3; \phi_{12} = 0; \varepsilon_{11} = -1.2; \varepsilon_{12} = 0.5.$
$\varepsilon_{21} = 0; \phi_{22} = 0.9; \varepsilon_{21} = 0.6; \varepsilon_{22} = -1.4.$
The A matrix is:
$\bf{A} = \begin{bmatrix} 1 & 0 & -\phi_{11} & -\phi_{12} \ 1 & 0 & -\varepsilon_{11} & -\varepsilon_{12} \ 0 & 1 & -\phi_{21} & -\phi_{22} \ 0 & 1 & -\varepsilon_{21} & -varepsilon_{22} \end{bmatrix} = \begin{bmatrix} 1 & 0 & -1.3 & 0 \ 1 & 0 & 1.2 & -0.5 \ 0 & 1 & 0 & -0.9 \ 0 & 1 & -0.6 & 1.4 \end{bmatrix}$
The b matrix is:
$\bf{b} = \begin{bmatrix} \% \Delta S_{1} \ \% \Delta D_{1} \ \% \Delta S_{2} \ \% \Delta D_{2} \end{bmatrix} = \begin{bmatrix} 0 \ 0 \ 0 \ 0 \end{bmatrix}$
The solution matrix (x) is:
$\bf{x} = \begin{bmatrix} \% \Delta Q_{1} \ \% \Delta Q_{2} \ \% \Delta P_{1} \ \% \Delta P_{2} \end{bmatrix} = \begin{bmatrix} 0 \ 0 \ 0 \ 0 \end{bmatrix}$
Linear systems of equations can be solved easily with today’s computers. For example, R, the software used to develop An Interactive Text is an excellent package to solve these kinds of systems. Figure $1$ contains the code needed to replicate the results in Demonstration $1$ within an R session. R is a good choice for this kind of work because it is designed to do matrix operations, is open source, and is widely used across industry, government, and academia. The grey blocks in Figure $1$ are the commands you would submit to define the matrices or solve the equations. The white blocks show the output that the R commands would generate. Note that the solution in Figure $1$ matches that in Demonstration $1$ for a positive supply shock when the products are substitutes in consumption.
## The command below defines and prints the A matrix using the elasticities given in Demonstration 6
## (case of substitutes).
A<-matrix(c(1, 0, -1.3, 0,
1, 0, 1.2, -0.5,
0, 1, 0, -0.9,
0, 1, -0.6, 1.4),
nrow=4,byrow=T,
dimnames=list(c("S1","D1","S2","D2"),c("Q1","Q2","P1","P2"))
); A
## Q1 Q2 P1 P2
## S1 1 0 -1.3 0.0
## D1 1 0 1.2 -0.5
## S2 0 1 0.0 -0.9
## D2 0 1 -0.6 1.4
## The command below defines and prints the b vector for a positive 3 percent supply shock to Market 1.
b<-matrix(c(3,0,0,0),nrow=4,dimnames=list(c("S1","D1","S2","D2"),c("shock")));b
## shock
## S1 3
## D1 0
## S2 0
## D2 0
## The command below finds the solution to the system of equations and rounds it to three decimal places.
x<-round(solve(A,b),digits=3)
## The command below formats the row names and column name of the solution vector and displays it.
dimnames(x)<-list(c("Q1","Q2","P1","P2"),c("Pct.Change")); x
## Pct.Change
## Q1 1.354
## Q2 -0.297
## P1 -1.266
## P2 -0.330
Figure $1$: Using R to find the solution to a two-market equilibrium model.
Most spreadsheets are also capable of solving these kinds of linear systems. LibreOffice Calc is an open-source spreadsheet program that can take the inverse of a block of cells you define as a matrix and multiply it by a column vector thereby implementing the solution to a market equilibrium model as $\bf{x = A^{-1}}$. The spreadsheet functions needed are minverse(), to take the inverse of the $\bf{A}$ matrix and mmult(), to multiply this inverse by a block of cells containing the exogenous shocks. The minverse() and mmult() functions (or functions similar to them) are available in spreadsheet programs from commonly used proprietary office suites as well.
Given the power of today’s computers, the two-market framework presented above can be expanded to encompass any number of markets. A general system of $N$ markets would be as follows. Once the matrices have been defined, the solution can be found in exactly the same fashion as in the two market case.
$\begin{bmatrix} 1 & 0 & 0 & \cdots & 0 & -\phi_{11} & -\phi_{12} & \cdots & -\phi_{1N} \ 1 & 0 & 0 & \cdots & 0 & -\varepsilon_{11} & -\varepsilon_{12} & \cdots & -\varepsilon_{1N} \ 0 & 1 & 0 & \cdots & 0 & -\phi_{21} & -\phi_{22} & \cdots & -\phi_{2N} \ 0 & 1 & 0 & \cdots & 0 & -\varepsilon_{21} & -\varepsilon_{22} & -\varepsilon_{2N} \ \vdots & \vdots & \vdots & \: & \vdots & \vdots & \vdots & \: & \vdots \ 0 & 0 & 0 & \cdots & 1 & -\phi_{N1} & -\phi_{N2} & \cdots & -\phi_{NN} \ 0 & 0 & 0 & \cdots & 1 & -\varepsilon_{N1} & -\varepsilon_{N2} & \cdots & -\varepsilon_{NN} \end{bmatrix} \begin{bmatrix} \% \Delta Q_{1} \ \% \Delta Q_{2} \ \vdots \ \% \Delta Q_{N} \ \% \Delta P_{1} \ \% \Delta P_{2} \ \vdots \ \% \Delta P_{N} \end{bmatrix} = \begin{bmatrix} \% \Delta S_{1} \ \% \Delta D_{1} \ \% \Delta S_{2} \ \% \Delta D_{2} \ \vdots \ \% \Delta S_{N} \ \% \Delta D_{N} \end{bmatrix}$
Anymore, computational resources are generally not a limiting factor in analyzing models with many markets. Rather, accurate estimates of the elasticities needed to implement the models can often be challenging. The Food and Agricultural Policy Research Group (FAPRI) maintains models of domestic and international agricultural commodity markets and provides a database of elasticities for agricultural commodities in many regions of the world to use in their modeling efforts. For a time, USDA’s Economic Research Service compiled a database of published elasticity estimates. This is no longer an active effort, but the elasticities compiled are available on the agency’s website. In some cases, estimates of the needed elasticities will not exist or will be outdated, and it will be necessary to estimate or impute elasticities to use in a modeling problem. The model of fresh berry markets developed by Sobekova (2012) and summarized below illustrates a reasonably simple example of a situation where elasticities had to be developed to parameterize an equilibrium model.
In her MS thesis, Sobekova (2012) estimated the demand elasticities she needed to model markets for fresh berries. She used data from Nielsen on retail berry sales by week across different US cities to estimate own and cross-price elasticities of demand for strawberries, blueberries, blackberries, and raspberries. She did not directly estimate retail-level supply elasticities but was able to develop reasonable estimates of farm-level supply elasticities from earlier work. She then gathered data from USDA’s Agricultural Marketing Service on value of fresh berries at shipping-point locations and estimated the an elasticity of price transmission, $\tau_{i}$, between the farm and retail levels of the market. This allowed her to express retail-level supply elasticities as
$\phi_{i}^{R} = \tau_{i} \phi_{i}^{F},$
where superscripts R and F refer to the retail and farm levels, respectively. Elasticities used in her model are presented below in Table $1$.
Table $1$. Elasticities used in Sobekova’s (2012) model of the retail berry market
Type of berry $P_{sb}$ $P_{bb}$ $P_{bk}$ $P_{rb}$ Farm Supply Price Transmission Retail Supply
Strawberries (sb) -1.26 0.32 0.52 0.39 0.30 0.98 0.29
Blueberries (bb) 0.12 -1.49 0.24 0.20 0.22 0.40 0.09
Blackberries (bk) 0.05 0.06 -1.88 0.06 0.20 0.47 0.09
Raspberries (rb) 0.08 0.10 0.13 -1.66 0.21 0.59 0.12
Note: Demand elasticities are in the first four columns of the table and can be interpreted as the the elasticity of retail demand for the product on the row with respect to the price in column.
Notice from the table that the own-price demand elasticities are all in the elastic range. All the cross-price elasticities are positive indicating that consumers view the different types of berries as substitutes. Demonstration $2$ presents the equilibrium model in matrix form. There are eight endogenous variables as shown in the column headings for the A matrix and in the solution vector. These consist of percentage changes in four quantities and four prices, corresponding to each of the four types of berries in the model. You can control exogenous demand or supply shocks using the radio buttons in the left panel of the demonstration. Take a moment to verify how the elasticities in Table $1$ translate into matrix A in Demonstration $2$.
Use Demonstration $2$ to consider the effect of a positive supply shock to one of the markets. Make sure all demand shocks are set to zero, then add a positive supply shock to one and only one of the markets. This will increase revenue to producers in the market experiencing the positive supply shock. You can see this because the positive change in quantity is larger in magnitude than the negative change in price. The impact of the shock on producers in the remaining berry markets is negative. Demand decreases in each market not affected by the shock because the remaining berries are substitutes in demand.
Now consider the effect of a positive demand shock to one of the markets. Make sure all supply shocks are set to zero, then add a positive shock to one and only one of the markets. The impact is biggest on the market experiencing the demand shock but the spillover effects cause an increase in price and quantity in each of the related markets as well. Spend some time with the demonstration by considering other shocks to demand and or supply. if you want to test your knowledge, see if you can replicate this model in a spreadsheet or in R.
Demonstration $2$. Interactive implementation of Sobekova’s (2012) model for retail fresh berry markets.
Matrix A
Qsb Qbb Qbk Qrb Psb Pbb Pbk Prb
Supply sb 1 0 0 0 -0.29 0.00 0.00 0.00
Demand sb 1 0 0 0 1.26 -0.32 -0.52 -0.39
Supply bb 0 1 0 0 0.00 -0.09 0.00 0.00
Demand bb 0 1 0 0 -0.12 1.49 -0.24 -0.20
Supply bk 0 0 1 0 0.00 0.00 -0.09 0.00
Demand bk 0 0 1 0 -0.05 -0.06 1.88 -0.06
Supply rb 0 0 0 1 0.00 0.00 0.00 -0.12
Demand rb 0 0 0 1 -0.08 -0.10 -0.13 1.66
Vector b
Pct. Shock
Supply sb 0
Demand sb 0
Supply bb 0
Demand bb 0
Supply bk 0
Demand bk 0
Supply rb 0
Demand rb 0
Solution Vector
Pct. Change
Qsb 0
Qbb 0
Qbk 0
Qrb 0
Psb 0
Pbb 0
Pbk 0
Prb 0 | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.05%3A_Section_5-.txt |
This chapter provided an opportunity to put almost everything you have learned up to this point in the course to work. In particular, you have learned how to use elasticities of demand an supply within a modeling framework to predict the effects of an exogenous shock on the market price and quantity. You have also learned how to use elasticities to estimate the exogenous shocks that go into your model. Problems Sets and 1 and 2 below are intended to reinforce these concepts within the context of a single market.
4.7: References
Bates, C. 2016. “When Foot-and-Mouth Disease Stopped the UK in its Tracks” BBC News Magazine. Published online February 17. http://www.bbc.com/news/magazine-35581830
Paarlberg, Philip L., John G. Lee, and Ann H. Seitzinger. 2002. “Potential Revenue Impact of an Outbreak of Foot-and-Mouth Disease in the United States.” Journal of the American Veterinary Medical Association 220(7):988-92.
Paarlberg, Philip L., Ann Hillberg Seitzinger, John G. Lee, and Kenneth H. Mathews, Jr. 2008. Economic Impacts of Foreign Animal Disease. ERR-57. U.S. Dept. of Agriculture, Econ. Res. Serv. Available at: https://www.ers.usda.gov/webdocs/publications/45980/12163_err57fm_1_.pdf?v=41056
Sobekova, K. 2012. Market Analysis of Fresh Berries in the United States University of Arkansas, MS Thesis.
USDA-APHIS. 2013a. “Factsheet: Food-and-Mouth Disease.” Available at: www.aphis.usda.gov/publications/animal_health/2013/fs_fmd_general.pdf
USDA-APHIS. 2013b. “Factsheet: Protecting America From Foot-and-Mouth Disease and Other High-Consequence Livestock Diseases.” Available at: www.aphis.usda.gov/publications/animal_health/2013/fs_fmd_hcd_protection.pdf
4.8: Problem Sets
Problem Set 1: Use Elasticities for Exogneous Variables to Estimate Shocks and Changes to an Equilibrium. In this problem set you can assume that it is appropriate to treat W and M as exogenous variables.
Exercise $1$
Given the following:
$\phi_{11} = 0.5$
$\phi_{1W} = -0.15$
$\varepsilon_{11} = -1.5$
$\varepsilon_{1M} = -0.5$
$\% \Delta M = 6$
$\% \Delta W = 0$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= 0$
$\textrm{Demand Shock}: D= -3$
$\% \Delta P_{1} = -1.5$
$\% \Delta Q_{1} = -0.75$
Exercise $2$
Given the following:
$\phi_{11} = 1.5$
$\phi_{1W} = -0.25$
$\varepsilon_{11} = -1.75$
$\varepsilon_{1M} = 0.5$
$\% \Delta M = 5$
$\% \Delta W = 3$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -0.75$
$\textrm{Demand Shock}: D= 2.5$
$\% \Delta P_{1} = 1$
$\% \Delta Q_{1} = 0.75$
Exercise $3$
Given the following:
$\phi_{11} = 0.5$
$\phi_{1W} = -0.3$
$\varepsilon_{11} = -2$
$\varepsilon_{1M} = -0.4$
$\% \Delta M = 8$
$\% \Delta W = 0$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= 0$
$\textrm{Demand Shock}: D= -3.2$
$\% \Delta P_{1} = -1.28$
$\% \Delta Q_{1} = -0.64$
Exercise $4$
Given the following:
$\phi_{11} = 2$
$\phi_{1W} = -0.1$
$\varepsilon_{11} = -3$
$\varepsilon_{1M} = 0.3$
$\% \Delta M = 0$
$\% \Delta W = 8$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -0.8$
$\textrm{Demand Shock}: D= 0$
$\% \Delta P_{1} = 0.16$
$\% \Delta Q_{1} = -0.48$
Exercise $5$
Given the following:
$\phi_{11} = 0.5$
$\phi_{1W} = -0.2$
$\varepsilon_{11} = -1.5$
$\varepsilon_{1M} = 0.4$
$\% \Delta M = 5$
$\% \Delta W = 4$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -0.8$
$\textrm{Demand Shock}: D= 2$
$\% \Delta P_{1} = 1.4$
$\% \Delta Q_{1} = -0.1$
Exercise $6$
Given the following:
$\phi_{11} = 0.25$
$\phi_{1W} = -0.3$
$\varepsilon_{11} = -1.75$
$\varepsilon_{1M} = 0.5$
$\% \Delta M = 0$
$\% \Delta W = 8$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -2.4$
$\textrm{Demand Shock}: D= 0$
$\% \Delta P_{1} = 1.2$
$\% \Delta Q_{1} = -2.1$
Exercise $7$
Given the following:
$\phi_{11} = 1$
$\phi_{1W} = -0.5$
$\varepsilon_{11} = -2$
$\varepsilon_{1M} = -0.5$
$\% \Delta M = 5$
$\% \Delta W = 8$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -4$
$\textrm{Demand Shock}: D= -2.5$
$\% \Delta P_{1} = 0.5$
$\% \Delta Q_{1} = -3.5$
Exercise $8$
Given the following:
$\phi_{11} = 0.5$
$\phi_{1W} = -0.7$
$\varepsilon_{11} = -3$
$\varepsilon_{1M} = 0.4$
$\% \Delta M = 0$
$\% \Delta W = 2$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -1.4$
$\textrm{Demand Shock}: D= 0$
$\% \Delta P_{1} = 0.4$
$\% \Delta Q_{1} = -1.2$
Exercise $9$
Given the following:
$\phi_{11} = 1.5$
$\phi_{1W} = -0.5$
$\varepsilon_{11} = -1.75$
$\varepsilon_{1M} = -0.6$
$\% \Delta M = 5$
$\% \Delta W = 6$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= -3$
$\textrm{Demand Shock}: D= -3$
$\% \Delta P_{1} = 0$
$\% \Delta Q_{1} = -3$
Exercise $10$
Given the following:
$\phi_{11} = 0.75$
$\phi_{1W} = -0.2$
$\varepsilon_{11} = -1.75$
$\varepsilon_{1M} = -0.4$
$\% \Delta M = 7$
$\% \Delta W = 0$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S= 0$
$\textrm{Demand Shock}: D= -2.8$
$\% \Delta P_{1} = -1.12$
$\% \Delta Q_{1} = -0.84$
Problem Set 2: Use Per Unit Cost or Valuation Estimates to Compute Shocks and Changes to an Equilibrium
Exercise $1$
Given the following:
$\phi_{11} = 1.5$
$\varepsilon_{11} = -1$
$\textrm{Per unit change in production cost is } 8 \%$
$\textrm{Per unit change in willingness to pay is } = 3 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = -12$
$\textrm{Demand Shock}: D = 3$
$\% \Delta P_{1} = 6$
$\% \Delta Q_{1} = -3$
Exercise $2$
Given the following:
$\phi_{11} = 1$
$\varepsilon_{11} = -2$
$\textrm{Per unit change in production cost is } 0 \%$
$\textrm{Per unit change in willingness to pay is } = -6 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 0$
$\textrm{Demand Shock}: D = -12$
$\% \Delta P_{1} = -4$
$\% \Delta Q_{1} = -4$
Exercise $3$
Given the following:
$\phi_{11} = 0.5$
$\varepsilon_{11} = -2$
$\textrm{Per unit change in production cost is } 6 \%$
$\textrm{Per unit change in willingness to pay is } = 7 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = -3$
$\textrm{Demand Shock}: D = 14$
$\% \Delta P_{1} = 6.8$
$\% \Delta Q_{1} = 0.4$
Exercise $4$
Given the following:
$\phi_{11} = 2$
$\varepsilon_{11} = -6$
$\textrm{Per unit change in production cost is } -2 \%$
$\textrm{Per unit change in willingness to pay is } = -3 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 4$
$\textrm{Demand Shock}: D = -18$
$\% \Delta P_{1} = -2.75$
$\% \Delta Q_{1} = -1.5$
Exercise $5$
Given the following:
$\phi_{11} = 2$
$\varepsilon_{11} = -3$
$\textrm{Per unit change in production cost is } 0 \%$
$\textrm{Per unit change in willingness to pay is } = 5 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 0$
$\textrm{Demand Shock}: D = 15$
$\% \Delta P_{1} = 3$
$\% \Delta Q_{1} = 6$
Exercise $6$
Given the following:
$\phi_{11} = 1.5$
$\varepsilon_{11} = -1.75$
$\textrm{Per unit change in production cost is } -5 \%$
$\textrm{Per unit change in willingness to pay is } = -5 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 9$
$\textrm{Demand Shock}: D = -10.5$
$\% \Delta P_{1} = -6$
$\% \Delta Q_{1} = 0$
Exercise $7$
Given the following:
$\phi_{11} = 1$
$\varepsilon_{11} = -4$
$\textrm{Per unit change in production cost is } -4 \%$
$\textrm{Per unit change in willingness to pay is } = 0 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 4$
$\textrm{Demand Shock}: D = 0$
$\% \Delta P_{1} = -0.8$
$\% \Delta Q_{1} = 3.2$
Exercise $8$
Given the following:
$\phi_{11} = 2$
$\varepsilon_{11} = -3$
$\textrm{Per unit change in production cost is } -6 \%$
$\textrm{Per unit change in willingness to pay is } = 0 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = 12$
$\textrm{Demand Shock}: D = 0$
$\% \Delta P_{1} = -2.4$
$\% \Delta Q_{1} = 7.2$
Exercise $9$
Given the following:
$\phi_{11} = 1.5$
$\varepsilon_{11} = -1.75$
$\textrm{Per unit change in production cost is } 5 \%$
$\textrm{Per unit change in willingness to pay is } = 5 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = -7.5$
$\textrm{Demand Shock}: D = 8.75$
$\% \Delta P_{1} = 5$
$\% \Delta Q_{1} = 0$
Exercise $10$
Given the following:
$\phi_{11} = 0.5$
$\varepsilon_{11} = -0.75$
$\textrm{Per unit change in production cost is } 6 \%$
$\textrm{Per unit change in willingness to pay is } = -7 \%$
What is the supply shock?
What is the demand shock?
What is the change in equilibrium price?
What is the change in equilibrium quantity?
Answer
$\textrm{Supply Shock}: S = -3$
$\textrm{Demand Shock}: D = -5.25$
$\% \Delta P_{1} = -1.8$
$\% \Delta Q_{1} = -3.9$
Problem Set 3: Multiple Choice
Exercise $1$
1. Which best describes a market equilibrium?
a) A price such that quantity supplied equals quantity demanded.
b) The confluence of exogenous factors that alter conditions within the market in question.
c) Forces that cause changes in price and or quantity in a market.
d) A situation where prices reach what many consider to be reasonable levels. For instance, the market for gasoline has finally returned to an equilibrium after several years of high prices.
Answer
a
Exercise $2$
1. In equilibrium models, endogenous variables
a) Are variables that cause shifts in the demand and supply curves.
b) Are prices and quantities in the markets being analyzed.
c) Are non-existent because all variables are exogenous in these models.
d) Are difficult to measure but still affect the equilibrium (e.g., changes in preferences).
Answer
b
Exercise $3$
1. If you are modeling a market equilibrium and you need to account for feedback from other markets or sectors of the economy then you should be using
a) A partial equilibrium model.
b) A feedback accountability model.
c) A general equilibrium model.
d) A model that forces cross-price elasticities to be negative.
Answer
c
Exercise $4$
1. Consider a single market. Which would be most likely to cause an increase in both the equilibrium price and the equilibrium quantity?
a) A positive supply shock
b) A decrease in consumer incomes, assuming demand is for an inferior good
c) A decrease in consumer incomes, assuming demand is for a normal good
d) A negative supply shock
Answer
b
Use the scenario below to answer questions 5 - 8.
Two products are substitutes in consumption and are unrelated in production. The Ukraine is a major supply source for Product 1. Given the current conflict in Eastern Ukraine, the supply for Product 1 (Market 1) shifts inwards (to the left).
Exercise $5$
1. Which of the following do you know will happen in Market 1?
a) Equilibrium quantity in Market 1 will increase
b) Equilibrium price in Market 1 will decrease
c) Equilibrium price in Market 1 will increase
d) Both a and c
Answer
c
Exercise $6$
1. Which of the following do you know will happen in Market 2?
a) Nothing because the supply shock was in Market 1.
b) Equilibrium price in Market 2 will increase
c) Equilibrium price in Market 2 will decrease
d) Equilibrium quantity in Market 2 will increase
e) Both b and d.
Answer
e
Exercise $7$
1. After considering feedback between these two markets. Which, if any, of the following schedules have not shifted once a new equilibrium is reached?
a) Supply in Market 1
b) Supply in Market 2
c) Demand in Market 1
d) Demand in Market 2
e) All of the above schedules have shifted
Answer
b
Exercise $8$
1. Which best describes the exogenous shock in this situation?
a) The conflict that led to the supply shift to Market 1
b) The change in equilibrium price in Market 1
c) The feedback from Market 2 into Market 1
d) All of the above.
Answer
a
Use the diagram below to answer questions 9 - 12.
Exercise $9$
1. Point D only
2. Points C, D, and E
3. Points B and A
4. Points C and E
5. None of the points
Answer
c
Exercise $10$
1. In which cases do you know for certain that demand has increased relative to the original equilibrium at point I?
a) Point B
b) Points C and E
c) Points B and A
d) Points A
e) None of the points
Answer
a
Exercise $11$
1. In which cases do you know for certain that supply has decreased relative to the original equilibrium at point I?
a) Point B
b) Points C and E
c) Points B and A
d) Points A
e) None of the points
Answer
b
Exercise $12$
1. In which cases do you know for certain that both demand and supply have shifted from the original equilibrium at point I?
a) Point B
b) Points C and E
c) Points B and A
d) Points A
e) None of the points
Answer
e | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/04%3A_Market_Equilibrium_and_Equilibrium_Modeling/4.06%3A_Section_6-.txt |
Learning Objectives
• You may have encountered the idea of popular sovereignty in a civics or political science course. This means that the people rule, as opposed to a monarch, dictator, clique of oligarchs, religious authorities, etc. When it comes to the economy, it is often said that consumers are sovereign. Consumer sovereignty is the idea that consumer choices rule the economy. A firm that provides a product or service that better meets consumer wants and needs is likely to succeed and be profitable. A firm that fails to do so will not remain in business very long, or so the theory goes. Evidence that businesses recognize the importance of consumer sovereignty is provided by placards common in many workplaces reminding employees that “the customer is always right.” This notion is also encapsulated in the Latin phrase, De gustibus non disputatum est, which translates into English as “tastes are not disputable”.
Consumer sovereignty helps explain the breadth of production and marketing activities observed in the economy. To illustrate, consider children’s breakfast cereals. Lots of money is spent on the packaging and promotion of these products. Even if it can be assumed that these cereals are good for children, a critic might argue that everyone would be better off if an entity was set up to simply take flour from oats, rice, corn, or wheat; add sugar and a binding agent; pellet it; and distribute it to families with children. Children would get the same nutrition regardless of whether there was a friendly looking pirate on the box and a cheap toy inside. The critic could argue that all the money that is spent on promoting these products is wasteful and contributes nothing to the nutritional well-being of children. These resources could instead be better used for a worthwhile cause like cancer research or public education. This critic may have a point, but consumer sovereignty suggests that if parents continue to vote with their purchases in favor of branded breakfast cereals (or if children have the power to influence their parents to do so), breakfast cereal companies will exist to meet this demand.
If consumers are sovereign, then it is probably a good idea to consider models of consumer behavior in a course like this. The aim of this chapter is to provide an overview of some economic theories of the consumer. The first section addresses the neoclassical theory of the consumer. Two extensions of this theory that have particular resonance in food markets are covered next. One is Lancaster’s (1966) model, which emphasizes products as delivery mechanisms for characteristics. The other, Becker’s (1965) model, theorizes that market-sourced products are inputs for household production activities. All three of three of these models – the Neoclassical model, Lancaster’s model, and Becker’s model – are based on the idea that consumers are rationale. They know what they want and what is available. Moreover they can make choices that are best for them given what they are able to afford. The primary objectives of this chapter are as follows:
• Explain the main logic of consumer choice theory in terms of preferences and budget sets.
• Graph budget sets and budget frontiers, given price and income data, and explain what happens to the budget set as prices and/or income change.
• Outline the basic assumptions required for well-behaved preferences. Given a specific example, be able to determine whether these assumptions are satisfied.
• Describe the difference between ordinal utility and cardinal utility.
• Graphically derive individual demand functions.
• Diagram efficient consumption frontiers (Lancaster-type budget constraints) and identify products that are and are not competitive.
• Analyze how changes in price, income, and product characteristics affect consumer choice in Lancaster’s framework.
• Describe hedonic pricing models and identify characteristics to be included in a hedonic pricing model for a given product.
• Derive the full-time income constraint of Becker’s model.
• Use the logic of Becker’s model to explain consumer valuation of time-saving (convenience) built into food products.
• Use the logic of Lancaster’s and Becker’s models to analyze trends in food consumption.
05: Consumer Theory and Models
You may have encountered the idea of popular sovereignty in a civics or political science course. This means that the people rule, as opposed to a monarch, dictator, clique of oligarchs, religious authorities, etc. When it comes to the economy, it is often said that consumers are sovereign. Consumer sovereignty is the idea that consumer choices rule the economy. A firm that provides a product or service that better meets consumer wants and needs is likely to succeed and be profitable. A firm that fails to do so will not remain in business very long, or so the theory goes. Evidence that businesses recognize the importance of consumer sovereignty is provided by placards common in many workplaces reminding employees that “the customer is always right.” This notion is also encapsulated in the Latin phrase, De gustibus non disputatum est, which translates into English as “tastes are not disputable”.
Consumer sovereignty helps explain the breadth of production and marketing activities observed in the economy. To illustrate, consider children’s breakfast cereals. Lots of money is spent on the packaging and promotion of these products. Even if it can be assumed that these cereals are good for children, a critic might argue that everyone would be better off if an entity was set up to simply take flour from oats, rice, corn, or wheat; add sugar and a binding agent; pellet it; and distribute it to families with children. Children would get the same nutrition regardless of whether there was a friendly looking pirate on the box and a cheap toy inside. The critic could argue that all the money that is spent on promoting these products is wasteful and contributes nothing to the nutritional well-being of children. These resources could instead be better used for a worthwhile cause like cancer research or public education. This critic may have a point, but consumer sovereignty suggests that if parents continue to vote with their purchases in favor of branded breakfast cereals (or if children have the power to influence their parents to do so), breakfast cereal companies will exist to meet this demand.
If consumers are sovereign, then it is probably a good idea to consider models of consumer behavior in a course like this. The aim of this chapter is to provide an overview of some economic theories of the consumer. The first section addresses the neoclassical theory of the consumer. Two extensions of this theory that have particular resonance in food markets are covered next. One is Lancaster’s (1966) model, which emphasizes products as delivery mechanisms for characteristics. The other, Becker’s (1965) model, theorizes that market-sourced products are inputs for household production activities. All three of three of these models – the Neoclassical model, Lancaster’s model, and Becker’s model – are based on the idea that consumers are rationale. They know what they want and what is available. Moreover they can make choices that are best for them given what they are able to afford. The primary objectives of this chapter are as follows:
• Explain the main logic of consumer choice theory in terms of preferences and budget sets.
• Graph budget sets and budget frontiers, given price and income data, and explain what happens to the budget set as prices and/or income change.
• Outline the basic assumptions required for well-behaved preferences. Given a specific example, be able to determine whether these assumptions are satisfied.
• Describe the difference between ordinal utility and cardinal utility.
• Graphically derive individual demand functions.
• Diagram efficient consumption frontiers (Lancaster-type budget constraints) and identify products that are and are not competitive.
• Analyze how changes in price, income, and product characteristics affect consumer choice in Lancaster’s framework.
• Describe hedonic pricing models and identify characteristics to be included in a hedonic pricing model for a given product.
• Derive the full-time income constraint of Becker’s model.
• Use the logic of Becker’s model to explain consumer valuation of time-saving (convenience) built into food products.
• Use the logic of Lancaster’s and Becker’s models to analyze trends in food consumption. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.01%3A_Section_1-.txt |
The basic idea behind consumer choice theory is very simple: The consumer seeks to obtain the best bundle of goods and services that he or she possibly can (Varian 1993). This is true of the neoclassical theory covered in this section as well as the extension to the theory to be described below. In deciding what is the best bundle of goods and services, economists generally assume that the consumer has preferences that can be represented by a utility function. The utility function assigns a number to a given bundle of goods and services. A bundle that the consumer likes more is assigned a higher number. A bundle that the consumer likes less is assigned a lower number. A utility function formalizes the idea that consumers have the ability to rank various bundles of goods and services in terms of their desirability.
Preferences represented by a utility function determine the “best” bundle of goods and services. However, think carefully about the fundamental idea that a consumer chooses the best bundle of goods and services that he or she possibly can. The “possibly can” part of the idea is very important. A consumer’s best bundle might include several multimillion-dollar homes: one at a ski resort in the Rockies or Alps, one on the north shore of Lake Superior (for summer months), and one in the Virgin Islands (for winter months when not on the ski slopes). Of course, the best bundle would also include a private jet to take the consumer wherever he or she fancied. Very few people could obtain this best bundle. This is because the dollars consumers have to spend is limited by their available income.
We could reformulate our fundamental idea in terms of economic jargon as follows: consumers maximize their utility subject to a budget or income constraint. The utility function determines what is best. The budget or income constraint determines the set of possible bundles that the consumer can obtain.
Budget Sets in the Neoclassical Model
The budget set contains all combinations of goods that the consumer can afford. In this course, simple budget sets that include only two goods will be used. Such a simplification may not work well in empirical applications using real-world data because each consumer probably has hundreds, if not thousands, of possible goods in their budget set (just think about the wide variety of goods available in any supermarket, department store, or online retailer). However, all models are simplifications, and in terms of understanding consumer choice behavior, a two-good world can get you a long way. With a simple two-good world you can develop an understanding of the essential logic of the consumer choice model. Simplifying the world to only two goods also allows the consumer’s choice space to be represented graphically (as in Demonstration 1 below).
Algebraically, the budget set is defined over the quantities of the two goods, $Q_{1}$ and $Q_{2}$ as all pairs:
${Q_{1}, Q_{2}}: P_{1}Q_{1} + P_{2}Q_{2} \leq M,$
where $P_{1}$ and $P_{2}$ are prices of goods 1 and and 2, respectively, and $M$ is the consumer’s income. The budget set simply states that the amount spent on good 1 plus the amount spent on good 2 must be less than the consumer’s income.
The budget frontier consists of those bundles that completely exhaust the consumer’s income. In the expression for the budget set above, replace the inequality with an equal sign and you have those points that comprise the budget frontier. Because $Q_{2}$ will be on the vertical axis this expression for $Q_{2}$. This is the equation for the budget frontier:
$Q_{2} = \dfrac{M}{P_{2}} - \dfrac{P_{1}}{P_{2}} Q_{1}.$
An example budgets set is presented in Demonstration $1$. Note that this is a line with a vertical intercept of $\dfrac{M}{P_{2}}$ and a slope of $-\dfrac{P_{1}}{P_{2}}$
There is an easy way to graph the budget set in a two-good economy. The vertical intercept is where the consumer spends all of his or her income on good 2. You only need to ask how many units of good 2 the consumer could afford if the entire budget went to good 2. The answer is $\dfrac{M}{P_{2}}$. The horizontal intercept can similarly be found be asking how many units of good 1 could be obtained if the consumer spend all his/her money on good 1, which is $\dfrac{M}{P_{1}}$. Thus if you know $M$, $P_{1}$, and $P_{2}$, you can, in a matter of seconds, graph the consumer’s budget frontier. Simply divide $M$ by $P_{2}$ to get your vertical intercept, divide $M$ by $P_{1}$ to get your horizontal intercept, and connect the dots. It is as easy as that! You now have your frontier. The budget set is comprised of the points on the frontier and the points south and west of the frontier.
Demonstration $1$. The Budget Set
First, use Demonstration $1$ to see what happens to the budget set when $P_{1}$ and/or $P_{2}$ changes. Start by increasing one of the prices, $P_{1}$ or $P_{2}$, but not both. The price increase changes the slope of the frontier because the intercept for the axis with the now higher-priced good moves towards the origin. The entire budget set becomes smaller. You will see a triangular area comprised of points that the consumer was able to afford before the price increase but can no longer afford afterwards. Now, go ahead and increase the other price as well. This further contracts the budget set. Finally, set the prices back to their initial values. Repeat the process for a price decrease and note what happens to the budget set. The takeaway here is that price changes affect both the size of the budget set and slope of the budget frontier.
Second, use Demonstration $1$ to evaluate a change in income ($M$). Decrease the consumer’s income in the demonstration and notice that both the vertical and horizontal intercepts contract towards the origin. The budget frontier line makes a parallel shift to the southwest. The entire budget set becomes smaller. Repeat the process for an increase in income and note what happens to the budget set. The conclusion to be drawn is that a change in income affects the size of budget set but not the slope of the budget frontier.
Preferences in the Neoclassical Model
A budget set identifies what bundles are affordable to a consumer. The fundamental idea behind consumer theory is that a consumer will choose the best bundle from this set. Just what this “best” bundle is depends on the consumer’s preferences. To facilitate a discussion of preferences, it will be useful to introduce some preference relations that we can use to indicate how the consumer views different bundles. These relations are defined in Table $1$.
Table 1. Preference Relations
Relation Name Example Interpretation
$\approx$ Indifference $x \approx y$ $x$ is indifferent to $y$
$\succeq$ Weakly preferred $x \succeq y$ $x$ is at least as good as $y$
$\succ$ Strictly preferred $x \succ y$ $x$ is better than $y$
Representing Preferences Graphically
In introductory microeconomics, you probably learned about indifference curves (they might also have been called iso-utility curves). Figure $1$ presents indifference curves that represent a consumer’s preferences. Each labeled point in Figure $1$ represents a bundle of the two goods. The curves are called indifference curves because they represent bundles that the consumer likes equally well. Unless, you are instructed otherwise, you are to assume that points on indifference curves to the northeast are increasingly preferred. For instance, E is preferred to all labeled bundles on this diagram because it lies on the indifference curve that is furthest northeast. Based on Figure $1$, it is possible to make the following statement about the five labeled bundles:
$E \succ D \approx C \succ B \approx A.$
Given the preference relations defined above, the following are also true, although less precise, statements of the preference ordering for the consumer with the preference map in Figure $1$:
$E \succeq D \succeq C \succeq B \succeq A,$
and
$E \succeq C \succeq D \succeq A \succeq B$
Utility Functions
A preference map, such as that in Figure $1$, is a two-dimensional representation of a utility function. The important thing about a utility function is that it assigns numbers that indicate the consumer’s strength of preference for a given bundle. If the consumer likes bundle C more than bundle A, then a utility function would assign a higher number to bundle C and a lower number to bundle A. If the consumer likes bundle B just as much as bundle A, then the utility function would assign the same number to both bundles A and B. There is an important concept here. This concept is that a utility function provides an ordinal (not cardinal) ranking of preferences. With an ordinal utility function, one does not particularly care about the utility number itself, only that higher numbers are assigned to bundles the consumer likes more, lower numbers to bundles the consumer likes less, and that the same number is assigned to bundles the consumer likes equally well.
Figure $2$ depicts a utility function. The function is in blue tones and shows the level of utility corresponding to different combinations of goods 1 and 2. The horizontal plane in the figure, depicted in green, intersects the utility function at a specified height. The intersection between the plane and function provides all combinations of goods 1 and 2 that provide the consumer with level of utility equal to the height of the plane. If you were to look at the utility function directly from above, you would see that the intersection of the plane with the function maps out an indifference curve. Thus, an indifference curve map, such as that shown in Figure $1$, is actually a two dimensional representation of a three dimensional phenomenon. Each indifference curve depicts a given height on the utility function.
Assumptions About Preferences
There are several assumptions that are commonly made about preferences. These assumptions simplify the consumer’s choice problem and also result in individual demand equations that conform to the law of demand.
Preferences are complete. If preferences are complete, it means that the consumer is able to rank bundles. This is not unreasonable assumption in most cases. If you were given a choice between two packages of almonds with one apple (bundle A) or one package of almonds with two apples (bundle B), you could probably indicate which bundle you most preferred or whether you were indifferent between the two.
Preferences are transitive. Transitive preferences simply mean that if $C \succeq B$, and $B \succeq A$, then it must be that $C \succeq A$. Like completeness, transitivity is a fairly straightforward assumption. The transitivity assumption assures that indifference curves will never intersect one another.
That preferences are reflexive and continuous are additional basic assumptions about preferences which are important to formal mathematical treatment of consumer theory but are of less practical importance in a course like this. The important thing is that if preferences are complete, transitive, reflexive, and continuous; there is an ordering of preferences that can be represented by a utility function (Varian 1992). It is common to make two additional assumptions about preferences and these are of more practical importance in this course. The first is that preferences are convex and the second is that preferences are monotonic.
Preferences are convex. Convexity is a common assumption made about preferences. Given (1) the consumer likes bundle A exactly as much as bundle B $(A \approx B)$, and (2) bundle A is not the same bundle as bundle B ($A \neq B$), preferences are strictly convex if the consumer prefers an average bundle $C = 0.5A + 0.5B$ to either bundle A or B by itself. Convexity implies that consumers like to have variety in their consumption. Another way to say this is that “means are preferred to extremes.”
In most cases, convexity is a reasonable assumption. It is actually hard to come up with cases where convexity might not hold. Suppose, for example, that a consumer likes cocktail olives and that the consumer also like chocolate ice cream. However, ice cream does not pair well with olives and so the the consumer does not like to have cocktail olives with his/her ice cream. In this case, you might argue that the consumer would prefer an extreme bundle (all cocktail olives or all ice cream) to a mean bundle (some cocktail olives and some ice cream) and his or her preferences would not be convex. This example is a bit stretched, however. It assumes that that the consumer would somehow be forced to eat cocktail olives and ice cream at the same time. Why could he or she not eat the ice cream now and save the olives for later? Over the course of the day, the consumer may want to have something sweet with lunch (ice cream) and something savory with supper (cocktail olives). Thus, even though he or she does not like cocktail olives and ice cream at the same time, preferences are still convex because the consumer likes a variety of sweet and savory foods over the course of a day.
Preferences are monotonic. The second additional assumption is that preferences are monotonic. Monotonicity simply means that the consumer prefers bundles with more goods to bundles with less. Given two bundles, bundles A and B, monotonicity means the consumer prefers B to A if:
1. B contains at least as much of each good as does A, and
2. B contains strictly more of at least one good than does A.
Is monotonicity a reasonable assumption? At first glance it would seem that it is not because there are some goods where too much of a good becomes a bad. For example, after eating two sandwiches, the consumer could be sick, literally, if forced to eat a third. That said, an argument can be made that monotonicity is a very reasonable assumption for models of the consumer. This is because consumers make market choices only in regions where their preferences are monotonic. For example, if a consumer is waiting in line to purchase a sandwich it is a pretty good assumption that an additional sandwich is something he or she wants and that preferences are monotonic at least with respect to one more sandwich. In short, consumers are only in the market when they want more of a good or when they have monotonic preferences for the good in question. The goal of the consumer model is to provide a reasonable approximation to what occurs in the real world. If, in the real world, consumers are only making choices in regions where monotonicity holds, then it is a reasonable to assume monotonicity for preferences used in the consumer model.
Choice in the Neoclassical Model
Having covered budget sets and preferences in some detail, let us now return to the basic idea of consumer theory: Consumers choose the best bundle of goods and services that they possibly can. The “best” part of the idea is given by preferences. The “possibly can” part of the idea is determined by budget sets. In the parlance of the model, the consumer’s problem is to achieve the highest indifference curve possible given the budget set.
Figure $3$ provides a graphical illustration of the consumer’s choice problem. Points A, B, and C are on the frontier of the budget set. At each of these points, the consumer is exhausting all of his/her income. Only point C, however, is optimal. Given convexity, point C is preferred to either A or B. As a result, our utility function places point C on a higher indifference curve. In fact, it is not possible to find a point within the consumer’s budget set that is preferred to point C. Thus, point C is the best bundle that the consumer can afford. At point C, the indifference curve is tangent to the budget frontier line.
Again, Figure $3$ is a two-dimensional representation of a three-dimensional phenomenon. Figure $4$, depicts the utility function (blue-toned surface). The yellow-toned vertical plane intersecting the utility function is the budget constraint. The consumer cannot afford points and corresponding levels of utility that lie to the right of this vertical budget plane. The consumer’s goal is to reach the highest elevation on the utility function possible. In Figure $4$, this highest level is shown by the purple point. The green-toned horizontal plane is set to the elevation of the affordable point that provides the greatest utility. If the model were to be viewed directly from above, this three-dimensional model would look very similar to the two-dimensional model in Figure $3$. You would see an indifference curve that is created by the intersection of the green horizontal plane and the utility function. This indifference curve would just touch the vertical budget plane at the optimal point.
Individual Demand Curves
The theory of consumer choice, the idea that the consumers seek the highest point on their utility function given an affordability constraint, can be used to generate demand curves. This is illustrated in Demonstration $2$ below. Notice that as $P_{1}$ increases, the consumer’s budget set becomes smaller and his or her optimal choice changes to include a smaller amount of $Q_{1}$. Conversely as $P_{1}$ decreases, the consumer’s budget set becomes larger and his or her optimal choice includes a larger amount of $Q_{1}$. The lower panel of the demonstration depicts a mapping of the optimal choices of $Q_{1}$ corresponding to different levels of $P_{1}$, holding $P_{2}$ and $M$ constant. The result is a nice, downward sloping, demand schedule. As you change the value of $P_{1}$ in the demonstration, be sure to note the relationship between the choice model in the upper panel and the demand schedule in the lower panel.
Anything aside from own-price that effects the budget sets or the preference map shifts the individual demand curve. For example, in Demonstration $2$, you can change the level of income. As you do this, notice that the budget set changes and the demand curve shifts. In general, any variable, aside from own-price, that affects the budget set or that effects the preference map will shift the individual’s demand schedule.
Demonstration $2$. The Choice Model and the Consumer’s Individual Demand Schedule | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.02%3A_Section_2-.txt |
In the neoclassical model of consumer choice described above, the consumer has preferences that can be represented by a utility function. The solution to the consumer’s choice involves a constrained optimization problem wherein the consumer seeks the bundle that returns the highest utility possible given his or her budget set. The benefit of the neoclassical model is that it provides a framework for examining the role of price changes, income changes, and (in some cases) preference changes on consumer behavior. You saw in Demonstration 5.2.2, for example, that given some reasonable assumptions, the solution to the neoclassical choice model results in demand functions that are downward sloping in own-price and that could depend on prices of related substitute and complement goods as well as consumer income.
An alternative formulation of the consumer’s choice problem is provided by Lancaster (1966). This model is similar to the neoclassical model in that it relies on the same basic premise: Consumers seek the best bundle of goods given an affordability constraint. However, it differs from the neoclassical model in terms of how preferences and budget sets are formulated.
Preferences in the Lancaster Model
The essential difference in the Lancaster model is that the consumer views a purchased good as a bundle of characteristics. For example, the consumer is not interested in a half gallon of orange juice per se. Rather he or she is interested in characteristics such as vitamin C, potassium, a sweet and tart taste sensation, carbohydrates for energy, dietary fiber, etc. The consumer could satisfy the desire for these characteristics through orange juice or through several other products. For example, grapefruit juice might provide similar micro-nutrient characteristics to orange juice but would differ in terms of the taste characteristics provided (less sweet with a slightly bitter aftertaste) and macro-nutrients (perhaps slightly fewer calories). Concord grape juice would lack the tartness of orange juice, provide a taste sensation that is more sweet, would likely contain more calories, provide more or less of certain micro-nutrients, and would provide a mouth-feel different from either orange juice or grapefruit juice. The point to be made here is that orange juice, grapefruit juice, and Concord grape juice are more than just products, they are delivery mechanisms for a variety of characteristics that the consumer may value.
Utility in the Lancaster Model
In Lancaster’s model, the consumer has preferences that can be represented by a utility function. However, preferences and utility levels are defined in terms of characteristics of purchased goods and services. A utility function in Lancaster’s framework can be defined as follows:
\(U = f(c_{11}, c_{12}, c_{13}, \cdots, c_{1N}, c_{21}, c_{22}, c_{23}, \cdots, c_{2N}, \cdots, c_{M1}, c_{M2}, C_{M3}, \cdots, c_{MN}),\)
where \(c_{ij}\) is the amount of the \(i^{th}\) characteristic contained in one unit of the \(j^{th}\) purchased good, \(i = 1, 2, 3, \cdots, M\) and \(j = 1, 2, 3, \cdots, N.\)
For example, it would be possible to identify and measure characteristics in three juice products: orange juice (\(Q_{1}\)) , grapefruit juice (\(Q_{2}\)), and Concord grape juice (\(Q_{3}\)). Suppose, for simplicity, that consumers care only about two characteristics: sweetness (characteristic 1) and tartness (characteristic 2). In this case, the \(c_{ij}\) terms in the consumer’s utility function would be interpreted as follows:
• \(c_{11}\) = the amount of characteristic 1 (sweetness) in product 1 (orange juice)
• \(c_{12}\)= the amount to characteristic 1 (sweetness) in product 2 (grapefruit juice)
• \(c_{13}\) = the amount of characteristic 1 (sweetness) in product 3 (Concord grape juice)
• \(c_{21}\) = the amount of characteristic 2 (tartness) in product 1 (orange juice)
• \(c_{22}\)= the amount characteristic 2 (tartness) in product 2 (grapefruit juice)
• \(c_{23}\)= the amount of characteristic 2 (tartness) in product 3 (Concord grape juice)
The formulation of preferences in the Lancaster model clearly has implications for product design and marketing. Within one single product, there can be the opportunity to adjust characteristics being offered to consumers with different tastes. For example, consider ready-to-serve orange juice in the typical supermarket. You will see variations in terms of pulp, whether the product is from concentrate, and whether the product has been fortified with other nutrients not naturally found in orange juice (e.g., calcium). Basically, food marketers understand that altering the characteristics of a product can make it more attractive to certain consumer segments.
The Lancaster model does assume that the characteristics that are of interest to consumers can be measured. In many cases, this would be straightforward. For example, consider an automobile. Characteristics that might be important to the consumer include horsepower, fuel efficiency, head room, leg room, number of doors, whether the vehicle is four-wheel drive, and so forth. Some characteristics that are important to the consumer such as reliability and smoothness of ride might be more difficult to measure. However, there are third-party entities that provide ratings for experience characteristics like reliability and handling. Moreover, the consumer will generally test drive the vehicle to assess some of these characteristics before purchase. In the case of food products, sensory labs with specialized equipment and trained sensory panelists can provide quantitative measures of characteristics such as texture, firmness, mouth-feel, aftertastes, and other attributes of the product.
Budget Sets in the Lancaster Model
Provided that characteristics can be measured, it is possible to construct a budget constraint for the Lancaster model. Remember that in the Lancaster model, consumers care about characteristics. Purchased goods matter to the consumer only because of the characteristics contained therein. In other words, utility is derived indirectly from purchased goods and services. This being the case, the budget constraint for Lancaster’s model needs to reflect the amount of characteristics the consumer can afford.
Figure \(1\) provides a diagram of a Lancaster-type budget set for two characteristics. Following the earlier conventions, let \(P_{1}\) and \(P_{2}\) be the prices of products 1 and 2, respectively, and let M be the consumer’s budget. Notice that in Figure \(1\), the characteristics are on the vertical and horizontal axis. The consumer cannot buy characteristics directly, but obtains characteristics by purchasing products 1 and 2. Thus, the affordable amounts of products 1 and 2 need to be converted into the characteristics they deliver. In Figure \(1\), each purchased good is a vector extending from the origin. The affordable set of characteristics in Figure \(1\) is contained within the triangular shaped area inside the two product vectors and the red line segment connecting the endpoints of the two vectors. The consumer can obtain any point inside this triangle by buying goods 1 and 2 in the appropriate combination. The efficient consumption frontier (in red) consists of combinations of products that provide the most characteristics for the consumer’s dollar. This efficient consumption frontier is analogous to the budget frontier in the neoclassical model.
Choice in the Lancaster Model
In the Lancaster Model, the consumer’s optimal choice is the bundle of goods that provides the combination of characteristics that provide him or her with the highest level of utility given the affordability constraint. If the consumer has monotonic preferences over the two preferences, this choice will occur somewhere on the efficient consumption frontier. In Figure \(2\), a consumer’s indifference curves are imposed over the affordable set, and the optimal choice occurs at point E. In this particular example, the consumer spends half of his or her budget on good 1 and half on good 2. This happens to occur at a tangency between the line segment constituting the efficient consumption frontier and the consumer’s indifference curve. However, optimal choices need not be points of tangency in the Lancaster model even if preferences are monotonic and convex over the characteristics. Had these preferences been drawn differently, the optimal choice could have occurred at one of the product vector endpoints. You will see this in the example that follows.
An Example
Consider the fictional characteristic and price data for red delicious (RD) and golden delicious (GD) apples as presented in Table \(1\). As should be clear from the table, RD apples are sweeter than GD apples but GD apples are crispier than RD apples in this example. Consider a consumer who purchases apples because he or she values the attributes of sweetness and crispiness.
Table \(1\). Fictional Characteristic and Price Data for the Apple Example
Characteristic Red Delicious (RD) Apple Golden Delicious (GD) Apple
Crispiness 1 unit 2 units
Sweetness 2 units 1 unit
The information in Table \(1\) is reflected below in Demonstration \(1\). As shown in the demonstration, the price of each type of apple is initially \$6 per unit and the consumer has an initial budget of \$30 that is used to purchase apples (\(M = \$30\)). If the consumer spends all of the \$30 budget on RD apples, he or she could obtain five RD apples in total. Multiplying this total by the value of the characteristics per apple indicates that these five RD apples would provide a total of five units of crispiness and 10 units of sweetness. Similarly, if the consumer spends all the budget on GD apples, he or she could obtain five GD apples in total, which would provide 10 units of crispiness and five units of sweetness. This sets up the initial values in the demonstration.
Demonstration \(1\). Efficient Consumption Frontier for Example of RD and GD Apples
Use Demonstration \(1\) to adjust the income and the price of the apples. Make note of the following features from the demonstration:
1. The efficient consumption frontier can collapse to a point if one of the products becomes noncompetitive. To see this, change the RD price to \$5 and set the GD price to \$12.50. In this case, a consumer that cared only about crispiness could still get more crispiness by buying RD apples. RD apples dominate GD apples in terms of both crispiness and sweetness meaning that GD is priced out of the market. Similarly, if you set the RD price to \$12.50 and the GD price to \$5, the efficient consumption frontier collapses to a point that includes only GD apples. GD apples become the most efficient mechanism by which to obtain both sweetness and crispiness and RD is priced out of the market.
2. An increase in price causes the product vector to contract radially towards the origin.
3. A decrease in price causes the product vector to expand radially away from the origin.
4. A change in income causes both vectors to contract or expand proportionately. The efficient consumption frontier shifts in the same direction of the income change. If both products are competitive, the new efficient consumption frontier is parallel to the old.
Now let us complicate the example by assuming that Fuji apples have all the sweetness of a RD apple and all the crispiness of a GD apple. The characteristics of the Fuji apple are presented in Table \(2\) below. This is clearly a better apple, but let us assume that it is also more costly to grow. In Demonstration \(2\), the Fuji apple is priced initially at \$10. Notice that at \$10, the Fuji apple is not on the efficient consumption frontier. Even though it is a better apple in terms of its attributes, it is too costly and is not market feasible at \$10. Consumers can obtain more of the characteristics in question by purchasing RD apples, GD apples, or some combination thereof.
Table \(2\). Updated Characteristics Table for the Apple Example
Characteristic Red Delicious (RD) Apple Golden Delicious (GD) Apple Fuji (FJ) Apple
Crispiness 1 unit 2 units 2 units
Sweetness 2 units 1 unit 2 units
Demonstration \(2\). The Expanded Example
If the price of the Fuji apples is reduced to \$8 in Demonstration \(2\), it becomes competitive with the other two apples. At an even lower price of \$7, Fuji apples start to push out the efficient frontier, causing it to kink. In this case, the Fuji apple becomes the best choice for those consumers who like a balance of crispiness and sweetness. Note that RD and GD apples are still on the frontier when Fuji apples are priced at \$7. This is because consumers who have strong preferences for sweetness but not crispiness or strong preferences for crispiness but not sweetness may still find it optimal to purchases bundles with RD or GD apples, respectively.
This is illustrated in Figure \(3\) below. Figure \(3\), shows indifference curves for three consumers. One consumer has the horizontal indifference curves shown in blue. This consumer cares only about sweetness and nothing about crispiness. His or her utility is maximized by purchasing all RD apples because this provides the largest amount of sweetness. Another consumer has the vertical indifference curves shown in yellow. This consumer cares only about crispiness and nothing about sweetness. He or she maximizes utility by purchasing only GD Apples. The consumer with the typically shaped and strictly convex indifference curves shown in green likes both crispiness and sweetness. He or she maximizes utility by purchasing the Fuji apples.
Hedonic Pricing Models
In Lancaster’s framework, characteristics are the things that matter in the consumer’s utility function. The consumer gets characteristics by purchasing goods and services that contain them. When a market price is observed, the price is for a product that probably reflects a number of characteristics. You cannot observe the value of individual characteristics directly. Continuing the automobile example above, the price of the automobile reflects horsepower along with several other characteristics. You may observe that cars with higher horsepower also tend to have higher price tags. This suggests that it should be possible to construct a model to get an estimate of the implicit price for horsepower. Such a model is called a hedonic pricing model. A hedonic pricing model could be specified as follows:
\(p = f(c_{1}, c_{2}, \cdots, c_{M}),\)
where \(p\) is price of the product in question and \(c_{1}, c_{2}, \cdots, C_{M}\) are levels of different characteristics.
A hedonic pricing model can be used to obtain the implicit marginal value of a characteristic. For example, if \(p\) is the price of an automobile and \(c_{1}\) is horsepower, then \(\dfrac{\Delta p}{\Delta c_{1}}\) (the slope coefficient for \(c_{1}\)) is the increase in automobile price that one would expect to result from increasing horsepower by a small amount.
As an example, suppose that you were asked to specify a hedonic pricing model for retail strip steaks. You might use something such as
\(p = f(weight, \: thickness, \: color, \: quality, \: freshness)\)
You could measure weight (g) and thickness (cm). There are techniques for quantifying color and quality could be measured in terms of internal marbling and/or through a series of binary (0 or 1) variables to control for USDA quality grade (prime, choice, select, and so forth). These grades take marbling into account. Freshness might be measured in terms of days remaining before the “sale by” date.
A hedonic pricing model provides information about the returns that could be expected by improvements to one or more of the characteristics. In the case of our retail strip steak, it may be possible to increase freshness by using vacuum packaging. Before investing in such a technology, it would be nice to know how much consumers would be willing to pay for this product improvement. Vacuum packaging could darken the color and result in a steak that is purplish rather than a bright red. It is possible that despite enhanced freshness, consumers would pay less for vacuum packed steaks because they view the darker color to be undesirable. A hedonic pricing model could be very useful decision tool in this type of a situation. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.03%3A_Section_3-.txt |
Another model of consumer behavior is Becker’s (1965) household production model. Here, the consumer has a utility function that depends on two things:
1. household produced goods and services, and
2. time spent in leisure activities.
To illustrate the idea of Becker’s model, suppose that the household produced good in question is a meal. To be more specific, let us suppose this meal consists of pasta with a marinara sauce. Ultimate utility comes from consuming the meal. However, in order to obtain this utility, the consumer will need to:
1. purchase ingredients from the marketplace,
2. spend time in the kitchen and dining room, and
3. have some knowledge about cooking. This can be called human capital.
A key point of the Becker model is that items the consumer buys at the supermarket provide him or her with no utility per se. In other words, Inputs such as a bag of pasta, tomatoes, garlic cloves, and oregano leaves do not satisfy the consumer. Satisfaction is not obtained until these ingredients have been combined with time and human capital to produce a meal.
Almost any human activity could be characterized in terms of the household production model. Even a good night’s rest could be viewed as household production. A good night’s requires purchased inputs (shelter, a bed, linens, and possibly sleeping pills). It requires an investment in time (normally 6 to 8 hours). Finally, it might require some human capital (the ability to clear one’s mind of the pressures of the day and relax into sleep). Similarly a sporting event, like a football game, could be characterized as another household produced good. This requires purchased inputs (tickets, television, cable or satellite subscription, snacks), time (several hours), and human capital (some knowledge of the rules and strategies of the game). The point being made here is that the household production idea is broadly applicable to human activities. However, in actual implementations of the Becker model, activities such as sleep or enjoying sporting events might be lumped into leisure time.
It would be wrong to suppose that only activities within the home would classify as household production and fall within the Becker framework. Suppose that instead of making the pasta dinner in the home kitchen, the consumer decides to purchase it from a restaurant. Utility is ultimately derived from consuming the prepared meal. In this case, the consumer requires purchased goods (transportation to the restaurant and a pasta dinner ordered from the menu). The consumer must also invest time to enjoy the meal. Human capital in the case of a restaurant meal involves knowledge about quality and service of competing restaurants and related products that go along with the meal (e.g., a suitable beverage or appetizer that complements the main course). Even though a restaurant meal is not “homemade”, it could easily conceptualize it within the household production model.
The formal elements of the Becker model include a utility function:
$U = f[(hh \: produced \: goods), \: (leisure \: time)]$
The consumer maximizes utility subject to:
1. A hh production function:
$hh \: goods = g[(time \: in \: hh \: production), \: (market \: goods), \: (human \: capital)]$
2. Income-use constraint:
$money \: income \geq spending \: on \: market \: goods$
1. Income-source constraint:
$money \: income = (wage) \times (time \: in \: labor \: force) + (other \: income)$
1. Time-use constraint:
$total \: time = (time \: in \: hh \: production) + (time \: in \: labor \: force) + (leisure \: time)$
A main advantage of Becker’s model is that it incorporates the value of the consumer’s time. The income-use constraint in the Becker model is essentially the same as in the neoclassical model. The consumer cannot spend more on purchased inputs than his or her available income. However, the model differs in that it incorporates where the consumer gets income (the income-source constraint) along with the potential uses for the consumer’s time. The income-use, income-source, and time-use constraints can be combined into one overall constraint known as the full time-income constraint below.
$(wage) \times (total \: time) + (other \: income) \geq (wage) \times (time \: in \: hh \: production) + (wage) \times (leisure \: time) + (spending \: on \: market \: goods)$
The left side of the full time-income constraint represents income potential. The right side of the full time-income constraint represents how income potential is used.
A key insight from Becker’s model for food marketing is that time spent in the kitchen has a very real cost. Many consumers are spending more time in the workforce to generate income. They are using this income to save time in household production by buying goods that require minimal preparation. Senauer, Asp, and Kinsey (1991) make a distinction between time-intensive goods and expenditure-intensive goods. A cake from the bakery costs more money than a couple of cups of flour, vegetable oil, eggs, and a bit of baking powder and cocoa. However, when you consider the opportunity cost of making a cake from scratch, the bakery cake might be the cheapest way to obtain this good. In this example, the bakery cake is an expenditure-intensive good while the raw ingredients to make a cake from scratch are time-intensive goods.
One of the best examples of Becker’s model in action is the growth in food-away-from-home expenditures (the overwhelming majority of which is accounted for by food consumed at restaurants) relative to growth in food purchased for at-home consumption. Figure $1$ shows these data from 1970 through 2014. In 2014 food-away from home expenditures actually surpassed food-at-home expenditures. Insights from Becker’s model are also reflected in the product assortments contained in supermarkets. New or recently renovated supermarkets tend to have larger deli and prepared food sections. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.04%3A_Section_4-.txt |
Market demand arises from the decisions of consumers. The aim of this chapter has been to provide background on three consumer choice models relevant to food demand. Each is based on the simple idea that consumers choose the best bundle that they can afford. The models differ in terms of how consumer utility is specified and how affordable sets are characterized.
In the neoclassical model of consumer choice, the consumer derives satisfaction directly from goods and services acquired in the marketplace. Affordability is defined as the set of product bundles the consumer can purchase with his or her money income. It was shown that given several reasonable assumptions, the neoclassical model of consumer choice can be used to derive individual demand schedules that have properties similar to market demand schedules introduced in Chapter 1. However, the model does not shed a great deal of light on why a consumer might prefer a particular market good or service or why he or she might prefer one product bundle to another.
Lancaster’s model differs in that it focuses not on the products themselves but on the characteristics they contain. In Lancaster’s model, you learned that the consumer derives satisfaction for characteristics, for example, sensory attributes or nutrients. Market provided goods are important to the model in that they constitute the delivery mechanism for the attributes desired by the consumer. Thus, Lancaster’s model can provide additional insight into attributes of products that influence the consumer’s desire for them. Lancaster’s model provides theoretical underpinnings for hedonic pricing models. The logic of Lancaster’s model is particularly suited to products that are in a state of latent demand as described in chapter 1. The Lancaster framework permits a new product innovation to be compared to existing products in the characteristic space and can provide insight into whether the new product would be competitive at a price that justifies its production cost. Many product design activities in the food marketing system can be viewed within the context of Lancaster’s model examples include fortification of food offering and the design of product offerings with reduced fat, sodium and/or sugar content.
Finally, Becker’s model differs in that market-sourced products are used as inputs for household production. Time is essential to understanding affordable set in Becker’s model, which explicitly accounts for the opportunity costs of household-produced goods. The consumer’s time allocation directly effects his/or her ability to secure products in the marketplace. Becker’s model provides a useful template to understand growth in convenience foods over recent decades. Time spent in household production has a clear opportunity cost in the form of time not spent in the labor force and the value of foregone utility from leisure. As opportunities for women to work outside of the home have increased markedly in the post World-War-II era, the food system has responded by increasing product offerings that reduce preparation time.
5.06: Section 6-
Becker, G. S. 1965. “A Theory of the Allocation of Time.” Economic Journal 75:493-517.
Lancaster, K. J. 1966. “A New Approach to Consumer Theory.” Journal of Political Economy 74:132-157.
Senauer, B., E. Asp, and J. Kinsey. 1991. Food Trends and the Changing Consumer. St. Paul, MN: Eagan Press.
Varian, H. 1992. Microeconomic Analysis 3rd Ed. New York, NY: W.W. Norton & Co.
Varian, H. 1993. Intermediate Microeconomics: A Modern Approach. 3rd Ed. New York, NY: W.W. Norton & Co. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.05%3A_Section_5-.txt |
Problem Set 1: Multiple Choice
Exercise \(1\)
1. This preference axiom says more is always preferred to less?
a) Preferences are complete
b) Preferences are transitive
c) Preferences are convex
d) Preferences are monotonic
Answer
d
Exercise \(2\)
1. This preference axiom says that consumers are capable of ranking bundles.
a) Preferences are complete
b) Preferences are transitive
c) Preferences are convex
d) Preferences are monotonic
Answer
a
Exercise \(3\)
1. Which preference axiom best characterizes the statement that “means are preferred to extremes”?
a) Preferences are complete
b) Preferences are transitive
c) Preferences are convex
d) Preferences are monotonic
Answer
c
Exercise \(4\)
1. In Lancaster’s model of the consumer, utility is a function of
a) Leisure time
b) Household produced goods and services
c) Product characteristics
d) Purchased goods
Answer
c
Exercise \(5\)
1. In the Neoclassical model of the consumer, utility is a function of
a) Leisure time
b) Household produced goods and services
c) Product characteristics
d) Purchased goods
Answer
d
Exercise \(6\)
1. Which best describes a hedonic pricing model?
a) The full time income constraint from Becker’s model
b) Product price is a function of product characteristics
c) Product price is a function of quantity placed on the market
d) All of the above
Answer
b
Exercise \(7\)
1. In consumer theory, the direct utility functions we examined in class
a) Are ordinal functions
b) Are cardinal functions
c) Are pointless because utility cannot be measured
d) Are applicable in Becker’s model but are not applicable in Lancaster’s model
Answer
a
Exercise \(8\)
1. Which best summarizes the basic idea of consumer choice theory?
a) Consumers optimize by choosing the healthiest but lowest cost bundle of food items
b) Consumers have preferences that are complete, reflexive, transitive, monotonic, and convex
c) Consumers select the bundle of goods of services they like best from all bundles in their budget set
d) Consumers minimize spending subject to meeting their minimum daily caloric needs
Answer
c
Exercise \(9\)
1. Hedonic pricing models
a) Could be used to value characteristics that are not traded on the market
b) Explain price of a purchased good in terms of characteristics that consumers perceive to be important
c) Have theoretical roots in Lancaster’s characteristics model
d) All of the above
e) Choices a and c only
Answer
c
Exercise \(10\)
1. Consumer sovereignty
a) Means that consumers are vulnerable and so sovereign states need to be especially vigilant when implementing and enforcing consumer protection laws
b) Means that economic activity is ultimately directed by consumers through their purchase decisions
c) Means that economic activity is directed by central planners who are elected by sovereign consumers
d) Was first introduced by the Magna Carta, which placed limits on the power of the reigning sovereign
Answer
b
Exercise \(11\)
1. An ordinal utility function differs from a cardinal utility function in that
a) Cardinal utility always satisfies the cardinal axioms of preferences (complete, reflexive, etc.) while ordinal utility might not.
b) Ordinal utility is usually used for ordinary products, while cardinal utility is used for the luxury goods
c) With an ordinal utility function we are interested primarily in how the function ranks bundles
d) Ordinal utility is a function of prices. Cardinal utility is a function of quantities
Answer
c
Exercise \(12\)
1. The full time-income constraint is featured in
a) Becker’s household production model
b) Lancaster’s characteristics model
c) The neoclassical model
d) All of the above
Answer
a
Exercise \(13\)
1. This model is based on the simple idea that consumers choose the best bundle of goods and services that they can possibly afford
a) Becker’s household production model
b) Lancaster’s characteristics model
c) The neoclassical model
d) All of the above
Answer
d
Exercise \(14\)
1. If preferences are transitive
a) More is always preferred to less
b) The consumer likes variety (means are preferred to extremes)
c) The consumer is able to rank bundles
d) They have a logical ordering in that if X is preferred to Y, and Y is preferred to Z, then X is preferred to Z
Answer
d
Exercise \(15\)
1. If preferences are complete
a) More is always preferred to less
b) The consumer likes variety (means are preferred to extremes)
c) The consumer is able to rank bundles
d) They have a logical ordering in that if X is preferred to Y, and Y is preferred to Z, then X is preferred to Z
Answer
c
Exercise \(16\)
16. Which best describes an expenditure intensive good as described in class
a) An organic tenderloin roast and fresh local organic vegetables from the farmers’ market
b) A fast food restaurant meal
c) A canoeing trip on Buffalo River
d) All-purpose flour
Answer
b
Use the diagram below to answer the remaining problems in this problem set.
Exercise \(17\)
17. The consumer likes C better than B
a) True
b) False
Answer
b
Exercise \(18\)
18. C costs more than B
a) True
b) False
Answer
a
Exercise \(19\)
19. E costs just as much as B
a) True
b) False
Answer
a
Exercise \(20\)
20. D costs less than E
a) True
b) False
Answer
a
Exercise \(21\)
21. A is the optimal choice
a) True
b) False
Answer
b
Exercise \(22\)
22. The consumer likes B and E the same
a) True
b) False
Answer
b
Exercise \(23\)
23. The consumer likes D and E the same
a) True
b) False
Answer
a
Exercise \(24\)
24. Of labeled points, A is the most preferred
a) True
b) False
Answer
a
Exercise \(25\)
25. Consider the utility functions in the table below and the preference map in the diagram above. Which, if any, of these functions provides a correct ordering of preferences?
a) Function 1 only
b) Function 2 only
c) Functions 1 and 3
d) Functions 1,2,and 3
e) Functions 1, 3, and 4
Answer
e
Bundle Function 1 Function 2 Function 3 Function 4
A 10 2 1000 0
B 5 5 500 -5
C 5 5 500 -5
D 2 10 200 -8
E 2 10 200 -8 | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/05%3A_Consumer_Theory_and_Models/5.7%3A_Problem_Sets.txt |
Learning Objectives
• Markets can be defined in terms of three dimensions (1) a product or service, (2) a location, and (3) a point in time. This chapter emphasizes prices over time. What constitutes a point in time can vary depending on the question being asked and the product and geographic context of the market. In markets for commodity futures and options, high-frequency intraday prices are available, but it has also been common to analyze daily reference points such as the open, close or settlement price. Cash prices for some agricultural commodities are reported daily or weekly. Monthly or quarterly periodicities are also common. In this chapter, you will learn to think about price series in terms of several components. A time series can be decomposed into four components as illustrated in quarterly price series presented in Demonstration 1. Specifically, these components are:
• The trend. The trend is the general long-term direction of movement in the series. Demonstration 1 shows a positive trend, with prices increasing with time. To better visualize the trend in Demonstration 1, remove every other component but the trend from the demonstration.
• The seasonal component. A seasonal pattern is observed with regularity over a year. Use Demonstration 1 to remove everything but the seasonal component. Look at the series carefully and you will see that the price is highest in the first quarter of the year and is lowest in the third quarter. This pattern repeats itself each year.
• The cyclical component. A cyclical pattern repeats with some regularity over several years. Cyclical patterns differ from seasonal patterns in that cyclical patterns occur over multiple years, whereas seasonal patterns occur within one year. In Demonstration 1, remove all components but the cyclical component. The period shown illustrates one full cycle from a peak in quarter 1 to another peak in quarter 22. Thus, the cycle shown lasts about 5.5 years.
• The random component. Movements in the series that cannot be explained by the trend, seasonal, or cyclical components are considered to be random.
Demonstration 1. The Components of a Time Series
• The overall aim of this chapter to provide you with some basic tools to work with and make sense of information contained in a price series. The specific objectives of this chapter are as follows:
• Explain the four components of a price series.
• Use index numbers to account for inflation and express monetary values in constant dollars.
• Compute an N-period moving average to remove the seasonal component from a price series.
• Distinguish between demand and supply induced seasonality and be able to provide examples of each.
• Describe conditions that are likely to give rise to price cycles.
06: Prices Over Time
Markets can be defined in terms of three dimensions (1) a product or service, (2) a location, and (3) a point in time. This chapter emphasizes prices over time. What constitutes a point in time can vary depending on the question being asked and the product and geographic context of the market. In markets for commodity futures and options, high-frequency intraday prices are available, but it has also been common to analyze daily reference points such as the open, close or settlement price. Cash prices for some agricultural commodities are reported daily or weekly. Monthly or quarterly periodicities are also common. In this chapter, you will learn to think about price series in terms of several components. A time series can be decomposed into four components as illustrated in quarterly price series presented in Demonstration 1. Specifically, these components are:
1. The trend. The trend is the general long-term direction of movement in the series. Demonstration 1 shows a positive trend, with prices increasing with time. To better visualize the trend in Demonstration 1, remove every other component but the trend from the demonstration.
2. The seasonal component. A seasonal pattern is observed with regularity over a year. Use Demonstration 1 to remove everything but the seasonal component. Look at the series carefully and you will see that the price is highest in the first quarter of the year and is lowest in the third quarter. This pattern repeats itself each year.
3. The cyclical component. A cyclical pattern repeats with some regularity over several years. Cyclical patterns differ from seasonal patterns in that cyclical patterns occur over multiple years, whereas seasonal patterns occur within one year. In Demonstration 1, remove all components but the cyclical component. The period shown illustrates one full cycle from a peak in quarter 1 to another peak in quarter 22. Thus, the cycle shown lasts about 5.5 years.
4. The random component. Movements in the series that cannot be explained by the trend, seasonal, or cyclical components are considered to be random.
Demonstration \(1\). The Components of a Time Series
The overall aim of this chapter to provide you with some basic tools to work with and make sense of information contained in a price series. The specific objectives of this chapter are as follows:
• Explain the four components of a price series.
• Use index numbers to account for inflation and express monetary values in constant dollars.
• Compute an N-period moving average to remove the seasonal component from a price series.
• Distinguish between demand and supply induced seasonality and be able to provide examples of each.
• Describe conditions that are likely to give rise to price cycles. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/06%3A_Prices_Over_Time/6.01%3A_Section_1-.txt |
The trend is the general long-term direction of movement in the series and is thought to arise when growth in long-run demand differs from growth in long-run supply. A positive trend, such as that shown in Demonstration 1, would result when increases in long-run demand outpace those in long-run supply. Similarly, a negative trend would occur when increases in long-run supply outpace increases in long-run demand.
One way to analyze a trend is through regression analysis. The analyst would estimate a model such as
$P_{t} = \alpha + \beta t + \epsilon_{t},$
where $P_{t}$ is the price at time $t$, $\alpha$ is the average price over the period analyzed, $\beta$ is the trend coefficient, and $\epsilon$ is an error term. The regression model could be augmented to include shift variables to remove seasonal components as well as quadratic terms to model cyclical patterns. Provided that the regression model captures the trend, seasonality, and cyclical components, ϵtϵt would reflect the random component of the time series. Another way to visualize a trend is to filter out seasonality and randomness through a moving average as described later in the chapter.
Because trends characterize the longer-term direction in prices, it is often necessary to account for inflation. Inflation refers to general increases in price levels over time. Deflation, by contrast, refers to general decreases in price levels over time. Because of inflation and deflation, the purchasing power of the dollar differs from year to year. In the post World-War II era, the US economy and most other economies have been characterized by inflation. Thus, you may incorrectly conclude that there is a positive trend in prices and that demand has outpaced supply, when in fact the price series simply reflects changes in the purchasing power of the dollar.
Real (Constant) vs. Nominal (Current) Prices
If you had a time machine that took you back to 1970, you would find that the supermarket price of a no-frills loaf of bread was about 24 cents. In 2016, a similar loaf of bread would have costed you about $1.40. These prices are nominal prices. Nominal prices are what consumers actually paid for a product at the time of purchase. In 1970, the nominal price was 24 cents, and in 2016 the nominal price was$1.40. However, between 1970 and 2016, the purchasing power of the dollar changed considerably. The 24 cent price reflects the purchasing power of the dollar in 1970 and the $1.40 price reflects the purchasing power of the dollar in 2016. Of course, wages and consumer incomes have increased in nominal terms since 1970 as well. The adjective “nominal” applies to any monetary value that has not been adjusted for inflation, e.g., nominal incomes, nominal tuition costs, nominal health care costs. Sometimes you will see monetary units expressed as “current dollars”. The adjective “current” is a synonym for “nominal.” Monetary units designated as current have similarly not been adjusted for inflation. If you see a table that has a note indicating that prices are in current dollars then you know that you are looking at nominal prices. With this in mind, the following two statements mean the same thing: 1. In nominal terms, the price of a loaf of bread was$0.24 in 1970 and $1.40 in 2016. 2. In current dollars, the price of a loaf of bread was$0.24 in 1970 and $1.40 in 2016. Real prices (or constant prices), by contrast, always refer to prices in terms of the purchasing power of the dollar in some reference year. Real prices (or constant prices) are adjusted for inflation. With real prices, the purchasing power of the dollar is held constant at some reference or base period. In a table or figure presenting real prices, the title, caption or a footnote will typically indicate the base period. For example, if prices are in constant 1990 dollars, this tells you that 1. The prices are adjusted for inflation, and 2. Prices reflect the purchasing power of the dollar in 1990. As you will see below, it turns out that in constant 2016 dollars the price of bread was$1.48 in 1970 and \$1.40 in 2016. Because these constant prices use 2016 as the reference period. The real price and nominal price will be the same for 2016.
In any kind of analysis with time series data, you would generally want to use real, not nominal, prices, especially if you are examining prices over an extended period of time. However, many sources where you might obtain data for your analysis will present nominal monetary values. For example, total sales figures from a company’s income statement will reflect nominal prices for the year the income statement was generated. If you are looking at a company’s sales over a period of several years, we might erroneously conclude that sales had grown when in actuality inflation, not true sales growth, resulted in higher values of total sales.
Converting Nominal (Current) Values into Real (Constant) Values
To convert any nominal price to a real price you need a broad price index that measures inflation. The most common index used in the United States is the Consumer Price Index for all Urban Consumers (CPI-U). The Consumer Price Index is provided by the US Department of Labor and is released each month. Annual values of the Consumer Price Index for some selected years are reported in Table $1$. You can obtain values of the CPI-U directly from the US Department of Labor’s Bureau of Labor Statistics website (US-BLS 2017).
Table $1$. Consumer Price Index for All Urban Consumers (1982-84 = 100), Selected Years
Year CPI-U Year CPI-U
1960 29.6 1995 152.4
1965 31.5 2000 172.2
1970 38.8 2005 195.3
1975 53.8 2010 218.1
1980 82.4 2011 224.9
1982 96.5 2012 229.6
1983 99.6 2013 233.0
1984 103.9 2014 236.7
1985 107.6 2015 237.0
1990 130.7 2016 240.0
A price index, such as the CPI-U presented in Table 1, reflects price levels as a percentage of prices in some base period. 1982-84 is the base period currently being used by the US Bureau of Labor Statistics, the entity responsible for computing the CPI (US-BLS 2017). Take an average of the index values reported in Table 1 for 1982, 1983, and 1984 and you will see that this average is 100.
$\dfrac{96.5 + 99.6 + 103.9}{3} = 100$
The BLS has been using the 1982-84 base period since January 1988.
The numbers in Table 1 present price levels as a percentage of the 1982-84 base period. To illustrate, consider the value of the index in 2000. In 2000, the CPI is 172.2. This means that general price levels in 2000 were (172.2 - 100) = 72.2 percent higher than they were during the 1982-84 base period. Similarly, the value of the index in 2016 is 240.0. Price levels in 2016 were (240-100) = 140 percent higher than in the base period. In 1980, the value of the index is 82.4. This means that price levels were (82.4-100) = -17.6 percent higher (or 17.6 percent lower) than they were during the 1982-84 base period.
The CPI-U reflects prices that consumers pay over a broad category of expense items including, food, housing, transportation, apparel, health care, education, and so forth (US-BLS 2017). As such, it is a measure of the purchasing power of the dollar relative to the base year and can be used to convert nominal prices into real prices.
Notice from Table 1 that the CPI-U increases as time passes. This indicates that the economy has been characterized by inflation. If the CPI fell from one year to the next, it would indicate deflation. Deflation occurred in the US during the great depression of the 1930s. The CPI-U with a base year of 1982-84 fell from 17.2 in 1929 to 12.9 in 1933. During the post-war period, year-to-year changes in the CPI have been positive with few exceptions. In the recent great recession, the annual-average CPI did fall slightly from 215.3 in 2008 to 214.5 in 2009.
Given a broad price index like the CPI-U, nominal prices can be converted into real prices via the following formula:
$Real \: Price = \dfrac{Nominal \: Price}{Index} \times 100$
When you do this conversion, your real prices will reflect the purchasing power of the dollar in the base period of your index. Consequently, if we used the CPI in Table $1$ to adjust nominal prices for inflation, we would get a real price series that reflects the purchasing power of the dollar during the 1982-84 period. Using Table $1$, we could get real prices for bread in constant 1982-84 dollars as shown in Table $2$.
Table $2$. Converting Bread Prices from Nominal to Real Terms
Year Nominal Price Real Price (1982-84 dollars)
1970 $0.24$ $\dfrac{0.24}{38.8} \times 100 = 0.62$
2016 $1.40$ $\dfrac{1.40}{240.0} \times 100 = 0.58$
Thus you can conclude that in real terms, the price of a no-frills loaf of bread decreased by 4 cents. The problem is that these 4 cents reflect the purchasing power of 1982-84 dollars. 1982-84 was a long time ago, before most of you were even born. Even old timers might have problems remembering what prices were way back in 1982-84.
Changing the Base Period
Fortunately, the base period of any price index can be changed. All you need to do is
1. choose a new base period,
2. divide the index numbers in all periods by the value of the original index for the new base period, and
3. multiply the resulting new index by 100.
For example, suppose you wanted 2016 to be the base period. Divide every index number in the series by the 2016 value of 240.0 and multiply the resulting new numbers by 100:
$I^{t}_{2016=100} = \dfrac{I^{t}_{1982-84=100}}{I^{2016}_{1982-84=100}} \times 100,$
where $I$ refers to the index, and $t$ reflects the year in question. This conversion is presented in Table $3$. Note that the index value in column 3 of the table for 2016 is now 100. Because there has been positive inflation during recent years, index values in years prior to 2016 in column 3 all have values less than 100. Take a moment to replicate a few of the transformed index values in the third column of the table.
Table $3$. Consumer Price Index for All Urban Consumers
Year 1982-84=100 2016=100
1970 38.8 16.2
1980 82.4 34.3
1990 130.7 54.5
2000 172.2 71.7
2010 218.1 90.9
2016 240.0 100.0
If you use this transformed index (2016=100) to adjust for inflation, you will obtain a real price series that reflects the purchasing power of the dollar in 2016. With this in mind, the real price of bread can be expressed in constant 2016 dollars as shown in Table $4$.
Table $4$. Real and Nominal Prices for Bread
Year Nominal Price Real Price (2016 = 100)
1970 $0.24$ $\dfrac{0.24}{16.2} \times 100 = 1.48$
2016 $1.40$ $\dfrac{1.40}{100.0} \times 100 = 1.40$
Be sure to notice that the real price equals the nominal price in the base year. This is because real prices reflect the purchasing power in terms of nominal base-year dollars. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/06%3A_Prices_Over_Time/6.02%3A_Section_2-.txt |
A seasonal pattern is observed with regularity within a given period of time, usually within a year. Typically, the interest is in seasonal patterns over a calendar or marketing year, but there may be contexts in which we could see regular patterns over shorter periods. For example, shopping traffic in a supermarket is seasonal through a week (with higher traffic on weekends) or even on a weekday (with more traffic around the end of the workday).
Seasonal patterns can be demand-induced or supply-induced. For example, demand for products like Christmas trees, carving pumpkins, and whole turkeys are highly seasonal. In these examples, demand is driven by consumption around holidays. In volume, although not so much in price, there are clear demand-induced seasonal patterns in wine consumption (Anez 2005). White and rose wines are traditionally served chilled. These have higher volume sales in the summer months. Red wines, traditionally served at room temperature, have higher volume sales in the winter months. There are volume spikes for all wines regardless of color around holidays.
Supply-induced seasonal patterns are observed in the market for perishable commodities like fruits and vegetables. For example, Sobekova, Thomsen and Ahrendsen (2013) show seasonal price patterns for strawberries, blueberries, blackberries and raspberries. For each of these crops, there is a clear relationship between available supply at different points in the year and price. This is because berries are sourced from different regions of the country or world during different parts of the year. The costs of producing and shipping berries to market differ depending on the supply region. Essentially, the supply curve for berries differs depending on the season of the year and this leads to seasonality in the prices of these berries.
Storage costs can result in supply-induced seasonal price patterns for storable commodities like grains and oilseeds. These crops are harvested once a year, but demand is spread over the year. It is often the case that prices are lowest around the harvest season but then increase in the following months. The increase in price is necessary to provide incentives to store commodities and make them available for use in non-harvest months. Figure 1 shows average cash prices for corn by month over the 2001 to 2016 period. The marketing year for corn runs from September 1 through August 31. Notice that prices are lowest during the harvest months (September through November) and increase consistently until July, about the time when there are good expectations of what the upcoming corn crop will be and when elevators are under pressure to make room for wheat and other small grains harvested in the summer.
An n-period moving average is an average of the n most recent time series observations. If one chooses n to correspond to the periodicity of the data, a moving average can be used to remove the seasonal component of a time series, which may help you better see the trend or cyclical components. The data presented in Table \(1\) are quarterly (four periods per year). Verify that the four-period moving average is simply the average of the four most recent observations. Note also that these price data show a very strong seasonal pattern. The moving average, however, removes that seasonality. This can be seen in Figure \(2\), which charts the data in Table \(1\) along with the four-period moving average.
Table \(1\). Computing a Four-period Moving Average
t Quarter Price Four-pd. Moving Avg.
1 1 3 -
2 2 8 -
3 3 4 -
4 4 8 5.75
5 1 11 7.75
6 2 16 9.75
7 3 12 11.75
8 4 16 13.75
9 1 19 15.75
10 2 24 17.75
11 3 20 19.75
12 4 24 21.75
13 1 27 23.75
14 2 32 25.75
15 3 28 27.75
16 4 32 29.75
In the example above, a four-period moving average was used because we had quarterly data. Every point in our moving average included one each of quarter 1 through 4. If, instead, we were interested in removing seasonality from monthly data or weekly data, we would use 12-period or 52-period moving average instead. The 12-period moving average would be used for monthly data because there are 12 months per year. The 52-period moving average would be used for weekly data since there are 52 weeks per year. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/06%3A_Prices_Over_Time/6.03%3A_Section_3-.txt |
A cyclical pattern repeats with some regularity over several years. Cyclical patterns differ from seasonal patterns in that cyclical patterns occur over multiple years, whereas seasonal patterns occur within one year.
One example of a cyclical pattern, the business cycle, is from macroeconomics. Over time, economic expansions are followed by economic recessions followed again by economic expansions. There is not perfect regularity in the business cycle, as expansions and recessions differ in length. Nevertheless, this process has repeated itself over and over through time.
Cycles are also observed in some agricultural commodity prices and are most pronounced when there is a time lapse between a change in price and the producer’s response to this change. The time lapse is due to two things:
1. A biological lag. The biological lag refers to the length of time between the decision to expand production and the resulting change in supply.
2. A psychological lag. The psychological lag is the length of time when prices must be high or low in order to convince producers that production plans should be changed.
Price cycles emerge when future production decisions are based on current prices and when producers have little control over prices (i.e., when producers are price takers). Thus, cycles are more likely to emerge in industries where there are a large number of relatively small operations. Price cycles are also more likely when there is a a large degree of control over output. Otherwise, random shocks tend to disrupt the cyclical pattern and cause it to dissipate. For this reason, cycles are often more common for livestock than for crops.
One commonly mentioned price cycle is the cattle cycle. The cattle cycle lasts about 8 to 12 years from peak to peak or trough to trough. There is some evidence of cycles, albeit shorter cycles, in hogs and broilers. Demonstration \(1\) shows monthly feeder cattle prices from the nearby feeder cattle futures contract from the mid-1970s through 2016. The raw prices are plotted as red points and a centered 12-period moving average is superimposed in blue. Do you see any evidence of a cattle cycle in these data? The demonstration allows you to examine the data in both nominal and real terms. Evidence of the cattle cycle is easier to see if you look at the data in real terms.
Demonstration \(1\). Feeder Cattle Prices with 12-Month Centered Moving Average (Sept. 1973 through Dec. 2016)
6.05: Section 5-
Movements in the series that cannot be explained by the trend, seasonal, or cyclical components are considered to be random. Many exogenous factors can cause demand or supply to shift and the equilibrium price to change. In agriculture, these include weather, plant or animal diseases, political upheavals that affect trade, and a number of other shocks to demand or supply. A moving average as described above can help to remove random elements of the time series as well as seasonality. Large random shocks could also disrupt a cyclical pattern as described above. In empirical work randomness describes movements in a price series that cannot be explained with the model.
6.06: Section 6-
The overall aim of this chapter was to provide you with some basic tools to work with and make sense of information contained in a time series of prices. At the University of Arkansas, there is a full-semester course dedicated specifically to agricultural prices and forecasting. This is true of most agricultural business and or agricultural economics programs. Consequently, coverage of price series in a general survey course will necessarily be brief. Nevertheless, given the information presented in this chapter, you should be able to identify the different components of a price time series, perform basic adjustment of a series for inflation, and explain some of the conditions that give rise to seasonal and cyclical patterns in agricultural commodity prices. Spend some time with the problem sets below to reinforce the material presented in this chapter.
6.7: References
The overall aim of this chapter was to provide you with some basic tools to work with and make sense of information contained in a time series of prices. At the University of Arkansas, there is a full-semester course dedicated specifically to agricultural prices and forecasting. This is true of most agricultural business and or agricultural economics programs. Consequently, coverage of price series in a general survey course will necessarily be brief. Nevertheless, given the information presented in this chapter, you should be able to identify the different components of a price time series, perform basic adjustment of a series for inflation, and explain some of the conditions that give rise to seasonal and cyclical patterns in agricultural commodity prices. Spend some time with the problem sets below to reinforce the material presented in this chapter. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/06%3A_Prices_Over_Time/6.04%3A_Section_4-.txt |
Problem Set 1: Inflation Adjustment
Year CPI-U (1982-84=100)
1970 38.8
1980 82.4
1990 130.7
2000 172.2
2010 218.1
2016 240.0
Exercise \(1\)
Given the following:
The nominal price in 2000 was \$120.
The nominal price in 2016 was \$520.
Express these prices in constant 1990 dollars.
Answer
The real price in 2000 was \$91.08.
The real price in 2016 was \$283.18.
Exercise \(2\)
Given the following:
The nominal price in 2000 was \$220.
The nominal price in 2016 was \$670.
Express these prices in constant 1970 dollars.
Answer
The real price in 2000 was \$49.57.
The real price in 2016 was \$108.32.
Exercise \(3\)
Given the following:
The nominal price in 2000 was \$310.
The nominal price in 2016 was \$320.
Express these prices in constant 2016 dollars.
Answer
The real price in 2000 was \$432.06.
The real price in 2016 was \$320.
Exercise \(4\)
Given the following:
The nominal price in 2000 was \$415.
The nominal price in 2016 was \$670.
Express these prices in constant 1982-84 dollars.
Answer
The real price in 2000 was \$241.
The real price in 2016 was \$279.17.
Exercise \(5\)
Given the following:
The nominal price in 2000 was \$520.
The nominal price in 2016 was \$560.
Express these prices in constant 1980 dollars.
Answer
The real price in 2000 was \$248.83.
The real price in 2016 was \$192.27.
Exercise \(6\)
Given the following:
The nominal price in 2000 was \$370.
The nominal price in 2016 was \$400.
Express these prices in constant 2000 dollars.
Answer
The real price in 2000 was \$370.
The real price in 2016 was \$287.01.
Exercise \(7\)
Given the following:
The nominal price in 2000 was \$320.
The nominal price in 2016 was \$360.
Express these prices in constant 2010 dollars.
Answer
The real price in 2000 was \$405.32.
The real price in 2016 was \$327.15.
Exercise \(8\)
Given the following:
The nominal price in 2000 was \$870.
The nominal price in 2016 was \$910.
Express these prices in constant 1990 dollars.
Answer
The real price in 2000 was \$660.34.
The real price in 2016 was \$495.56.
Exercise \(9\)
The nominal price in 2000 was \$425.
The nominal price in 2016 was \$415.
Express these prices in constant 2016 dollars.
Answer
The real price in 2000 was \$592.33.
The real price in 2016 was \$415.
Exercise \(10\)
Given the following:
The nominal price in 2000 was \$425.
The nominal price in 2016 was \$415.
Express these prices in constant 1982-84 dollars.
Answer
The real price in 2000 was \$246.81.
The real price in 2016 was \$172.92.
Problem Set 2: Multiple Choice
Exercise \(1\)
1. Which scenario is most likely to give rise to seasonal price patterns in a prices series?
a) Storage costs for a storable agricultural commodity
b) Production lags (e.g., biological lags)
c) Random factors that shock supply or demand
d) A consistent and sustained general growth in market demand over a long period of time
Answer
a
Exercise \(2\)
1. Which scenario is most likely to give rise to cyclical price patterns in a price series?
a) Storage costs for a storable agricultural commodity
b) Production lags (e.g., biological lags)
c) Random factors that shock supply or demand
d) A consistent and sustained general growth in market demand over a long period of time
Answer
b
Exercise \(3\)
1. Which scenario is most likely to give rise to a trend in a price series?
a) Storage costs for a storable agricultural commodity
b) Production lags (e.g., biological lags)
c) Random factors that shock supply or demand
d) A consistent and sustained general growth in market demand over a long period of time
Answer
d
Exercise \(4\)
1. Production lags, such as the biological lag or the psychological lag are likely to give rise to
a) Spatial patterns in a time series of prices
b) Cyclical patterns in a time series of prices
c) Seasonal patterns in a time series of prices
d) All of the above
Answer
b
Exercise \(5\)
1. Which best describes inflation?
a) Inflated statements such as “our product is the most delicious”
b) An effort to set the selling price above the break-even point
c) A general increase in calorie consumption as foods have become cheaper over time
d) A general increase in price levels across the economy
Answer
d
Exercise \(6\)
1. What best describes a four-period moving average?
a) An average of the four periods with the largest values
b) An average of the four periods with the smallest values
c) An average of the four most recent periods
d) All of the above
Answer
c
Exercise \(7\)
1. Which is not one of the four components of a time series?
a) The trend component
b) The random component
c) The spatial component
d) The seasonal component
Answer
c
Exercise \(8\)
1. If a price index number is 103, we can say:
a) That prices are 103 percent higher than they were in the base year.
b) That price levels are 3 percent higher than they were in the base year.
c) Nothing, unless we first convert to nominal dollars.
d) That relative to the base year, prices have fallen slightly.
Answer
b
Exercise \(9\)
1. If you were to adjust a monetary time series for inflation using the Consumer Price Index with 1982-84 = 100 you would get
a) nominal prices.
b) real prices in 1982-84 dollars.
c) prices that are always equal to 100.
d) current prices.
Answer
b
Exercise \(10\)
1. If you have weekly data and wanted to remove seasonality, you could
a) Use a 52-period moving average
b) Use a 7-period moving average
c) Use a 5-period moving average (assuming weekends are not included)
d) Estimate the biological lag model
e) Choices (b) and (c) only
Answer
a
Exercise \(11\)
1. Fluctuations in prices over time that cannot be explained by a trend, a cycle, or a seasonal pattern are called
a) the market component of the time series.
b) the demand-induced component of the time series.
c) the equilibrium component of the time series.
d) the random component of the time series.
Answer
d
Exercise \(12\)
1. If a price index has a value of 0.96 then we know that
a) We are probably looking at the base period since this number is close to 100.
b) Relative to the base period prices are 4 percent lower.
c) Relative to the base period prices are 96 percent higher.
d) We are dealing with a producer price index and not a consumer price index.
Answer
b
Exercise \(13\)
1. If you are presented with ‘nominal’ prices then you know that:
a) Prices are in US dollars as opposed to some other currency
b) These prices have not been adjusted for inflation
c) These prices have been adjusted for inflation
d) These prices reflect the trade-off between two physical commodities, for example the price of one nominal product such as corn as a ratio to the price of another nominal product such as soybeans.
Answer
b
Exercise \(14\)
1. If you see a table indicated that prices are in constant 2010 dollars then you know that
a) You are looking at current prices.
b) Prices have been adjusted for inflation.
c) Prices have not been adjusted for inflation.
d) Both (a) and (c).
Answer
b
Exercise \(15\)
1. A price cycle is most likely to be observed
1. In areas of the United States, such as Colorado, where cycling is an especially popular pastime.
2. When there has been a general increase in long run demand over the period being analyzed.
3. When there has been a general decrease in long run supply over the period being analyzed.
4. When there is a significant biological lag (e.g., tree fruits, livestock).
Answer
d
Exercise \(16\)
1. If we have monthly time series data that is highly seasonal, the best way to remove the seasonal component would be to
1. Employ the time series seasonal decompression model that has been the main topic of the course since we returned from Spring Break.
2. Apply a 12-period moving average to the data.
3. Throw out observations from August and December. In most cultures, these months usually contain aberrations that are due to summer vacations and major winter holidays.
4. Do none of the above. We must first determine whether the seasonal component is supply induced or demand induced.
Answer
b
Exercise \(17\)
1. In the base year, the value of a price index is
1. 100
2. 0
3. Indeterminate unless you are using inflation adjusted numbers
4. The highest point in the index series
Answer
a | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/06%3A_Prices_Over_Time/6.8%3A_Problem_Sets.txt |
Learning Objectives
• Markets vary in ways that affect competition and pricing. In some markets, competition is fierce. In others, it is light. Some firms have broad discretion in setting prices, while others face take-it-or-leave-it market prices. Pricing and competition depend on the structural characteristics of the market. Economists classify markets as monopolies, oligopolies, monopolistically competitive, or perfectly competitive depending on the characteristics of selling firms in the market. A brief overview of each market structure is as follows:
A monopoly is a market with only one seller. The seller (called a monopolist) will often have quite a bit of control over the price that it charges. Earlier in the course, you examined a firm that was a price taker. A monopolist is not a price taker. As the only seller, the monopolist has an incentive to keep its price above its marginal cost. In so doing, it takes surplus from consumers and turns that surplus into profits for itself. Naturally, sellers like to have monopoly power. The problem for the monopolist is to get as much of the consumer surplus as it can. This problem is complicated in that the monopolist faces the market demand curve. Because of the law of demand, the monopolist must lower its price if it wants to sell more, which entails sacrificing its profit margin. On the other hand, if the monopolist attempts to raise price, and thereby increase its profit margin, it sacrifices volume. There is a balancing act here that you have seen before with demand elasticities in Chapter 3. In this chapter, you will see that the demand elasticity facing the monopolist is relevant and can help you solve the monopolist’s problem.
An oligopoly is a market where there are a few sellers. There must be at least two sellers (a duopoly), and there is no magic number on what constitutes the upper limit of a “few” sellers. Like monopolists, oligopolists do have some discretion in setting their prices. However, the problem is further complicated by the fact that the oligopolist must pay attention to the actions of its competitors. Interactions among competitors are of primary interest in oligopoly models.
Monopolistic competition refers to situations where there are generally many sellers (again, there is no magic number that divides “few sellers” from “many sellers”). A key feature of monopolistic competition is that products are differentiated in the minds of consumers and/or transactions costs give rise to varied perceptions among consumers as to the advantages or disadvantages of patronizing one firm over another. Because products are differentiated, sellers are not price takers. Like the monopolist, firms in monopolistic competition face a downward sloping demand curve. In fact, you will see that the individual firm’s problem in monopolistic competition has the same set-up as the monopolist’s problem.
Perfect competition refers to situations where there are many sellers. Products are homogeneous or differ only in ways that readily apparent to all buyers. The actions of any single seller has no effect on the market price. Firms under perfect competition are price takers. The price taking assumption was introduced earlier in Chapter 2. This assumption is the one key feature of perfect competition. While the market demand curve slopes downward, the firm does not face the market demand curve; it only sees the prevailing market price. It can sell all that it wants (or all that it can produce) at the going market price. If the firm attempts to raise its price, there are no buyers. For this reason, it can be said that the firm faces an elasticity of demand that is negative infinity.
This chapter is about competition and market outcomes under these different market structures. The specific learning objectives for the chapter are as follows:
• Describe and explain characteristics of different market structures on the selling side of the market.
• Use the MR = MC profit maximizing condition to find profit maximizing solutions under different market structures.
• Explain the strategic interactions in duopoly models, distinguish between Cournot and Bertrand models of duopoly, and explain how each is an example of the prisoners’ dilemma
• Explain the folk theorem and the ability of firms to avoid prisoners’ dilemma outcomes in price competition over time.
• Understand the economic welfare implications of imperfectly competitive market structures relative to the perfectly competitive benchmark.
07: Imperfect Competition and Strategic Interactions
Markets vary in ways that affect competition and pricing. In some markets, competition is fierce. In others, it is light. Some firms have broad discretion in setting prices, while others face take-it-or-leave-it market prices. Pricing and competition depend on the structural characteristics of the market. Economists classify markets as monopolies, oligopolies, monopolistically competitive, or perfectly competitive depending on the characteristics of selling firms in the market. A brief overview of each market structure is as follows:
A monopoly is a market with only one seller. The seller (called a monopolist) will often have quite a bit of control over the price that it charges. Earlier in the course, you examined a firm that was a price taker. A monopolist is not a price taker. As the only seller, the monopolist has an incentive to keep its price above its marginal cost. In so doing, it takes surplus from consumers and turns that surplus into profits for itself. Naturally, sellers like to have monopoly power. The problem for the monopolist is to get as much of the consumer surplus as it can. This problem is complicated in that the monopolist faces the market demand curve. Because of the law of demand, the monopolist must lower its price if it wants to sell more, which entails sacrificing its profit margin. On the other hand, if the monopolist attempts to raise price, and thereby increase its profit margin, it sacrifices volume. There is a balancing act here that you have seen before with demand elasticities in Chapter 3. In this chapter, you will see that the demand elasticity facing the monopolist is relevant and can help you solve the monopolist’s problem.
An oligopoly is a market where there are a few sellers. There must be at least two sellers (a duopoly), and there is no magic number on what constitutes the upper limit of a “few” sellers. Like monopolists, oligopolists do have some discretion in setting their prices. However, the problem is further complicated by the fact that the oligopolist must pay attention to the actions of its competitors. Interactions among competitors are of primary interest in oligopoly models.
Monopolistic competition refers to situations where there are generally many sellers (again, there is no magic number that divides “few sellers” from “many sellers”). A key feature of monopolistic competition is that products are differentiated in the minds of consumers and/or transactions costs give rise to varied perceptions among consumers as to the advantages or disadvantages of patronizing one firm over another. Because products are differentiated, sellers are not price takers. Like the monopolist, firms in monopolistic competition face a downward sloping demand curve. In fact, you will see that the individual firm’s problem in monopolistic competition has the same set-up as the monopolist’s problem.
Perfect competition refers to situations where there are many sellers. Products are homogeneous or differ only in ways that readily apparent to all buyers. The actions of any single seller has no effect on the market price. Firms under perfect competition are price takers. The price taking assumption was introduced earlier in Chapter 2. This assumption is the one key feature of perfect competition. While the market demand curve slopes downward, the firm does not face the market demand curve; it only sees the prevailing market price. It can sell all that it wants (or all that it can produce) at the going market price. If the firm attempts to raise its price, there are no buyers. For this reason, it can be said that the firm faces an elasticity of demand that is negative infinity.
This chapter is about competition and market outcomes under these different market structures. The specific learning objectives for the chapter are as follows:
• Describe and explain characteristics of different market structures on the selling side of the market.
• Use the MR = MC profit maximizing condition to find profit maximizing solutions under different market structures.
• Explain the strategic interactions in duopoly models, distinguish between Cournot and Bertrand models of duopoly, and explain how each is an example of the prisoners’ dilemma
• Explain the folk theorem and the ability of firms to avoid prisoners’ dilemma outcomes in price competition over time.
• Understand the economic welfare implications of imperfectly competitive market structures relative to the perfectly competitive benchmark. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.01%3A_Section_1-.txt |
How do you know whether a market is a monopoly, an oligopoly, monopolistically competitive, or perfectly competitive? To answer this question, it is useful to clarify the boundaries of the market you are considering. There are three dimensions of a market. These are the product, the time, and the place. You should think about market boundaries in terms of each of these three dimensions. In the product dimension, clarify how narrowly you are defining the product. For instance, are you interested in the market for herbicides broadly, or are you interested in the market for herbicides designed to control a specific weed or class of weeds? Once you have specified the product boundaries, you can then identify competitors that are operating in the market. The next dimension is time. Agricultural products are sometimes sourced from different locations at different times of the year. Because of this, the set of sellers who comprise the market could be different at different points in time. Finally, the place dimension is important because agricultural products are bulky and transportation costs are often an important consideration. Thus, sellers in one geographic area may be different than sellers in another. Moreover, there may be more sellers in one geographic area than another depending on demand conditions in the respective geographic areas. Having defined the boundaries of a market along these three dimensions (product, time, and place), you can use several characteristics of the market to classify its structure.
The first, and probably most obvious, characteristic is the number of firms that comprise the market. The number of firms is central to the definitions of market structures above. In a monopoly, the market is comprised of one firm. In an oligopoly there are a few firms. If there are many firms, the market is either monopolistically or perfectly competitive, depending on the nature of the product.
Another issue of specific importance is whether the product of one seller is different from the product of another in the minds of consumers. If so, the products are differentiated. If not, the products are homogeneous. If products are differentiated, it is useful to distinguish between two different types of product differentiation:
1. A product is vertically differentiated if there are clear quality differences that can be measured objectively. All buyers can agree upon the presence or absence of the quality attribute, regardless of whether the buyer actually places a value on the attribute in question. For example, in lumber, there are vertical differences between oak and pine. Buyers are knowledgeable about these differences and situations wherein one type of lumber is better suited than the other. Usually there are vertical differences among agricultural products. In many cases, grades and standards are used to convey information about these vertical quality differences.
2. Products are horizontally differentiated if there are less tangible quality differences among products that are nonetheless important to the consumer or some segments of consumers. Horizontal differences usually come down to a matter of taste. Most horizontal differences are conveyed through brand image. For example, if you were to compare the ingredient lists on two different brands of cola, you would see that they were nearly identical. It is hard to make the case that one brand is truly better than another for its intended purpose. However, some consumers are probably quite loyal to one of the brands and may even dislike the other.
If horizontal product differences exist, then brands can play a role in conveying these differences, and an industry comprised of many competitors will be monopolistically competitive, as opposed to being perfectly competitive. Vertical product difference can exist in either perfect or monopolistic competition. In a perfectly competitive market, the market price is augmented by a series of market-determined discounts or premiums to account for the vertical quality differences.
Finally, the ease with which new firms can enter the market is important to market structure and market outcomes. Entrants are latent or potential competitors. As you learned in Chapter 2, if an outside firm finds a market to be attractive, it will come into the market, cause supply to shift outwards and depress prices. Outcomes of some of the market structures depend on entry being difficult in one way or another. Entry can be difficult for several reasons:
1. Economies of scale are large compared to the size of the market. In some cases, production technology is such that a firm must produce a very large number of units in order to cover fixed costs. If demand is limited, there may only be room for one or two firms to operate at an efficient scale within a given market. This could foreclose entry because outside firms will not be able to achieve an efficient scale if the market is entered.
2. Access to raw materials, technology, or distribution channels. The inability to access key sources of raw materials, technology, or distribution channels can prevent entry, even if the production process is well understood and economies of scale are inconsequential. In some cases, access is limited by patents or other legal restrictions. This is common with some plant materials, seed varieties, and crop protectants.
3. Network externalities. A network externality exists if there are benefits when multiple consumers use the same platform. A livestock auction provides a good example. Buyers benefit when there are more sellers participating in the auction. Similarly, sellers benefit when there are more buyers participating in the auction. Software, such as a word processing package, provides another example of a network externality. You have an incentive to use the package that is most commonly used by other users. This way, if a colleague sends you a document, you will likely be able to open and edit it without problems. Once established, the existence of network externalities in a market can make entry difficult.
Usually, entry is impossible in a market that is a monopoly. The inability to enter the market is presumably why the market can remain a monopoly. There is one exception, however. This is the case of a contestable monopoly (Baumol, Panzar, and Willig 1982). A contestable monopoly exists in cases where the market can be served by one seller, but if this seller attempts to exploit its monopoly position by charging a high price, the market will be attacked by entrants who will cause the price to fall. If entrants can get in and out of the market easily, the monopolist will be attacked by entry whenever the monopolist attempts to raise its price. A contestable monopoly can exist if the fixed costs of entry can be recovered upon exit. An argument could be made that some food brands have characteristics of contestable monopolies.
Table \(1\). Summary of Industry Characteristics and Market Structures
Structure Number of Firms Horizontal Differences Vertical Differences Entry
Monopoly One Not Applicable Possible, by product line Difficult*
Oligopoly Few Possible Possible Difficult
Monopolistic Comp. Many Yes Possible Easy
Perfect Comp. Many No Possible Easy
* The exception is a contestable monopoly | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.02%3A_Section_2-.txt |
The basics of profit maximization were described in Chapter 2 for a price-taking firm. A price-taking firm falls under the perfectly competitive market structure. Let us now extend the concept to other market structures, situations where firms are not price takers. Recall that marginal revenue (MR) was defined as the increase in revenue that results from producing an additional unit of output. Recall also that marginal cost (MC) was defined as the increase in total cost that results from producing an additional unit of output. Profit is maximized where MR = MC. One way to prove this is to use the logic of contradiction.
To prove that the only situation where profit could be maximized is if MR = MC, let us suppose otherwise. Suppose MR > MC, could profit be maximized? The answer is no. If the firm produced on more unit, its revenue would increase by MR but its cost would increase by MC. Since MR > MC, its profit would go up as it produced more. Thus, profit could not be at a maximum if MR > MC. Now suppose that MR < MC, could profit be maximized? Again the answer is no. If the firm produced one less unit, its revenue would go down by MR and its cost would go down by MC. Since MR < MC, its profit would go up as it produced less. Thus profits could not be maximized if MR < MC.
In Chapter 2, you learned that MR = P for a firm that is in a perfectly competitive market (a firm that is a price taker). In imperfectly competitive markets like monopoly, oligopoly, or monopolistic competition, this is not the case. In fact, MR < P in imperfectly competitive markets. This is because the price that the firm receives is impacted by quantity that the firm places on the market. A general formula for marginal revenue that applies to all market structures is
$MR = P + \dfrac{\Delta P}{\Delta Q} Q.$
The law of demand indicates that $\dfrac{\Delta P}{\Delta Q} < 0$. If more is placed on the market, price will need to fall in order to induce additional consumers into the market and/or convince existing consumers to purchase larger amounts. Thus, marginal revenue depends on the quantity placed on the market so long as $\dfrac{\Delta P}{\Delta Q}$ does not equal zero.
Marginal Revenue if Inverse Demand is Linear
Look carefully at the MR formula above. The second term, $\dfrac{\Delta P}{\Delta Q}Q$, is the slope of the inverse demand curve facing the firm multiplied by quantity. The first term, $P$, is the inverse demand curve itself. Thus if you have a linear inverse demand curve of the form
$P = a + bQ$, you can use the fact that $b = \dfrac{\Delta P}{\Delta Q}$ and the general formula above to find a simple expression for marginal revenue:
$MR = P + bQ = a + bQ + bQ \Rightarrow MR = a + 2bQ.$
Thus, if the inverse demand curve is linear, then the marginal revenue curve will have the same intercept as the inverse demand curve and twice the slope. In the formula above, it is important to emphasize that the inverse demand curve in question is that which faces the firm. Unless the firm is a monopolist, the inverse demand curve facing the firm will be different than the inverse demand curve facing the market.
Marginal Revenue in Terms of the Elasticity of Demand Facing the Firm
Using the definition of the point elasticity and a little bit of algebra, you can use the general formula for marginal revenue above to show that
$MR = P(1 + \dfrac{1}{\varepsilon}),$
where $\varepsilon$ is the price elasticity of demand facing the firm. It is important to emphasize that in this case, $\varepsilon$ is the elasticity facing the firm, which is not the same as the market elasticity. Only if the firm is a monopolist will the elasticity of market demand be the same as the elasticity of demand facing the firm.
There are two interesting implications of the elasticity version of the MR formula. First, if you know demand elasticity and assume profit maximizing behavior, you can arrive at an estimate of marginal cost because $MR = MC$ when profits are maximized. Second, given a non-negative marginal cost, a firm that faces a downward sloping demand curve will always price in a region where demand is elastic. This argument has been made before in Chapter 3. Here you see it again in terms of the firm’s profit maximizing condition.
Elasticity of Demand Facing Firms in Perfect Competition
The difference between the elasticity of demand facing a firm and that facing the market is most pronounced in perfect competition. In perfect competition, there are many firms. Each firm is small relative to the size of the market. As a result, the firm can put more quantity on the market and not have a material effect on the market price. In this case, $\dfrac{\Delta P}{\Delta Q} = 0$ and the elasticity of demand facing the firm is $- \infty$. The market demand may be elastic or inelastic. However, the elasticity facing the firm is negative infinity (perfectly elastic). In other words, if the competitive firm attempts to raise its price, it loses all of its sales. Thus,
$MR = P(1 + \dfrac{1}{- \infty}) = P.$
This is the profit maximizing condition for price-taking firm that was presented earlier in Chapter 2.
7.04: Section 4-
The profit maximizing condition can be used to solve the monopolist’s problem. Suppose, as in Demonstration \(1\) below, that the inverse demand curve facing the monopolist is \(P = 100 - 3Q\). Since this inverse demand curve is linear, the marginal revenue curve has the same intercept and a slope that is twice as steep. Thus, \(MR = 100 - 6Q\). Suppose further that marginal cost is equal to \$4Q. Set \(MR = MC\) or \(100 -6Q = 4Q\)and solve for \(Q\). You get \(Q\) = 10 units. This is the profit maximizing quantity.
Next, use the inverse demand curve to find the profit maximizing price. Although the monopolist equates marginal revenue with marginal cost, it uses the inverse demand curve (not the marginal revenue curve) to set the price. Substituting the profit maximizing quantity into the inverse demand curve, you get a price of \(100-3(10) = \$70\).
Notice in the demonstration that the area of the blue rectangle represents profits. Use Demonstration 1 to verify that profits go down if the monopolist does no set the quantity so that \(MR = MC\).
Demonstration \(1\). Profit Maximization Problem for a Monopolist
Marginal Cost (MC) = \$40.00
Average Total Cost (AC) = \$30.00
Profit = (P - AC)Q =\$400.00
The steps involved in finding the solution to the firm’s problem under monopolistic competition are exactly the same as the monopolist’s problem above. The primary difference between monopoly and monopolistic competition is that entry is possible in monopolistic competition. If profits are positive, new firms will enter the market and/or existing firms will mimic the successful practices of competitors. When economic profits are zero, there is no additional entry, and the market is at an equilibrium. In a no-entry equilibrium under monopolistic competition, the rectangular area that represents profits will be just equal to the sunk costs that would need to be incurred if the market were to be entered by a new firm. New firms would see entry into the market as unattractive since the profits to be gained would be consumed by the sunk costs of entry. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.03%3A_Section_3-.txt |
To introduce oligopoly, consider an example where there are only two firms that supply the market, Firm A and Firm B. This is the simplest form of oligopoly (a duopoly). To simplify the example further, assume that both firms have identical variable cost functions $VC= 20Q_{i}$, where $i \in [A, B]$. This means that the marginal cost facing each firm is $MC = 20$. Finally, suppose that the inverse demand curve for this industry is $P = 200 - 2Q_{A}-2Q_{B}$
Just to be clear, $Q_{A}$ is the amount that Firm A produces and $Q_{B}$ is the amount that Firm B produces.
Because the inverse demand curve is linear, it is easy to find marginal revenue. Note that Firm A can only choose $Q_{A}$. The amount of $Q_{B}$ is outside of Firm A’s control, so the $Q_{B}$ component of the industry inverse demand curve becomes part of the intercept of the inverse demand curve that Firm A actually faces. With this in mind, the MR for Firm A is
$MR_{A}=200-4Q_{A}-2Q_{B}$.
Set $MR=MC$ for Firm A to find profit maximizing quantity for Firm A conditional on Firm B’s output choice
$200-4Q_{A}-2Q_{B} = 200 \Rightarrow Q_{A} = 45 - \dfrac{1}{2} Q_{B}$.
This is known as the reaction function for Firm A. It indicates Firm A’s optimal quantity choice as a function of Firm B’s quantity. In other words, it says how Firm A’s quantity will react to a change in Firm B’s quantity.
Next, repeat the above steps to find profit maximizing quantity for Firm B conditional on Firm A’s output choice. MR for Firm B is
$MR_{B} = 200 - 2Q_{A} -4Q_{B}$.
Set MR = MC for Firm B and solve for $Q_{B}$ to get Firm B’s reaction function.
$200-2Q_{A} - 4Q_{B} = 20 \Rightarrow Q_{B} = 45 \dfrac{1}{2} Q_{A}$
Cournot Nash Equilibrium
A Cournot Nash equilibrium occurs where the reaction functions for these two firms intersect (see Figure $1$). To find the equilibrium, we can substitute Firm B’s reaction function into the reaction function for Firm A:
$Q_{A} = 45 - \dfrac{1}{2}(45 - \dfrac{1}{2}Q_{A}) Now there is one equation and one unknown. Solving for \(Q_{A}$ provides $Q_{A} = 30$. Putting this back into Firm B’s reaction function, we find that $Q_{B} = 30$ as well.
Finally, we can find the price at the Cournot Nash Equilibrium by putting these quantities into the industry inverse demand curve to get
$P = 200 - 2(30) - 2(30)= 80.$
A Nash equilibrium refers to a situation wherein each agent chooses a strategy that maximizes his or her payoffs conditional on the strategies of all other agents. In the example above, the strategy variable is the quantity to be placed on the market. The Cournot equilibrium is a Nash equilibrium because 30 units is the optimal quantity to be placed on the market by Firm A, given that Firm B places 30 units on the market and vice versa. This type of equilibrium, is named after John Forbes Nash, Jr., a mathematician who was awarded the Nobel Prize in Economics for this idea. The model in this example is one of Cournot oligopoly, wherein competition is on quantity. This model is named after another mathematician, Antoine Augustin Cournot.
The Prisoners’ Dilemma
The Cournot Nash equilibrium outcome is not optimal from the standpoint of the two oligopolists because there exists another feasible outcome that provides each firm with a higher level profits. To demonstrate, suppose that the two firms merged. Now there would be just one combined quantity to put on the market $Q_{M} = Q_{A} + Q_{B}$. The inverse demand equation for the combined firm would be
$P = 200 - 2Q_{M}.$
Assuming that the merger does not impact marginal cost, the marginal cost would still be $MC=20$, but marginal revenue for the merged firm would now be $P-200 -4Q_{M}$. Setting marginal revenue equal to marginal cost and solving for $Q_{M}$ results in the merged firm (now a monopolist) putting a quantity of 45 units on the market and charging a price of $P=200-2(45) = 110$. The point here is that technically it would be feasible for the oligopolists to each put half of this amount, 22.5 units, on the market. The industry price would be $110, and they would each be more profitable. • At the Cournot Nash equilibrium, each firm makes profits above fixed costs of $(80-20) \times 30 = 1800$. • By each putting half of the monopoly quantity on the market, each firm would make profits above fixed costs of $(110-20) \times 22.5 = 2025$ The prisoners’ dilemma is a metaphor commonly used in the social sciences, including economics, to help understand problems such as that facing the oligopolists in Cournot competition. In the prisoners’ dilemma, two criminals are apprehended and placed in separate cells. The prosecutor has enough evidence to put each away for two years. However, these criminals are guilty of an offence that carries an eight year sentence if evidence is sufficient to convict. The prosecutor needs one or both of the prisoners to turn state’s evidence. The payoffs facing these prisoners is summarized in the following table Table $1$. Payoffs in the Prisoners’ Dilemma Prisoner 1 (rows), Prisoner 2 (cols.) Prisoner 2 Tells Prisoner 2 Doesn’t Tell Prisoner 1 Tells -6, -6 0, -8 Prisoner 1 Doesn’t Tell -8, 0 -2, -2 Note: Prisoner 1’s payoff is the first number in each cell (no pun intended), Prisoner 2’s payoff is the second number. The prosecutor meets the prisoners separately and offers to reduce the sentence by two years in return for implicating the other in the more serious crime. Thus, if one prisoner implicates his friend while the other remains silent, the one that turns state’s evidence will get a suspended sentence (zero years), while the other will get eight years. If both prisoners implicate each other, both get six-year sentences. If both remain silent, both get two-year sentences. The Nash equilibrium in the prisoners’ dilemma is for each prisoner to tell on the other. As a result, each prisoner gets six years. Had the prisoners kept quiet, they would have gotten only two years each, something better from their perspective. The reason the prisoners have a dilemma is that if I think you will tell on me, it is certainly in my best interest to tell on you. Similarly, if I think you will not tell on me, it is still in my interest to tell on you and get the suspended sentence. Moreover, I know that if I do not tell on you, your best course of action is to tell on me. Thus, each prisoner’s best action given his expectation of the other’s action is to tell. The Cournot model of oligopoly is like the prisoners’ dilemma. In our example of the duopolists above, placing half of the monopoly quantity on the market is analogous to “not telling” in the prisoners’ dilemma. Now, suppose that Firm B decides to do this and sets its quantity at $Q_{B} = 22.5$. Firm A uses its reaction function to set its quantity as $Q_{A} = 45 \dfrac{1}{2}(22.5) = 33.75.$ In this case, Firm B’s profits above fixed costs are$1,518.75. Firm A’s profits above fixed costs are $2,278.13. This is much better than what Firm A could get by matching Firm 2’s quantity at 22.5 units and much worse for Firm B in comparison to what it could have achieved had it simply put its Cournot equilibrium quantity on the market. Thus, in a Cournot oligopoly, firms have an incentive to put more on the market than that which optimizes profits for the industry as a whole. This problem is compounded as more and more firms to the Cournot oligopoly. In fact, the market price approaches the competitive price ($P=MC$) and profits go to zero as the number of firms in a Cournot oligopoly becomes large. Demonstration $2$ shows what happens to total industry profits at the Cournot Nash equilibrium as the number of firms in the industry increases. Notice that the prisoners’ dilemma becomes even more pronounced as the number of firms increases. Demonstration $2$. Profitability of a Cournot Oligopoly Relative to a Monopoly as Number of Firms Change* *In Demonstration $2$, the market inverse demand curve is $P = 200 - 2 \Sigma Q_{i}$ and $MC = 20$ for all firms. Alternative Bertrand Version of the Oligopoly In the Cournot model, firms compete by setting quantities. The Bertrand model is an alternative formulation of the oligopolists’ problem and differs in that the firms compete by setting prices instead. This model is named after Joseph Bertrand, a mathematician who is credited with formalizing this model. Again, to keep things simple, assume that there are two firms. Furthermore, assume that the products produced by each firm are identical. This permits us to take the example above and adapt it to the Bertrand framework. If Firm A sets its price lower than Firm B’s price ($P_{A} < P_{B}$), then Firm A faces a direct demand function of $Q_{A} = 100 - \dfrac{1}{2} P_{A}.$ If Firm A sets its price above Firm B’s price, then Firm A’s demand is $Q_{A} = 0$ Finally, if Firm A’s price matches Firm B’s price ($P_{A} = P_{B}$), then consumers randomly choose to patronize Firm A or Firm B with equal probability. In this case, Firm A stands to get about half the market, so its demand is $Q_{A} = 0.5(100 - \dfrac{1}{2}P_{A}).$ The demand facing Firm B is similarly structured. Firm B gets the entire market if $P_{B} < P_{A}$, sells nothing if $P_{B} > P_{A}$, and splits the market 50/50 with A if $P_{B} = P_{A}$. As before, assume that each firm faces a constant marginal cost of MC =$20.
The Bertrand Nash equilibrium outcome occurs where $P_{A} = P_{B} = MC$. In this case, profits to each firm are zero, and the oligopoly outcome is the same as that which would have occurred under perfect competition. Demonstration $3$ reflects the scenario just described and shows why.
Suppose that Firm A and Firm B have each chosen the monopoly price of $110. Each makes$2,025. This cannot be a Nash equilibrium because $110 is not the best price for Firm A given that Firm B charges$110. Firm A could undercut Firm B by charging a price of $80, in which case Firm A’s profits would go up to$3,600. Of course, Firm B would undercut Firm A and the process would continue until each firm’s price fell to its marginal cost of $20. This is the Bertrand Nash Equilibrium. No firm would cut below its marginal cost. Demonstration $3$. Bertrand Duopoly Price Quantity Profits Firm A 80.00 30.00 1800.00 Firm B 80.00 30.00 1800.00 The Folk Theorem Both Cournot and Bertrand outcomes typify the prisoners’ dilemma because equilibrium outcomes do not maximize industry profits. In each case, there is a feasible outcome (sharing the market at the monopoly price and quantity) that makes firms better off than the Nash equilibrium profits. Might firms be able to coordinate tacitly on a quantity less than the Cournot quantity or on a price higher than the Bertrand price? Suppose, for sake of argument, that Firm A and B are in Bertrand competition and each has matched the others price at$80. This price is above the Bertrand Nash Equilibrium price of $20 per unit, but it corresponds to the market price the firms would get at the Cournot Nash Equilibrium. If, in the current period, Firm A raises its price from$80 to $110, the monopoly price, how should Firm B respond? Pretend that you are Firm B. You might reason as follows: • If I keep my price at$80 and do not raise my price to match Firm A, I will have the entire market during this period. My profits will be $3,600. This is certainly better than$2,025 I would receive if I did match Firm A’s higher price.
• However, if I do not match, I cannot expect that Firm A will not continue to keep its price high in the next period. When it sees that I have not matched its price increase and it loses market share, it will certainly cut is price back to $80 during the next period or possibly even lower. I will be back to getting$1,800 in profits (or possibly something worse).
• If I do match Firm A’s price increase, Firm A will probably continue to keep its price high at $110. Thus I will be getting$2,025 each period as opposed to $1,800. Over the long-term, matching the price increase would pay off. In this highly stylized example, the decision to match the price increase boils down to taking a one-time windfall of$3,600 (if Firm B does not match) or a \$2,025 in profits in every period going forward (if Firm B does match).
The folk theorem states that for an indefinitely repeated prisoners’ dilemma (such as Bertrand) and provided that discount rates are not too high, an outcome preferable to the Nash equilibrium (e.g., a price above the Bertrand price) can be sustained over time. One way firms reinforce the folk theorem is to match their competitors’ pricing decisions tit-for-tat. Tit-for-tat means that one agent responds in kind to another. In the Bertrand example, Firm B plays tit-for-tat if it cuts (raises) its price whenever Firm A cuts (raises) its price. Firm B would want Firm A to know that it intends to play tit-for-tat in setting its prices. Thus, it might advertise to make sure Firm A is aware that it will face tit-for-tat retaliation in the event it decides to cut its price.
Many advertisements that you see send a subtle message to competitors that they can expect tit-for-tat retaliation in the event of a price cut. For example, consider the following Walmart advertisement: go to youtube.com. The advertisement is designed to make you feel like you will be getting the best price if you shop at Walmart and that the whole supply chain is organized to keep prices low. However, this add could also sends a subtle message to competing retailers. The message is as follows: If you cut your price, Walmart will match it. In other words, think carefully before making a price cut because Walmart will respond tit-for-tat!
Oligopolists may appeal to the folk theorem and avoid the prisoners’ dilemma inherent in the Cournot and Bertrand models provided certain conditions are met. The theorem itself mentions two conditions.
1. The first is that all firms expect the competitive interaction to continue indefinitely. The folk theorem works because future profits serve as an incentive not to undercut competitors today. If firms know that competition will be for this period and this period only, then there is no incentive not to undercut. Moreover, if firms know they will compete for a known and finite number of periods, the incentive not to undercut unravels. This is because all firms expect the others to undercut them in the last period, which means it would be best to undercut in the second-to-last period, which means it would best to undercut in the third-to-last period, and so forth. The folk theorem only works if firms expect to be in competition for the foreseeable future.
2. Another requirement is that discount rates not be too high. For the folk theorem to apply, future returns that result from not undercutting your competitor’s price must be large enough to offset the immediate gains you will receive if you do undercut a competitor. If discount rates are high, then returns in the future have less value today and the folk theorem is less likely to apply.
The rapidity with which firms can respond to price changes of competitors also affect whether the folk theorem can hold. If firms play tit-for-tat, then when one firm undercuts, it can expect retaliation by other firms. If it takes a long time for other firms to retaliate, then undercutting becomes more attractive regardless of the discount rate.
It also helps if firms are similar. This is because it is illegal for firms to collude to fix prices. There must be some price point that all firms can agree upon tacitly, without formally colluding to fix a price. The existence of such a point will be more likely if firms are reasonably similar in terms of costs and product characteristics. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.05%3A_Section_5-.txt |
In imperfectly competitive markets like monopoly, oligopoly, and monopolistic competition, it is often the case that sellers can increase profits at the expense of consumers through their ability to control quantity or price. This is good for the seller but is bad for society as a whole. To conclude this chapter, it is worthwhile to spend some time on the welfare implications of imperfect competition. When markets are imperfectly competitive, the results are that (1) too little is produced; (2) too high of a price is charged for what is produced; and (3) there is a resulting dead-weight loss to the economy. In short, imperfect competition costs the economy in terms of a misallocation of resources. The combined value of economic activity measured as the sum of producers’ and consumers’ surplus would be higher if imperfectly competitive markets behaved competitively. Table \(1\) illustrates this point using the Cournot Nash equilibrium example above. Notice that total surplus in the market increases as the market becomes more competitive. Producers’ surplus declines but the gains in consumers’ surplus more than offset the decline in producers’ surplus.
Table \(1\). Economic Welfare at Cournot Nash Equilibrium for Different Numbers of Firms*
Number of Firms Producers’ Surplus (Profits) Consumers’ Surplus Total Surplus
1 (monopoly) \$4,050 \$2,025 \$6,075
2 (oligopoly) \$3,600 \$3,600 \$7,200
5 (oligopoly) \$2,250 \$5,625 \$7,875
10 (oligopoly) \$1,339 \$6,694 \$8,033
Many (approaching perfect competition) \$32 \$8,068 \$8,100
*In Table \(3\), the market inverse demand curve is \(P = 200 - \Sigma Q_{i}\) and \(MC = 20\) for all firms.
For the simple reason that total surplus increases with stronger competition, most governments have laws in place to encourage competition in markets. These are referred to as antitrust laws. Regulatory agencies evaluate mergers and acquisitions to determine whether they will adversely impact competition. A good example is provided by Hayenga and Wisner (2000). These authors describe antitrust issues that were evaluated in approving a merger between Cargill and Continental Grain, two entities with large grain merchandising businesses. Moreover, antitrust laws make it illegal to fix prices or form a cartel to limit quantity. A famous case of price fixing in agriculture involved lysine, an amino acid used in livestock and poultry feeds. ADM, a US company, conspired with Japanese and South Korean lysine manufacturers to keep the price of lysine above competitive levels. The conspirators faced criminal and civil penalties as a result of the price-fixing conspiracy. A very good overview of this case is presented by Connor (1997). In fact, there was even a movie made about this incident starring Matt Damon. See the trailer on youtube.com. The movie is titled The Informant and is based on a book by the same name. I am unable to recommend the movie one way or the other as I have not seen it, but it may be something you want to check out some weekend. If you do watch it, I will be interested to hear what you think. Both the Hayenga and Wisner (1997) and Connor (1997) articles are available through the University of Arkansas Libraries.
7.7: References
Baumol, W. J., J. C. Panzar, and R. D. Willig. 1982. Contestable Markets and the Theory of Industry Structure. New York: Harcourt Brace Jovanovich.
Hayenga, M. and R. Wisner. 2000. Cargill’s Acquisition of Continental Grain’s Grain Merchandising Business. Review of Agricultural Economics 22:252-266
Connor, J. M. 1997. The Global Lysine Price-Fixing Conspiracy of 1992-1995. Review of Agricultural Economics 19:412-427 | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.06%3A_Section_6-.txt |
Problem Set 1. Profit Maximization for the Monopolist of Monopolistically Competitive Firm
Exercise \(1\)
Given the following:
The inverse demand is P = 100-2Q.
Marginal cost is 20.
Average variable cost is 20.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 20 units.
The price is 60 dollars.
Profits above FC are 800 dollars.
Exercise \(2\)
Given the following:
The inverse demand is P = 200-2.5Q.
Marginal cost is 20.
Average variable cost is 20.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 36 units.
The price is 110 dollars.
Profits above FC are 3240 dollars.
Exercise \(3\)
Given the following:
The inverse demand is P = 300-3Q.
Marginal cost is 30.
Average variable cost is 30.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 45 units.
The price is 165 dollars.
Profits above FC are 6075 dollars.
Exercise \(4\)
Given the following:
The inverse demand is P = 400-4Q.
Marginal cost is 40.
Average variable cost is 40.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 45 units.
The price is 220 dollars.
Profits above FC are 8100 dollars.
Exercise \(5\)
Given the following:
The inverse demand is P = 460-5Q.
Marginal cost is 50.
Average variable cost is 50.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 41 units.
The price is 255 dollars.
Profits above FC are 8405 dollars.
Exercise \(6\)
Given the following:
The inverse demand is P = 200-3Q.
Marginal cost is 20.
Average variable cost is 20.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 30 units.
The price is 110 dollars.
Profits above FC are 2700 dollars.
Exercise \(7\)
Given the following:
The inverse demand is P = 288-3Q.
Marginal cost is 30.
Average variable cost is 30.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 43 units.
The price is 159 dollars.
Profits above FC are 5547 dollars.
Exercise \(8\)
Given the following:
The inverse demand is P = 300-2.5Q.
Marginal cost is 30.
Average variable cost is 30.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 54 units.
The price is 165 dollars.
Profits above FC are 7290 dollars.
Exercise \(9\)
Given the following:
The inverse demand is P = 400-4Q.
Marginal cost is 80.
Average variable cost is 80.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 40 units.
The price is 240 dollars.
Profits above FC are 6400 dollars.
Exercise \(10\)
Given the following:
The inverse demand is P = 456-4.5Q.
Marginal cost is 42.
Average variable cost is 42.
Assume a profit maximizing monopolist or monopolistically competitive firm.
Find the quantity, price and profits above fixed costs (FC).
Answer
The quantity is 46 units.
The price is 249 dollars.
Profits above FC are 9522 dollars.
Problem Set 2. Two-Firm Cournot Duopoly
Exercise \(1\)
Given the following:
The inverse demand is P = 200-2Qa-2Qb.
Marginal cost for each firm is 20.
Average variable cost for each firm is 20.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 30 units.
The market price is 80 dollars.
Each firm's profits above FC are 1800 dollars.
Exercise \(2\)
Given the following:
The inverse demand is P = 200-2.5Qa-2.5Qb.
Marginal cost for each firm is 20.
Average variable cost for each firm is 20.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 24 units.
The market price is 80 dollars.
Each firm's profits above FC are 1440 dollars.
Exercise \(3\)
Given the following:
The inverse demand is P = 250-5Qa-5Qb.
Marginal cost for each firm is 25.
Average variable cost for each firm is 25.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 15 units.
The market price is 100 dollars.
Each firm's profits above FC are 1125 dollars.
Exercise \(4\)
Given the following:
The inverse demand is P = 300-4Qa-4Qb.
Marginal cost for each firm is 36.
Average variable cost for each firm is 36.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 22 units.
The market price is 124 dollars.
Each firm's profits above FC are 1936 dollars.
Exercise \(5\)
Given the following:
The inverse demand is P = 400-5Qa-5Qb.
Marginal cost for each firm is 40.
Average variable cost for each firm is 40.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 24 units.
The market price is 160 dollars.
Each firm's profits above FC are 2880 dollars.
Exercise \(6\)
Given the following:
The inverse demand is P = 500-4Qa-4Qb.
Marginal cost for each firm is 80.
Average variable cost for each firm is 80.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 35 units.
The market price is 220 dollars.
Each firm's profits above FC are 4900 dollars.
Exercise \(7\)
Given the following:
The inverse demand is P = 300-3Qa-3Qb.
Marginal cost for each firm is 30.
Average variable cost for each firm is 30.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 30 units.
The market price is 120 dollars.
Each firm's profits above FC are 2700 dollars.
Exercise \(8\)
Given the following:
The inverse demand is P = 300-2.5Qa-2.5Qb.
Marginal cost for each firm is 30.
Average variable cost for each firm is 30.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 36 units.
The market price is 120 dollars.
Each firm's profits above FC are 3240 dollars.
Exercise \(9\)
Given the following:
The inverse demand is P = 500-4Qa-4Qb.
Marginal cost for each firm is 80.
Average variable cost for each firm is 80.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 35 units.
The market price is 220 dollars.
Each firm's profits above FC are 4900 dollars.
Exercise \(10\)
Given the following:
The inverse demand is P = 420-4.5Qa-4.5Qb.
Marginal cost for each firm is 42.
Average variable cost for each firm is 42.
Qa and Qb are quantities Firms A and B place on the market, respectively.
Find the Cournot Nash equilibrium quantity for each firm.
Calculate the market price at this equilibrium.
Calculate the resulting profits above fixed costs (FC) for each firm.
Answer
Each firm's quantity is 28 units.
The market price is 168 dollars.
Each firm's profits above FC are 3528 dollars.
Problem Set 3. Find the Monopolist’s or Monopolistically Competitive Firm’s Price
Exercise \(1\)
Given the following:
The elasticity of demand facing the firm is -1.5.
The firm's marginal cost is 8.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 24.
Exercise \(2\)
Given the following:
The elasticity of demand facing the firm is -2.5.
The firm's marginal cost is 30.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 50.
Exercise \(3\)
Given the following:
The elasticity of demand facing the firm is -2.
The firm's marginal cost is 30.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 60.
Exercise \(4\)
Given the following:
The elasticity of demand facing the firm is -3.
The firm's marginal cost is 20.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 30.
Exercise \(5\)
Given the following:
The elasticity of demand facing the firm is -2.
The firm's marginal cost is 20.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 40.
Exercise \(6\)
Given the following:
The elasticity of demand facing the firm is -1.5.
The firm's marginal cost is 20.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 60.
Exercise \(7\)
Given the following:
The elasticity of demand facing the firm is -2.5.
The firm's marginal cost is 12.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 20.
Exercise \(8\)
Given the following:
The elasticity of demand facing the firm is -2.
The firm's marginal cost is 20.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 40.
Exercise \(9\)
Given the following:
The elasticity of demand facing the firm is -3.
The firm's marginal cost is 40.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 60.
Exercise \(10\)
Given the following:
The elasticity of demand facing the firm is -2.
The firm's marginal cost is 40.
What price maximizes this firm's profits?
Answer
The profit maximizing price is 80.
Problem Set 4. Multiple Choice
Exercise \(1\)
1. An industry with many sellers with differentiated products is classified as
a) A monopoly
b) An oligopoly
c) Monopolistically competitive
d) Perfectly competitive
Answer
c
Exercise \(2\)
1. The folk theorem is of primary interest in understanding competition in an industry that is
a) A monopoly
b) An oligopoly
c) Monopolistically competitive
d) Perfectly competitive
Answer
b
Exercise \(3\)
1. An industry where firms are price takers is
a) A monopoly
b) A monopsony
c) Monopolistically competitive
d) Perfectly competitive
Answer
d
Exercise \(4\)
1. An industry where firms face an infinitely negative own-price elasticity is
a) A monopoly
b) A monopsony
c) Monopolistically competitive
d) Perfectly competitive
Answer
d
Exercise \(5\)
1. In the Cournot model, competitors compete by choosing
a) Prices
b) Quantities
c) Contracting methods
d) Management styles
Answer
b
Exercise \(6\)
1. In the Bertrand model, competitors compete by choosing
a) Prices
b) Quantities
c) Contracting methods
d) Management styles
Answer
a
Exercise \(7\)
1. The Cournot or Bertrand Nash equilibrium is
a) Analogous to the prisoner’s dilemma outcome because there is a feasible outcome that is better for the firms involved.
b) Modeled using a hedonic pricing model
c) Similar to 1st degree price discrimination
d) Similar to 3rd degree price discrimination
Answer
a
Exercise \(8\)
1. Which is true of a price taking firm?
a) It can sell all that it wants at the going price.
b) Its actions have a negligible impact on the market price.
c) It will maximize profits by producing where price is equal to marginal cost.
d) All of the above.
Answer
d
Exercise \(9\)
1. A profit maximizing firm will set price = marginal cost (p = MC) in which market structure?
a) Perfect competition
b) Monopolistic competition
c) Oligopoly
d) Monopoly
e) All of the above
Answer
a
Exercise \(10\)
1. A profit maximizing firm will set marginal revenue = marginal cost (MR = MC) in which market structure?
a) Perfect competition
b) Monopolistic competition
c) Oligopoly
d) Monopoly
e) All of the above
Answer
e
Exercise \(11\)
1. In which market structure are strategic interactions among firms of primary interest?
a) Perfect competition
b) Monopolistic competition
c) Oligopoly
d) Monopoly
Answer
c
Exercise \(12\)
1. Which best describes a tit-for-tat response?
a) The firm always prices lower than the competitor
b) The firm always prices a bit higher than the competitor to protect its margin
c) The firm cuts (raises) its price in response to a cut (raise) in price by its competitor
d) The firm chooses its Nash equilibrium price
Answer
c
Exercise \(13\)
1. A firm that advertises, “We will match any competitors price”
a) Could be warning its competitors that it follows a tit-for-tat pricing strategy
b) Must have low costs
c) Is more worried about market share than profits
d) All of the above
Answer
a
Exercise \(14\)
1. Which factor makes it more likely that firms will be able to tacitly cooperate on a price above the Bertrand price?
a) Discount rates are high
b) It takes a long time for firms to respond to a price change by a competitor
c) Firm’s know that the competitive interaction will last for only three periods
d) Discount rates are low
e) There are major differences among firms in terms of costs and quality
Answer
d
Exercise \(15\)
1. Which best describes a Nash equilibrium?
a) Tacit coordination on the monopoly price
b) A situation where MR < P
c) A situation where each agent is choosing its best strategy given the strategies of all other agents.
d) Cases where price is above the break-even point
Answer
c | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/07%3A_Imperfect_Competition_and_Strategic_Interactions/7.8%3A_Problem_Sets.txt |
Learning Objectives
• Price discrimination is a way for firms to turn consumer surplus into profits by charging different consumers different prices based on their willingness to pay. A number of pricing schemes are encountered in everyday commerce, which are discriminatory in one way or another. Such schemes are common in food and agricultural markets as well. The goal of this chapter is to explain the economic logic of these pricing schemes.
Price discrimination occurs when consumers or groups of consumers are charged different prices even though the cost of providing the product or service to each consumer or each group of consumers is the same. For example, it would be price discrimination if a cafe offers a senior-citizen discount for its coffee. The cost of providing the cup of coffee is the same regardless of whether the customer is 25-years old or 75-years old. Nevertheless, the 25-year-old customer is being charged more. As you will learn below, the cafe owner probably has evidence that senior citizens have more elastic demands than young or middle-aged customers. Because of these differences in elasticity, the cafe can make more money by charging a different price to seniors than it charges to everyone else. It is important to reiterate that price discrimination occurs when different prices are charged even though the cost of providing the good or service is the same. There are non-discriminatory situations where some customers are charged more than others. For example, parents of teenage drivers pay more for automobile insurance. This, however, is not price discrimination because teenage drivers are more likely to be in accidents and are more costly to insure.
Some forms of price discrimination are illegal under anti-trust laws. Specifically, price discrimination that reduces competition is illegal under the Robinson-Patman Act (Lieberman and Siedel 1989). Also, the kinds of discrimination covered in this chapter are discriminatory in that different prices are based on differences in consumer willingness to pay. The different prices are not based on dislike or ill will towards a consumer or group of consumers. For example, in the senior-citizen example, the cafe owner offers the senior discount because seniors have more elastic demands for coffee. Seniors are not given the discount because the cafe owner dislikes middle-aged or young adults.
Objectives for this chapter are as follows:
• Distinguish between first-degree, second-degree, and third-degree price discrimination.
• Explain the logic of bundle pricing and access fees to capture consumer surplus.
• Characterize the self-selection problem inherent in second-degree price discrimination.
• Explain third-degree price discrimination and provide examples encountered in everyday commerce.
• Describe conditions that are necessary for the various types of discriminatory pricing strategies described in this chapter.
• Explain the logic of package pricing (bundling across products), contractual tie-in sales, and captive-product pricing.
08: Price Discrimination
Price discrimination is a way for firms to turn consumer surplus into profits by charging different consumers different prices based on their willingness to pay. A number of pricing schemes are encountered in everyday commerce, which are discriminatory in one way or another. Such schemes are common in food and agricultural markets as well. The goal of this chapter is to explain the economic logic of these pricing schemes.
Price discrimination occurs when consumers or groups of consumers are charged different prices even though the cost of providing the product or service to each consumer or each group of consumers is the same. For example, it would be price discrimination if a cafe offers a senior-citizen discount for its coffee. The cost of providing the cup of coffee is the same regardless of whether the customer is 25-years old or 75-years old. Nevertheless, the 25-year-old customer is being charged more. As you will learn below, the cafe owner probably has evidence that senior citizens have more elastic demands than young or middle-aged customers. Because of these differences in elasticity, the cafe can make more money by charging a different price to seniors than it charges to everyone else. It is important to reiterate that price discrimination occurs when different prices are charged even though the cost of providing the good or service is the same. There are non-discriminatory situations where some customers are charged more than others. For example, parents of teenage drivers pay more for automobile insurance. This, however, is not price discrimination because teenage drivers are more likely to be in accidents and are more costly to insure.
Some forms of price discrimination are illegal under anti-trust laws. Specifically, price discrimination that reduces competition is illegal under the Robinson-Patman Act (Lieberman and Siedel 1989). Also, the kinds of discrimination covered in this chapter are discriminatory in that different prices are based on differences in consumer willingness to pay. The different prices are not based on dislike or ill will towards a consumer or group of consumers. For example, in the senior-citizen example, the cafe owner offers the senior discount because seniors have more elastic demands for coffee. Seniors are not given the discount because the cafe owner dislikes middle-aged or young adults.
Objectives for this chapter are as follows:
• Distinguish between first-degree, second-degree, and third-degree price discrimination.
• Explain the logic of bundle pricing and access fees to capture consumer surplus.
• Characterize the self-selection problem inherent in second-degree price discrimination.
• Explain third-degree price discrimination and provide examples encountered in everyday commerce.
• Describe conditions that are necessary for the various types of discriminatory pricing strategies described in this chapter.
• Explain the logic of package pricing (bundling across products), contractual tie-in sales, and captive-product pricing. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/08%3A_Price_Discrimination/8.01%3A_Section_1-.txt |
If a seller can perfectly price discriminate, he or she is able to charge the buyer’s maximum willingness to pay for each unit. This is discriminatory because the price depends on the consumer’s willingness to pay not the cost of providing the product. If demand is downward sloping, the seller will charge a high price for the first unit purchased and progressively lower prices for additional units until willingness to pay reaches the seller’s marginal cost. By pricing in this manner, the seller leaves no consumer surplus. What would have been consumer surplus has been turned into profits. Perfect price discrimination is also called first-degree price discrimination.
To effectively employ first-degree price discrimination, the seller needs to know the demand curve of each individual. Fortunately for consumers, this is something that the seller is not likely to know. However, there are some sales situations where the seller may attempt to ascertain the consumer’s reservation price and charge him or her accordingly. One example is a car dealership. Most car buyers do not expect to pay the full sticker price. The sticker price is simply a reference point. The salesperson interacts with the buyer, attempts to ascertain his or her reservation price, and then charges accordingly. Thus, it is in your interest to not appear overly eager when buying new car.
Schemes that Approximate First-Degree Price Discrimination
Even though sellers are not likely to know the consumers’ demand schedules, there are pricing schemes that can come close to first-degree price discrimination. These can occur if consumer demands are very similar, i.e., each consumer has about the same demand for the product. Before explaining why, it is useful to emphasize a couple of points about the models used to understand these pricing schemes and some that will follow later in the chapter:
1. The models that follow use individual-level demands as opposed to the market demand. An individual demand schedule reflects the demand for a given consumer (or the demand from a given segment of consumers). The market demand is the sum of these individual demands.
2. It will be assumed that marginal cost is constant with volume. In addition to simplifying the analysis, a constant marginal cost is probably not unreasonable given output changes necessary to respond to demand at the scale of the individual consumer.
In addition to these two points, it is useful to revisit the difference between consumer surplus under a competitive (\(P= MC\)) outcome relative to the monopolist (\(MR=MC\)) outcome. Consider a case where all individual demand curves can be expressed in inverse form as
\(P = 5-0.5Q,\)
and marginal cost is given by MC=3MC=3.
If the market is competitive (\(P=MC\)), each consumer buys four units at a price of \$3 each and receives consumer surplus of \$4. This is shown in Panel A of Figure 1. If, on the other hand, quantity is set so that marginal revenue from each consumer equals marginal cost (the monopolist’s solution), the monopolist gets economic profits of \$2 from each consumer, \$1 is left for each consumer as surplus, and \$1 is lost because of the resource distortion inherent in the monopoly solution. This is shown in Panel B of Figure \(1\).
Could the firm do better then simply pricing as a monopolist? After all, the monopolist in this example leaves half of the potential surplus on the table. Specifically, \$1 remains with the consumer and \$1 goes away in the form of a dead-weight loss. It turns out that the answer to this question is yes. Because each consumer has the same demand curve, the firm can do much better. The firm can implement one of two pricing schemes:
1. Bundle the goods and sell bundles.
2. Charge an access fee that is equal to consumer surplus then set the price per unit equal to marginal cost.
Bundle Pricing
The seller that faced the consumers each with the individual demand curve in Figure 1 could sell four-unit bundles and charge a bundle price. The bundle price would equal to the consumer’s maximum willingness to pay for the four units, which is the entire area under the demand curve as we move from zero to four units. This is \$16/bundle and is computed as the consumer surplus of \$4 in Panel A of Figure 1 plus the \$12 cost of producing the four-unit bundle.
With the bundle pricing scheme, the firm only offers bundles for sale. Consumers cannot buy individual units. They must buy bundles of four and pay the \$16 price or not buy the product at all. The bundle price is set at the consumer’s maximum willingness to pay. No surplus is left for the consumer. In this example the bundle pricing scheme results in \$4 in economic profits, double the profits that could be obtained by pricing as a monopolist.
Access Fees
Alternatively, the firm could charge an access fee of \$4. Again, this is equal to the consumer surplus shown in Panel A of Figure \(1\). The price per unit is then set at MC or \$3/unit. The consumer who pays the access fee is then able to purchase all he or she wants at \$3/unit. Note, however, that the consumer will only purchase four units. His or her willingness to pay for additional units beyond four is less than the \$3 price. In the end, the firm receives \$16 from each customer (the \$4 access fee and the \$12 in product sales). Again the access-fee scheme results in profits of \$4 from each consumer, which is double the profits of pricing as a monopolist. Some examples of access fees include all-you-can-eat buffets, cover charges at a bar or night club, and membership fees at a club store. In each of these situations the consumer pays up-front for access to a facility. Once in the facility, he or she can consume/purchase items at a fixed price (which could be zero in the case of an all you can eat buffet) and stops consuming once the willingness to pay for an additional consumption item exceeds the set price. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/08%3A_Price_Discrimination/8.02%3A_Section_2-.txt |
Second-degree price discrimination can occur when there are different segments of consumers, for example, high demand customers and low demand customers. However, the firm is unable to accurately assign a customer to a segment prior to the sale. In this case, the seller provides volume discounts, essentially bundle pricing, but offers different amounts in the bundles at different prices. The separate bundles are carefully calibrated to extract the most surplus possible from each market segment. Schemes aimed at second-degree price discrimination are encountered every day (e.g., family-sized packaging).
The problem facing the seller is that he or she cannot assign consumers to one segment or another. Thus, the seller needs to set the bundles so that members of each segment self select into a particular bundle. To successfully implement second-degree price discrimination, the bundles must be designed so that the small bundle is most attractive to the low-demand customers and the large bundle is most attractive to the high-demand customers.
The firm must be careful when setting the volume discount. In fact, for second-degree price discrimination to work, the volume discount must satisfy the following conditions:
1. The small bundle must be attractive to the low-demand segment (non-negative surplus).
2. The large bundle must be attractive to the high-demand segment (non-negative surplus).
3. The small bundle must provide a value to the low-demand segment that is at least as good as the large bundle.
4. The large bundle must provide a value to the high-demand segment that is at least as good as the small bundle.
The first two conditions are called participation constraints. They will be satisfied provided the prices charged for the small and large bundles do not exceed the total willingness to pay of low-demand and high-demand customers, respectively. The last two conditions are called self-selection constraints and must be satisfied in order for the low-demand customers to voluntarily choose the small bundle and the high-demand customers to voluntarily choose the large bundle.
To meet these constraints, the firm should choose the size of the small bundle and set its price in order to extract the entire willingness to pay from the low-demand segment. By doing so, the firm gets as much as it can while still satisfying the participation constraint (specifically, the condition 1 above). Consumer surplus for low-demand customers will be zero.
The firm will then choose the size of the large bundle and set its price in order to capture as much of the high-demand customers’ willingness to pay as possible. However, unlike the low-demand segment, the firm will be unable to extract the entire magnitude of willingness to pay from the high-demand customers. Consequently, high-demand customers will have positive consumer surplus. To see why, note that the high-demand segment will derive a strictly positive net benefit from purchasing the small bundle. Consequently, if the firm were to set the large bundle and its price in a fashion that took all of the consumer surplus from high-demand customers, the high-demand customers would simply choose small bundles instead. In other words, the self-selection constraint (condition 4) would not hold. Thus, the firm must design and price the large bundle so that it provides at least as much surplus to high-demand customers as does the small bundle.
An example of a pricing scheme that meets all four conditions is presented in Figure \(1\). Panel A shows demand for a low-demand consumer. Panel B shows the demand for a high-demand consumer. The small bundle offered to the low-demand consumer consists of a two units. The low-demand consumer is charged his or her full willingness to pay (the area under the demand curve from 0 to 2 units) of \$12. The size and price of the small bundle are determined in exactly the same way as described above under the bundle-pricing scheme.
The important thing is that a high-demand consumer gets positive surplus if they buy this small bundle. In this case, the high-demand consumer gets surplus of \$4 from the small bundle. For this reason, the firm cannot charge the high-demand consumer his or her full willingness to pay for the large bundle. If it did, the high-demand consumer would simply buy small bundles in order to get positive surplus. Thus, the firm must set the price of the large bundle so that it provides at least \$4 in surplus. The large bundle is set at three units. The large bundle price is set at no more than \$17, which induces the high-demand consumer to purchase the large bundle. The per-unit price of the large bundle is \$0.33 lower than the per unit price of the small bundle. Thus, the firm is giving the high-demand consumer a volume discount.
This volume discount is not offered because the firm is trying to be nice to its high-demand consumers. The volume discount allows it to make more money. It makes \$4 by selling the small bundle. It makes \$5 when it sells the large bundle. Thus, the ability to sell extra to the high-demand customers via the large bundle allows the firm to be more profitable. The volume discount described above is discriminatory because it allows the firm to price in a way that exploits differences in demand between the high- and low-demand segments. That said, not all volume discounts are discriminatory. For example, if it is less costly to package an deliver larger lots, volume discounts could represent differences in cost of providing the good in larger lots, not differences in willingness to pay.
Let us take a moment to verify that the example in Figure \(1\) meets the participation and self selection constraints.
1. The small bundle must be attractive to the low-demand segment (non-negative surplus). This constraint is met in the example. The price of the small bundle just equals the willingness to pay of the low-demand segment. This is the highest the price can be and still have a bundle that is attractive enough for low-demand segment to participate. Surplus is zero but not negative.
2. The large bundle must be attractive to the high-demand segment (non-negative surplus). This constraint is met in the above example. High-demand consumers get \$4 of surplus from the large bundle.
3. The small bundle must provide a value to the low-demand segment that is at least as good as the large bundle. In this example, the small bundle provides no consumer surplus to the low-demand consumer, but the large bundle provides -\$4 of surplus.
4. The large bundle must provide a value to the high-demand segment that is at least as good as the small bundle. In this example, it does; the large bundle provides surplus of \$4 to the high-demand consumer. This is exactly what could have been obtained from the small bundle. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/08%3A_Price_Discrimination/8.03%3A_Section_3-.txt |
If the seller can easily identify customers with different demand elasticities, then the seller may be able to employ third-degree price discrimination. There are many examples of third-degree price discrimination. These include senior citizen or student discounts, weekend (weekday) rates, and variable utility rates. Historically, federal marketing orders for agricultural products have been offered as examples of third-degree price discrimination. For example, the federal milk marketing orders reflect differences in demand for milk sold for use as a beverage, soft dairy products (e.g., yogurts and soft cheeses), hard dairy products (e.g., butter and hard cheeses), dry milk (Chouinard et al. 2010). For third-degree price discrimination to work, the following conditions must hold:
1. The firm can assign customers into distinct groups and enforce differential pricing by group or there is a relatively straightforward mechanism of self selection.
2. Reselling between consumer groups is not feasible. Otherwise, arbitrage will occur between segments with different demands.
3. The different groups have different elasticities of demand. Otherwise, there is no point in offering different prices to different segments even if differential pricing by segment is possible.
4. The deals being offered must be socially benign.
With third-degree price discrimination, bundling or charging access fees are not possible. If it were, the firm would simply offer different bundles or different access fees to each segment and would approximate first-degree price discrimination in each segment. In third-degree price discrimination, the best the firm can do is charge the monopoly price to each segment. As you might recall from Chapter 7, each segment will be charged the price that satisfies $MC = P_{i}(1 + \dfrac{1}{\varepsilon_{i}})$, where $\varepsilon_{i}$ is the elasticity of demand from the $i^{th}$ segment. Table $1$ provides an example of three segments, each with a different elasticity of demand. Verify that $MC = P_{i}(1 + \dfrac{1}{\varepsilon_{i}})$ for each segment in the table.
Table $1$: Prices charged to different segments under third-degree price discrimination
Value Segment A Segment B Segment C
Marginal Cost 4.00 4.00 4.00
$\varepsilon_{i}$ -2.81 -2.55 -1.87
$P_{i}$ 6.21 6.58 8.60
Note that in Table $1$, the firm does not face any difference in cost across the different segments. In each case, the marginal cost is \$4. However, each segment is charged a different price. The price is based solely on the differences in the elasticity of demand. Note that Segment C pays the highest price. Members of this segment have the least elastic demand. Members of segment A pay the lowest price; they have the most elastic demand.
8.05: Section 5-
There are several other pricing schemes that are commonly encountered. Some of these have elements of discrimination. Package pricing, or bundling across products or services, can benefit the seller in some circumstances. Often, goods or services are priced and sold as a take-it-or-leave-it package. Some examples include vacation packages, combo meals, cable TV packages. Table \(1\) helps to illustrate why package pricing could makes sense.
Table \(1\). Valuations for different food items across three customers
Customers Fries Sandwich Drink Total Bundle
Customer A 2.00 5.00 0.75 7.75
Customer B 2.50 3.50 1.50 7.50
Customer C 1.75 4.25 1.00 7.00
Let us consider the case where the firm’s costs are such that it is most profitable to have each customer in the market for each item. In this case, the highest price the firm can charge without bundling is the lowest willingness to pay for each item. Without package pricing, the firm can charge \$1.75 for the fries, \$3.50 for the sandwich, and \$0.75 for the drink. It gets \$6.00 in revenue from each customer. By offering take-it-or-leave-it combo packages, the firm can charge \$7.00 per package. This represents a nice 16.7 percent increase in revenue per customer.
Contractual tie-in sales are another way to extract additional revenues from high-demand customers when the firm is unable to distinguish between high- and low-demand a priori but plans to enter into a long-term contractual relationship. The logic is that all customers are charged the same entry fee. Once on board, the high-demand customer generates more revenue from tie-in sales. The best example is a franchise. After entering into franchise agreement, the franchisee will normally need to buy inputs from the franchisor. High-demand franchisees, those with good locations and brisk businesses, will therefore generate more revenue for the franchisor than the low-demand franchisees.
Captive product pricing is a similar, related pricing strategy but without contractual obligations (e.g., vacuum cleaner bags, replacement blades for hand razors, printer cartridges). In these cases, the product itself, e.g., the shaving handle or inkjet printer, is priced low and may even be given away. The revenue is made on high-priced sales of replacement components, e.g., razor blades or ink cartridges, which the consumer purchases once he/she becomes captive.
8.06: Section 6-
Through this chapter you have learned about several pricing schemes that are commonly used to convert would-be consumer surplus into higher profits. The content of this chapter is a natural extension to the material presented in Chapter 7 and represents extensions wherein discriminatory pricing strategies may bring about outcomes that are superior, from the firms perspective, to monopoly pricing. Importantly, some of these schemes could result in outcomes that are socially superior as well. In particular, if a firm is able to perfectly price discriminate, all consumer surplus is converted to profit, but the allocation of resources is efficient and the economy avoids the dead-weight loss to occurs under monopoly pricing. The issue is the distribution of value from a transaction between buyer and seller. As you complete problems sets 1 and 2 below, note that consumer surplus that would have accrued to buyers under the competitive outcome simply gets transformed into profits when the seller is able to perfectly price discriminate.
8.7: References
Lieberman, J. K. and G. J. Siedel. 1989. The Legal Environment of Business. Harcourt Brace Jovanovich.
Chouinard, H. H., D. E. Davis, J. T. LaFrance, and J. M. Perloff. 2010. Milk marketing order winners and losers. Applied Economic Perspectives and Policy 32 (1): 59-76. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/08%3A_Price_Discrimination/8.04%3A_Section_4-.txt |
Problem Set 1. Bundle pricing (approximates first-degree price discrimination).
Exercise \(1\)
Given the following:
The individual inverse demand is P = 10-2Q.
Marginal cost is 4.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 3 units.
The bundle price is 21 dollars.
Profits per bundle are 9 dollars.
Consumer surplus is 0 dollars.
Exercise \(2\)
Given the following:
The individual inverse demand is P = 9-3Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 2 units.
The bundle price is 12 dollars.
Profits per bundle are 6 dollars.
Consumer surplus is 0 dollars.
Exercise \(3\)
Given the following:
The individual inverse demand is P = 6-1.5Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 2 units.
The bundle price is 9 dollars.
Profits per bundle are 3 dollars.
Consumer surplus is 0 dollars.
Exercise \(4\)
Given the following:
The individual inverse demand is P = 12-2Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 3 units.
The bundle price is 27 dollars.
Profits per bundle are 9 dollars.
Consumer surplus is 0 dollars.
Exercise \(5\)
Given the following:
The individual inverse demand is P = 24-3Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 6 units.
The bundle price is 90 dollars.
Profits per bundle are 54 dollars.
Consumer surplus is 0 dollars.
Exercise \(6\)
Given the following:
The individual inverse demand is P = 32-4Q.
Marginal cost is 16.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
Add texts here. Do not delete this text first.
Exercise \(7\)
Given the following:
The individual inverse demand is P = 20-2Q.
Marginal cost is 10.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 5 units.
The bundle price is 75 dollars.
Profits per bundle are 25 dollars.
Consumer surplus is 0 dollars.
Exercise \(8\)
Given the following:
The individual inverse demand is P = 12-3Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 2 units.
The bundle price is 18 dollars.
Profits per bundle are 6 dollars.
Consumer surplus is 0 dollars.
Exercise \(9\)
Given the following:
The individual inverse demand is P = 15-3Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 4 units.
The bundle price is 36 dollars.
Profits per bundle are 24 dollars.
Consumer surplus is 0 dollars.
Exercise \(10\)
Given the following:
The individual inverse demand is P = 8-2Q.
Marginal cost is 4.
Assume all individuals in the market have this inverse demand.
What is the bundle size, bundle price, and profits per bundle?
What is consumer surplus after purchasing the bundle?
Answer
The bundle size is 2 units.
The bundle price is 12 dollars.
Profits per bundle are 4 dollars.
Consumer surplus is 0 dollars.
Problem Set 2. Access fee (approximates first-degree price discrimination).
Exercise \(1\)
Given the following:
The individual inverse demand is P = 10-2Q.
Marginal cost is 4.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 9 dollars.
The per-unit price is 4 dollars.
Each customer buys 3 units.
Profits per customer are 9 dollars.
Each customer's surplus is 0 dollars.
Exercise \(2\)
Given the following:
The individual inverse demand is P = 9-3Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 6 dollars.
The per-unit price is 3 dollars.
Each customer buys 2 units.
Profits per customer are 6 dollars.
Each customer's surplus is 0 dollars.
Exercise \(3\)
Given the following:
The individual inverse demand is P = 6-1.5Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 3 dollars.
The per-unit price is 3 dollars.
Each customer buys 2 units.
Profits per customer are 3 dollars.
Each customer's surplus is 0 dollars.
Exercise \(4\)
Given the following:
The individual inverse demand is P = 12-2Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 9 dollars.
The per-unit price is 6 dollars.
Each customer buys 3 units.
Profits per customer are 9 dollars.
Each customer's surplus is 0 dollars.
Exercise \(5\)
Given the following:
The individual inverse demand is P = 24-3Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 54 dollars.
The per-unit price is 6 dollars.
Each customer buys 6 units.
Profits per customer are 54 dollars.
Each customer's surplus is 0 dollars.
Exercise \(6\)
Given the following:
The individual inverse demand is P = 32-4Q.
Marginal cost is 16.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 32 dollars.
The per-unit price is 16 dollars.
Each customer buys 4 units.
Profits per customer are 32 dollars.
Each customer's surplus is 0 dollars.
Exercise \(7\)
Given the following:
The individual inverse demand is P = 20-2Q.
Marginal cost is 10.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 25 dollars.
The per-unit price is 10 dollars.
Each customer buys 5 units.
Profits per customer are 25 dollars.
Each customer's surplus is 0 dollars
Exercise \(8\)
Given the following:
The individual inverse demand is P = 12-3Q.
Marginal cost is 6.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 6 dollars.
The per-unit price is 6 dollars.
Each customer buys 2 units.
Profits per customer are 6 dollars.
Each customer's surplus is 0 dollars.
Exercise \(9\)
Given the following:
The individual inverse demand is P = 15-3Q.
Marginal cost is 3.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 24 dollars.
The per-unit price is 3 dollars.
Each customer buys 4 units.
Profits per customer are 24 dollars.
Each customer's surplus is 0 dollars.
Exercise \(10\)
Given the following:
The individual inverse demand is P = 8-2Q.
Marginal cost is 4.
Assume all individuals in the market have this inverse demand.
What is the access fee and per-unit price?
How many units will each customer purchase after paying the access fee?
What are the firm's profits per customer?
How much consumer surplus does each customer get?
Answer
The access fee is 4 dollars.
The per-unit price is 4 dollars.
Each customer buys 2 units.
Profits per customer are 4 dollars.
Each customer's surplus is 0 dollars.
Problem Set 3. Prices charged to each segment (third-degree price discrimination).
Exercise \(1\)
Given the following:
Sement 1's elasticity is -2.
Sement 2's elasticity is -3.
Marginal cost is 2.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 4 dollars.
Segment 2 is charged 3 dollars.
Exercise \(2\)
Given the following:
Sement 1's elasticity is -4.
Sement 2's elasticity is -1.5.
Marginal cost is 3.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 4 dollars.
Segment 2 is charged 9 dollars.
Exercise \(3\)
Given the following:
Sement 1's elasticity is -3.
Sement 2's elasticity is -2.
Marginal cost is 4.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 6 dollars.
Segment 2 is charged 8 dollars.
Exercise \(4\)
Given the following:
Sement 1's elasticity is -2.
Sement 2's elasticity is -1.5.
Marginal cost is 5.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 10 dollars.
Segment 2 is charged 15 dollars.
Exercise \(5\)
Given the following:
Sement 1's elasticity is -2.
Sement 2's elasticity is -3.
Marginal cost is 4.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 8 dollars.
Segment 2 is charged 6 dollars.
Exercise \(6\)
Given the following:
Sement 1's elasticity is -4.
Sement 2's elasticity is -2.
Marginal cost is 3.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 4 dollars.
Segment 2 is charged 6 dollars.
Exercise \(7\)
Given the following:
Sement 1's elasticity is -2.
Sement 2's elasticity is -3.
Marginal cost is 2.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 4 dollars.
Segment 2 is charged 3 dollars.
Exercise \(8\)
Given the following:
Sement 1's elasticity is -4.
Sement 2's elasticity is -2.
Marginal cost is 3.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 4 dollars.
Segment 2 is charged 6 dollars.
Exercise \(9\)
Given the following:
Sement 1's elasticity is -4.
Sement 2's elasticity is -2.
Marginal cost is 6.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 8 dollars.
Segment 2 is charged 12 dollars.
Exercise \(10\)
Given the following:
Sement 1's elasticity is -6.
Sement 2's elasticity is -2.
Marginal cost is 5.
Assume third-degree price discrimination is feasible.
What price is charged to Segment 1?
What price is charged to Segment 2?
Answer
Segment 1 is charged 6 dollars.
Segment 2 is charged 10 dollars.
Problem Set 4. Multiple Choice
Exercise \(1\)
1. Which best explains price discrimination?
a) Charging different prices based on quality differences
b) Charging higher prices to reflect higher costs of service
c) Charging different prices for the same product based on willingness to pay
d) All of the above
Answer
c
Exercise \(2\)
1. Which practice is most consistent with second-degree price discrimination?
a) Charging access fees that are equal to consumer surplus
b) Volume discounts
c) Special offers for groups of consumers (e.g., student discounts)
d) All of the above
Answer
b
Exercise \(3\)
1. Which practice could approximate first-degree price discrimination?
a) Charging access fees that are equal to consumer surplus
b) Volume discounts
c) Special offers for groups of consumers (e.g., student discounts)
d) All of the above
Answer
a
Exercise \(4\)
1. Under third-degree price discrimination
a) The firm takes the consumer’s entire surplus
b) The firm sets the monopoly or monopolistically competitive price (MR = MC) in each of the market segments it faces
c) The firm must worry about self-selection constraints and so must leave some surplus for high demand customers
d) The firm charges the competitive price (P = MC)
Answer
b
Exercise \(5\)
1. If individual demands are homogeneous, bundle pricing can approximate
a) First-degree price discrimination
b) Second-degree price discrimination
c) Third-degree price discrimination
d) Fourth-degree price discrimination
Answer
a
Exercise \(6\)
1. If individual demands are homogeneous, an access fee plus fixed price per unit can approximate
a) First-degree price discrimination
b) Second-degree price discrimination
c) Third-degree price discrimination
d) Fourth-degree price discrimination
Answer
a
Exercise \(7\)
1. In which case does the seller set price to take the consumer’s entire surplus?
a) First-degree price discrimination
b) Second-degree price discrimination
c) Third-degree price discrimination
d) Fourth-degree price discrimination
Answer
a
Exercise \(8\)
1. When would third-degree price discrimination not work?
a) When the market can be divided into segments with very different elasticities of demand
b) When all market segments have very similar elasticities of demand
c) When resale between segments is easy
d) Both (b) and (c)
Answer
d | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/08%3A_Price_Discrimination/8.8%3A_Problem_Sets.txt |
Learning Objectives
The specific objectives of this chapter are as follows:
• Explain the problems of adverse selection and moral hazard that result from information asymmetries.
• Explain the role of advertising to facilitate transactions that involve costly information, asymmetric information, or some combination of the two.
• Distinguish between default-independent and default-contingent signals, provide examples of each, and describe situations where each may be effective.
• Explain the concept of a separating equilibrium and why it is important to the functioning of economic signals.
In many economic models, it is assumed that information is freely available. For example, in the neoclassical model of the consumer covered in Chapter 5, the consumer knew prices and the amount of satisfaction that would derived from purchased goods. In Lancaster’s model or Becker’s model, the consumer knew even more and could ascertain the amounts of characteristics that were inherent in purchased goods or the time commitments required for household production. Moreover, both the buyer and seller were equally informed about characteristics of the product. In many real world cases, information is not freely available. Information is costly to obtain and a buyer must search for availability of goods and the prices at which they are being offered. Moreover, it is often difficult to judge, pre-purchase, how much of a given characteristic a product will contain.
If information is necessary for economic decision making and is costly, then it might be interesting to subject it to more formal analysis. In fact, economic analysis of information has been one of the most productive areas in the past few decades. The focus in this chapter will be necessarily brief with the overall aims being (1) to shed light on some primary information problems in the functioning of markets and (2) to emphasize the roles that advertising and other activities can play in solving these problems.
09: Signals and Advertising
In many economic models, it is assumed that information is freely available. For example, in the neoclassical model of the consumer covered in Chapter 5, the consumer knew prices and the amount of satisfaction that would derived from purchased goods. In Lancaster’s model or Becker’s model, the consumer knew even more and could ascertain the amounts of characteristics that were inherent in purchased goods or the time commitments required for household production. Moreover, both the buyer and seller were equally informed about characteristics of the product. In many real world cases, information is not freely available. Information is costly to obtain and a buyer must search for availability of goods and the prices at which they are being offered. Moreover, it is often difficult to judge, pre-purchase, how much of a given characteristic a product will contain.
If information is necessary for economic decision making and is costly, then it might be interesting to subject it to more formal analysis. In fact, economic analysis of information has been one of the most productive areas in the past few decades. The focus in this chapter will be necessarily brief with the overall aims being (1) to shed light on some primary information problems in the functioning of markets and (2) to emphasize the roles that advertising and other activities can play in solving these problems. The specific objectives of this chapter are as follows:
• Explain the problems of adverse selection and moral hazard that result from information asymmetries.
• Explain the role of advertising to facilitate transactions that involve costly information, asymmetric information, or some combination of the two.
• Distinguish between default-independent and default-contingent signals, provide examples of each, and describe situations where each may be effective.
• Explain the concept of a separating equilibrium and why it is important to the functioning of economic signals. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.01%3A_Section_1-.txt |
Asymmetric information describes situations wherein one party to the transaction (e.g., the seller) has more information about the product or service in question than another party (e.g., the buyer). For example, in many cases, the producer will possess better information about the quality of raw materials used in the manufacture of a product than the buyer. The producer may present the product to the buyer as representing the finest quality. The buyer could inspect the product prior to purchase, but there may be ways that the producer could mask shoddy workmanship. In many cases, the buyer will be unable to distinguish between good and poor quality before the sale. The consumer may only learn whether the producer used substandard inputs after consumption of the product or through its extended use. In short, the producer could use better information (and the buyer’s lack of information) to his or her advantage.
If only as a savvy consumer, you can relate to the scenario just described. In a famous paper, Akerlof (1970) noted that asymmetric information could, in severe cases, cause markets for high quality products to fail. He described a “lemons market,” where only low-quality products are provided. In this context, the term “lemons” refers to used automobiles of poor quality, the example used in Akerlof’s (1970) paper. The lemons market occurs because no buyer would be willing to pay a premium for high quality because everyone understands that sellers have an incentive to pass off low-quality products at a high-quality price.
To consider further how asymmetric information could cause market failures, let us explore two problems that relate to asymmetric information. One is called adverse selection. The other is called moral hazard. Adverse selection refers to cases where asymmetric information makes it difficult for parties to enter into a mutually beneficial transaction because of concerns that one party could use its informational advantage to the detriment of the other. The lemons market is an example of adverse selection. Adverse selection problems are the primary focus of this chapter. Moral hazard, on the other hand, refers to cases where asymmetric information can create problems after two parties have entered into a business arrangement because of one party’s inability to accurately monitor the behavior or effort of the other. According to Milgrom and Roberts (1992), adverse selection and moral hazard arose out of insurance market terminology but have since taken on broader meanings. Given the origins in insurance markets, let us use insurance as an example to illustrate each of these two problems.
Adverse Selection
Adverse selection results when asymmetric information creates pre-contractual problems. For example, customers who buy dental insurance likely know more about their risks of needing costly dental procedures than do insurance providers. Let us take the hypothetical case of John Doe. John is a recent graduate and knows that he has a high likelihood of being predisposed to dental problems because they run in his family. Moreover, he has had many cavities up to this point in his life. John is fairly certain that there will be expensive dental procedures in his near future. When there is an opportunity to sign up for dental insurance through his employer, John Doe jumps at the chance. To him it seems like a great deal. Jane Doe (no relation to John), on the other hand, has the same opportunity to sign up for dental insurance. Jane has never had a cavity before and feels fortunate to have a good set of teeth. To Jane, the premiums for dental insurance seem high. She would like to have some insurance against the costs of expensive dental care should she need it, but she knows that the most she will pay her dentist in a normal year will be the cost of routine cleanings and checkups. She can pay those out-of-pocket for much less than what she would pay in dental insurance premiums. Because of this, Jane decides not to enroll in the dental insurance program.
In the end, one would expect customers with bad teeth to enroll in dental insurance and customers with good teeth not to enroll. This is adverse selection. Many people with good teeth would like to insure against the cost of dental care should it be needed. but a problem arises because the insurance company is unable to distinguish between high-risk and low-risk customers a priori. It is possible that dental insurance is lemons market in that only high-premium insurance catering to high-risk customers is available. Asymmetric information, in this example, could prevent the emergence of a market for lower-cost dental insurance tailored to lower-risk customers.
Moral Hazard
Moral hazard results when asymmetric information creates post-contractual problems that result from one party being unable to fully monitor the effort or actions of the other. Once a people buy insurance, they may be less careful because they are at least partially insured against a loss. Insurance companies cannot monitor customers all the time, so an asymmetric information problem emerges after an insurance policy has been sold. Moral hazard is partially mitigated by providing incentives in the form of deductibles, co-payments, and partial coverage. For example, a person who has dental insurance, will likely still practice good oral hygiene. Aside from large deductibles and copayments, corrective dental procedures such as fillings, root canals, and crowns can be painful and inconvenient. Such losses in utility are not covered by the insurance.
Market Solutions to Adverse Selection and Moral Hazard
In the case of moral hazard, a common market solution is to develop contracts that provide incentives. For example, your automobile insurance company probably gives you a discount on your premiums if you have not filed a claim in the past few years, have a good driving record (few or no arrests for traffic violations), and/or have good grades. Basically, the company that insures you would like you to drive carefully. Since you are often in a hurry and have coverage that at least partially offsets the costs you would incur in the event of an accident, it knows that you may, on occasion, not be as careful as it would like you to be. It is prohibitively costly for the company to have a representative follow you around and file detailed reports on the carefulness of your driving habits. Instead, the insurance company offers you a set of incentives, based on things that it can observe (like the number of traffic violations) and that it knows are correlated with the degree of risk it takes in insuring you.
Livestock production contracts in agriculture are good examples of incentive-based contracts designed to address moral hazard problems. In broiler chicken production, an integrator provides contract growers with chicks, feed, and other inputs. The integrator would like its contract growers to work hard to minimize mortality and increase feed conversion. The integrator could offer a fixed payment for each flock of birds grown. However, this would result in a moral hazard problem because contract growers would get the same payment regardless of whether they put lots of effort or minimal effort into growing the birds. To address moral hazard, broiler contracts are designed so that growers who do well relative to others in their settlement pool receive premiums while those who do less well receive penalties. Again, it is costly for the integrator to monitor the effort expended by each of its contract growers, but it can easily measure mortality and feed conversion rates. If these are correlated with grower effort, it can design contract provisions to provide incentives for growers to put the desired levels of effort into raising the birds.
A common market solution to adverse selection problems is to rely on an economic signal. A signal is a way for one party to send a believable message to another about the characteristics contained in the products. Advertising is an example of an economic signal. As you will see, advertising clearly has a multifaceted role and can address problems of costly information as well as problems of asymmetric information. The remainder of the chapter is comprised primarily of a discussion of advertising and other economic signals to overcome adverse selection problems resulting from asymmetric information. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.02%3A_Section_2-.txt |
Advertising, until recent decades, has been fairly neglected in economic analysis. It is probably safe to say that economists saw advertising as an obvious way for sellers to influence consumer tastes and preferences. It was taken for granted that the purpose of advertising was to make the demand curve less elastic and provide sellers with more discretion in setting prices. There is probably truth in this. However, recent work has shown that advertising can do much to overcome informational problems in markets and, hence, can be valuable in helping markets function and in improving the efficiency of the economic allocation problem. In a classic article, Nelson (1974) noted that the messages conveyed in advertising activities depend on whether the good being advertised has search characteristics or experience characteristics.
Search characteristics refer to aspects of a product that can readily be assessed by inspection prior to sale. There is no asymmetric information problem with search characteristics. Customers have access to the same information as the seller. However, knowledge about search characteristics could be costly information because finding out about search characteristics might require effort on part of the consumer. Thus, advertising could play a role in reducing search costs to consumers. Unlike search characteristics, experience characteristics are known to customers only through use of the product and cannot be determined by inspection prior to sale. Asymmetric information can be a major problem when it comes to experience characteristics.
To better develop the distinction between search and experience characteristics, consider corn flakes. A box of corn flakes at the supermarket contains both search characteristics and experience characteristics. Assuming that labeling regulations are effective and adequately enforced, the consumer can look at the box to determine how many ounces it contains, the ingredients that were used in the manufacture of the product, a date that provides information about the product’s freshness, and the nutrients that the product will provide. Each of these is a search characteristic. The customer does not need to buy the product to be fully informed about characteristics such as these. A consumer might have other questions about the corn flakes such as: Will they have a rich toasted corn flavor? Are they crunchy, and will they stay crunchy after milk is added? Will the corn flakes pair well with a handful of fresh blueberries? These are all questions about experience characteristics. There is no way for the consumer to be sure about the taste and texture attributes of the cornflakes until after the cornflakes leave the store and he or she consumes them.
Advertising Can Address Both Search and Experience Characteristics
Advertising can clearly play a role when it comes to helping consumers become informed about search characteristics. Advertising can inform consumers that a product exists and provide information about its price and search attribute. This can lower the cost that consumers would otherwise face in their search for information and can help the economy work smoothly. However, many advertising messages do not seem to be doing anything that would aid in information search.
For example, anyone in the United States, and most of the world for that matter, knows that Coca-Cola is a soft drink available for purchase almost anywhere at any time. Most people do not need an advertising message to let them know Coca-Cola exists, tastes sweet, is carbonated, and provides caffeine. Occasionally Coca-Cola may come out with a new flavor variation, e.g., vanilla-flavored Coke. In such instances, it might facilitate consumer search to have an advertising campaign informing consumers that a new vanilla-flavored variation of Coca-Cola is available. Similarly, a retail establishment might offer a temporary price reduction on Coca-Cola products. Consumer search would be aided if an advertising message provided information about this change in price.
These exceptions aside, most advertisements for soft drinks like Coca-Cola do not convey material information about product availability, search attributes or price. Most consumers would find it hard to believe that Coca-Cola plays a central role in the recreational excursions of polar bear families as depicted in a recent Super Bowl advertisement. Why would Coca-Cola spend the enormous sum of money that it takes to develop and run an add on the Superbowl that ultimately does little to reduce search costs? Nelson (1974) provides a compelling explanation.
Nelson’s (1974) main argument is that when it comes to experience characteristics, advertising is informative. The mere fact that a seller advertises provides information about experience characteristics, even if the content of the advertisement does not explicitly mention the characteristic. As shown below, Nelson’s (1974) basic idea can be formalized using an economic model that shows an equilibrium wherein high-quality producers choose to advertise and low-quality producers choose to not advertise. In this model, “high quality” will refer to products containing experience characteristics for which consumers are willing to pay a premium.
The Logic of Advertising as a Signal
Let us consider a market with the following features:
1. There is asymmetric information wherein sellers have more information about the quality of their products than do buyers.
2. Buyers are aware that they have less information and are naturally wary of adverse selection problems. As a result, buyers discount quality claims made by sellers.
The high-quality seller needs some way to convince the skeptical buyer that the product she is selling indeed does provide high quality. If she cannot convince buyers of her high quality, she cannot sell at the high-quality price and will not be willing to incur extra costs required to produce high-quality products. The high-quality seller must convince the buyer that it would be against her interest to use asymmetric information to her advantage. That is, the seller needs to convince buyers that it would not make sense for her to charge a high-quality price for a low-quality product.
An extravagant advertising campaign is something that is visible to the buyer and something that the buyer will presumably understand to be costly. The buyer might reason that if the seller is spending a great deal of money on an advertisement, the seller must have good quality because the only way to recoup the advertising outlay would be to generate repeat purchases. If quality is bad, repeat purchases would not materialize, and the seller would not recover advertising costs. Hence, firms that advertise must be those who are providing high quality. As explained in more detail below, under certain conditions expenditures on things like advertising can serve as an irredeemable bond that commits the seller to high quality. Advertising is one example of a signaling mechanism that could potentially overcome adverse selection problems that result from asymmetric information. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.03%3A_Section_3-.txt |
Advertising is a good example of an economic signal, but there are many others. For example, a firm that develops a new product that is of high quality could face reluctance from consumers who, never having encountered the product before, are skeptical of the quality claims. A low introductory price could send a signal to consumers in much the same way as a costly advertising campaign. In fact, low introductory prices are often used in conjunction with advertising campaigns for new products. By offering a low introductory price, the message the firm is trying to send is: “We are selling this product for less than it is worth because we know that once you try it, you will like it so much we will make up our initial losses in repeat purchases.” Both advertising and low introductory prices depend on repeat purchases in order to be effective signals.
Some signals do not depend on repeat purchases. For example, a company that offers a warranty is signaling customers that their product is of high quality. Customers understand that the firm will incur costs if it has to fulfill warranty obligations, so it would be unprofitable to offer a generous warranty on low-quality products. Hence, customers and firms might use the presence, absence, or terms of warranties to overcome asymmetric information problems.
Types of Market Signals
Kirmani and Rao (2000) reviewed both theoretical and empirical literature on economic signals and the ways they overcome asymmetric information problems in different contexts. They grouped signals broadly into two groups. The first group is what they termed to be default-independent signals. These signals represent up-front costs that firms incur to show customers that providing low quality would not be in the firm’s economic interest. Advertising and low introductory prices, two examples already mentioned, are classified as default-independent signals. Other default independent signals include investments in brand equity defined broadly, coupons, and slotting allowances that manufacturers pay to retailers. With a default-independent signal, the firm incurs the signaling cost regardless of whether it ultimately provides high quality or low quality. The main feature is that buyers understand the signal to mean that it is in the firm’s interest to provide high quality. Investments in advertising, profits lost through low introductory prices, or large cash outlays for slotting allowances, can only be recovered if quality turns out to be high and repeat sales are good. Repeat sales are very important to default-independent signals. For non-durable and frequently purchased items (like food products) default-independent signals are common.
The second group of signals consists of what Kirmani and Rao (2000) classify to be default-contingent signals. These include warranties, money-back guarantees, and the like. For these types of signals, the firm makes no significant initial investment in the signal. If quality turns out to be bad, however, the firm stands to face costs associated with the signal. For example, if a warranty is used to signal quality and the firm defaults by providing low quality contrary to claim, it would face losses that come from settlement of customer warranty claims. In this case, repeat sales are irrelevant to whether the warranty is an effective signal. Hence, default-contingent signals are commonly associated with durable and infrequently purchased items. However, default-contingent signals can be important for frequently purchased products as well. One example is the use of a high selling price to signal high quality. This involves no up-front cost to the firm, but if the firm defaults and provides low quality at a high price, its ability to charge the high price in the future is jeopardized. By charging the high price, the firm is putting its future revenues at risk if it provides low quality.
An Effective Signal Requires a Seperating Equilibrium
This is a good place to introduce the notion of a separating equilibrium. A separating equilibrium is an outcome where the high-quality firms send signals and the low-quality firms do not. For a signal of any sort to work, it must be that high-quality firms find it advantageous to signal and low-quality firms find signals to be against their economic interest. When there is a separating equilibrium, the only thing customers need to do is to identify which firms are sending signals and which firms are not. Customers are informed of quality differences merely by observing which firms signal. In short, the signal becomes information about quality.
Unfortunately, there is nothing that says separating equilibriums will always result or will even be the norm. For example, most, if not all, producers of consumer products go to some extra expense in making their packaging look attractive. If both poor-quality and high-quality products come in attractive packaging, then attractive packaging cannot be an effective signal and cannot be used by customers to make quality judgments. In this case, there is not a separating equilibrium because both poor-quality and high-quality producers find it advantageous to signal.
Potential for Customer Abuse and Other Limitations of Signals
For some types of default-contingent signals, particularly warranties and money back guarantees, there is potential for customer abuse that results in both high-quality and low-quality firms being unwilling to signal. For example, if attention to maintenance is bothersome and costly, then customers with warranty protection may give less attention to such matters than customers without warranty protection. (Note that this is an example of moral hazard on part of the customer.) Also, the degree of subjectivity that constitutes acceptable quality will be important for default-contingent signals, such as warranties, to be effective. Warranties might work well with automobiles. It is likely that both the buyer and seller can reach an agreement as to whether a problem exists and would be covered under the warranty. For example, the transmission either works or it does not. For vacation packages, another infrequently purchased item, it would be much harder to determine whether the customer who wanted his money back after reporting a bad vacation experience has a legitimate complaint or is simply trying to abuse a money back guarantee.
Similarly, some default independent signals such as low introductory prices could, in some situations, be ineffective for lack of a separating equilibrium. If a high-quality firm uses a low introductory price, it is likely to attract quality-insensitive customers as well as quality-sensitive customers. When the high-quality firm stops its low price campaign and raises its price to the high-quality level, it loses its quality-insensitive customers. These customers do not much care about quality anyway and opt for lower-priced and lower-quality products once the campaign ends. The low introductory price signal depends on repeat purchases and a large proportion of quality-insensitive customers who do not provide repeat purchases raises the cost of using a low introductory price as a signal. In this case, customer heterogeneity raises the cost of a signal perhaps to the point where both high-quality and low-quality firms find it in their advantage to not signal. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.04%3A_Section_4-.txt |
Consider a market with two kinds of firms. The first type is a high-quality firm. This firm is capable of producing high-quality products but must incur extra production costs if it decides to produce high quality. Because of asymmetric information, the high-quality firm might cheat customers by charging a high-quality price for low-quality products. The other type of firm is a low-quality firm. This firm is only capable of producing low quality. Because of asymmetric information, the low-quality firm might deceive customers by offering its low-quality products at a high-quality price. Finally, assume that there is a demand for both high-quality and low-quality products. The high-quality demand is comprised of quality-sensitive customers who are willing to pay a premium for quality. The low-quality market is comprised of quality-insensitive customers who are unwilling to pay a premium for quality.
Let us define the following profit outcomes in terms of the firm’s choice of price and/or quality level.
1. $\pi(P_{H}, H)$ is the profit level of a high-quality firm that sells at the high-quality price and truthfully provides high quality (and incurs extra production costs).
2. $\pi(P_{H}, L)$ is the profit level of a high- or low-quality firm that is untruthful. It sells at the high-quality price but actually provides customers with a low-quality product.
3. $\pi(P_{L}, L)$ is the profit level of a high- or low-quality firm that truthfully provides low quality.
4. $\pi(P_{L}, H)$ is the profit of a high-quality firm who provides high quality (and incurs extra production costs) but sells at the low-quality price.
Let us rule out the the fourth case by assuming $\pi(P_{L}, H) < 0$. That is, it is never profitable for a high-quality firm to produce a high-quality product but sell at the low-quality price. Thus, cases 1 to 3 are the only ones of interest in our model.
Conditions for a Lemons Market
Given asymmetric information, a lemons market could occur if
1. There is an incentive for high-quality firms to cheat by providing low quality at the high-quality price. In other words, $\pi(P_{H}, L) > \pi (P_{H}, H)$. In this case, the incentive to cheat is the difference $\pi (P_{H}, L) - \pi (P_{H}, H) > 0$,
and/or
1. There is an incentive for low-quality firms to deceive by pretending to be high-quality firms because $\pi (P_{H}, L) > \pi (P_{L}, L)$. In this case, the incentive to deceive is $\pi (P_{H}, L) - \pi (P_{L}, L) > 0$.
With either or both of these incentives in place, customers would be wary of any firm that charges the high-quality price. Even if the customer cares a great deal about quality, he/she would naturally be suspicious of cheating or deception by sellers and would want to avoid paying a premium for quality that is not provided. If customers were very suspicious of cheating or deception, none may be willing to pay the high-quality price. The result is a market outcome where only low quality is provided and all firms get $\pi (P_{L}, L)$. It may be true that $\pi (P_{H}, H) > \pi (P_{L}, L)$ and high-quality firms would be better off economically by truthfully providing high quality. However, customer suspicions prevent high-quality firms from accessing the high-quality market. This is the lemons problem mentioned earlier in the chapter.
A Signal to Correct the Lemons Problem
An economic signal could correct the lemons problem if the cost of the signal was lower when a firm provided high quality and higher when the firm provided low quality. Let us consider the case of a warranty. Define $C$ as the warranty cost of a firm that provides high quality and define $C'$ to be the warranty cost of a firm that provides low quality. High-quality products should have fewer warranty claims, so it is reasonable to assert that $C' > C$.
Could offering a warranty serve as the entry ticket for a high-quality firm that wants to truthfully sell on the high-quality market? The answer is yes, provided that customers understand the signal and each of the following conditions hold.
Condition 1. Access to the high-quality market is economically attractive in the presence of a truthful signal. If warranties are to be a successful signal, then high-quality firms must be willing to truthfully provide high quality in the presence of warranty costs. It must be that
1A. $\pi (P_{H}, H)-C>\pi (P_{L}, L),$
which implies
1B. $\pi (P_{H}, H) - \pi(P_{L}, L) > C$
The left side of 1B represents the benefits of truthfully accessing the high-quality market and selling at a high-quality price. The right side is the cost of offering warranties on high-quality products.
Condition 2: The signal removes the incentive for high-quality firms to cheat. If warranties are to be a successful signal, then the warranty must remove the incentive for high-quality firms to cheat. It must be that
2A. $\pi (P_{H}, H) - C > \pi (P_{H}, L) - C',$
which implies
2B. $C' - C > \pi(P_{H}, L) - \pi (P_{H}, H).$
The left side of inequality 2B represents the additional signal cost the firm would face if it cheated. The right side represents the incentive to cheat. Thus, if 2B holds, the cost of cheating is larger than the benefits of cheating.
Condition 3: The signal removes the incentive for low-quality firms to deceive. Finally, if warranties are to be a successful signal then they must make it unattractive for low-quality firms to deceive customers by pretending to be high-quality firms. It must be that
3A. $\pi (P_{L}, L) > \pi(P_{H}, L) - C',$
which implies
3B. $C' > \pi(P_{H}, L) - \pi (P_{L}, L).$
The left side of inequality 3B is the cost of offering a warranty on low-quality products, and the right hand side represents the incentive to deceive. Thus if 3B holds, the costs of deception exceed the benefits.
If all three of these conditions hold, there will be a separating equilibrium in the model where high-quality firms will signal and truthfully provide high-quality and low-quality firms will not signal and will provide low quality. Consumers who are willing to pay a premium for quality can safely purchase from firms with the signal. Those consumers who are not quality conscious will buy from firms that do not signal. In short, the signal corrects the lemons market problem and allows for the high-quality market to exist. If any one of these three conditions do not hold, however, there is no separating equilibrium and the signal is ineffective.
Advertising Cost as Quality-Dependent
The example of a warranty was chosen to explain the separating equilibrium because it is simple to see why warranty costs in the presence of false quality claims would be higher than warranty costs in the presence of true quality claims. Let us now consider why and how advertising might also be an effective signal. Given the model presented above, advertising could be an effective signal if advertising had a lower cost when quality claims were true than when quality claims were false.
To see why this might be the case, let $A$ represent brand equity and suppose that access to the high-quality market in any given time period, $t$ requires that $A_{t} > \bar{A}$. Firms with brand equity greater than or equal to $\bar{A}$ are able to charge the high-quality price. Firms with brand equity below $\bar{A}$ cannot and must charge the low-quality price. Suppose further that brand equity depreciates with time and needs to be replenished with advertising. The dynamics of brand equity when high quality is truthfully provided are
$A_{t} = \delta A_{t -1} + a_{t},$
where $0 < \delta < 1$ is the rate of depreciation in brand equity and $a_{t}$ is advertising expenditure in the current period.
The dynamics of brand equity when a firm provides low quality are
$A_{t} = \delta' A_{t-1} + a_{t},$
where $0 \leq \delta ' < \delta$. If a firm puts low-quality products on the market, a smaller portion, $\delta ' < \delta$, of its brand equity carries over from the prior period. This means that brand equity depreciates at a faster rate when low quality is provided. This is a reasonable assertion.
Given these dynamics, the minimal steady-state expenditure required to maintain continuous access to the high-quality market for a firm that truthfully provides high quality would be $a_{t} = (1-\delta) \bar{A}$. If a firm falsely claimed high quality, its cost of accessing the high-quality market would be higher at $a_{t} = (1 - \delta ') \bar{A}$. Thus, advertising has the feature that it is less expensive when high-quality is provided than when not. In the parlance of the signalling model above, we have a truthful signal cost, $C$, and a false signal cost, $C'$, that satisfy
$C = (1 - \delta) \bar{A} < C' = (1- \delta ') \bar{A}.$
This quality-dependent difference in advertising cost could bring about a separating equilibrium provided that $C$ and $C'$ are of appropriate magnitudes to satisfy conditions 1 through 3 above.
9.06: Section 6-
Economists have long held that advertising has been a means of influencing consumer preferences in a manner that makes demand less elastic and gives further discretion in price setting. The argument here is that advertising is way for sellers to increase their market power in an imperfectly competitive market. This argument is not without merit but does not explain the breadth and differences in advertising messages observed in real world commerce. Furthermore, if this were the only purpose of advertising, it would be difficult to defend it as a valuable use of economic resources. Advertising would be doing nothing to make the economy more productive. Its sole purpose would be to transfer wealth from buyers to sellers and would probably worsen welfare losses that result from resource misallocation problems observed in models of imperfectly competitive behavior. As such, advertising would be a prime candidate for regulation or even prohibition under laws similar to those that prohibit collusion, price fixing, or other anti-competitive behavior.
Recent work in information economics has noted that advertising can facilitate consumer search and can provide believable signals about experience attributes that cannot be verified pre-sale. Economists are developing a deeper understanding of advertising and its role in a market economy. If advertising does aid search and mitigate problems of asymmetric information, then it plays a valuable role that can facilitate the functioning of markets.
9.7: References
Akerlof, G. “The Market for Lemons: Qualitative Uncertainty and the Market Mechanism” Quarterly Journal of Economics 84(1970):488-500.
Kirmani, A. and A. R. Rao. “No Pain, No Gain: A Critical Review of the Literature on Signaling Unobservable Product Quality.” Journal of Marketing 64(2000):66-79.
Milgrom, P. and J. Roberts. Economics, Organization, and Management. Englewood Cliffs, NJ: Prentice Hall, 1992.
Nelson, P. “Advertising as Information.” Journal of Political Economy 82(1974):729-754. | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.05%3A_Section_5-.txt |
Exercise \(1\)
Given the following:
Profits of falsely claiming high quality with no signal are 120.
Profits of truthfully claiming high quality with no signal are 100.
Profits of truthfully claiming low quality are 80.
The cost of a true signal of high quality is 16.
The cost of a false signal of high quality is 38.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): No
There is a separating equilibrium if all answers are 'Yes'
Exercise \(2\)
Given the following:
Profits of falsely claiming high quality with no signal are 130.
Profits of truthfully claiming high quality with no signal are 100.
Profits of truthfully claiming low quality are 60.
The cost of a true signal of high quality is 32.
The cost of a false signal of high quality is 71.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): Yes
There is a separating equilibrium if all answers are 'Yes'
Exercise \(3\)
Given the following:
Profits of falsely claiming high quality with no signal are 140.
Profits of truthfully claiming high quality with no signal are 120.
Profits of truthfully claiming low quality are 70.
The cost of a true signal of high quality is 24.
The cost of a false signal of high quality is 75.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): Yes
There is a separating equilibrium if all answers are 'Yes'
Exercise \(4\)
Given the following:
Profits of falsely claiming high quality with no signal are 150.
Profits of truthfully claiming high quality with no signal are 120.
Profits of truthfully claiming low quality are 50.
The cost of a true signal of high quality is 31.
The cost of a false signal of high quality is 99.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): No
There is a separating equilibrium if all answers are 'Yes'
Exercise \(5\)
Given the following:
Profits of falsely claiming high quality with no signal are 160.
Profits of truthfully claiming high quality with no signal are 120.
Profits of truthfully claiming low quality are 80.
The cost of a true signal of high quality is 41.
The cost of a false signal of high quality is 80.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): No
Answer for (2): No
Answer for (3): No
There is a separating equilibrium if all answers are 'Yes'
Exercise \(6\)
Given the following:
Profits of falsely claiming high quality with no signal are 150.
Profits of truthfully claiming high quality with no signal are 110.
Profits of truthfully claiming low quality are 60.
The cost of a true signal of high quality is 38.
The cost of a false signal of high quality is 93.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): Yes
There is a separating equilibrium if all answers are 'Yes'
Exercise \(7\)
Given the following:
Profits of falsely claiming high quality with no signal are 140.
Profits of truthfully claiming high quality with no signal are 110.
Profits of truthfully claiming low quality are 70.
The cost of a true signal of high quality is 34.
The cost of a false signal of high quality is 66.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): No
There is a separating equilibrium if all answers are 'Yes'
Exercise \(8\)
Given the following:
Profits of falsely claiming high quality with no signal are 130.
Profits of truthfully claiming high quality with no signal are 110.
Profits of truthfully claiming low quality are 50.
The cost of a true signal of high quality is 20.
The cost of a false signal of high quality is 82.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): Yes
Answer for (2): Yes
Answer for (3): Yes
There is a separating equilibrium if all answers are 'Yes'
Exercise \(9\)
Given the following:
Profits of falsely claiming high quality with no signal are 120.
Profits of truthfully claiming high quality with no signal are 90.
Profits of truthfully claiming low quality are 80.
The cost of a true signal of high quality is 29.
The cost of a false signal of high quality is 44.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): No
Answer for (2): No
Answer for (3): Yes
There is a separating equilibrium if all answers are 'Yes'
Exercise \(10\)
Given the following:
Profits of falsely claiming high quality with no signal are 130.
Profits of truthfully claiming high quality with no signal are 90.
Profits of truthfully claiming low quality are 60.
The cost of a true signal of high quality is 42.
The cost of a false signal of high quality is 66.
(1) Is truthful access to the high-quality market profitable given the signal?
(2) Does the signal remove the incentive of high-quality firms to cheat?
(3) Does the signal remove the incentive of low-quality firms to deceive?
(4) Is there a separating equilibrium that corrects the lemons market?
Answer
Answer for (1): No
Answer for (2): No
Answer for (3): No
There is a separating equilibrium if all answers are 'Yes'
Problem Set 2. Multiple Choice
Exercise \(1\)
1. Which was not one of the examples of an economic signal?
a) Low introductory prices
b) A warranty
c) Advertising
d) Production management contracts
Answer
d
Exercise \(2\)
1. Which of the following is a market solution to the adverse selection problem?
a) Incentive-based contracts
b) First degree price discrimination
c) Equilibrium pricing mechanisms
d) Behavioral economics models
e) Economic signals
Answer
e
Exercise \(3\)
1. Which of the following is a market solution to the moral hazard problem?
a) Incentive-based contracts
b) First degree price discrimination
c) Equilibrium pricing mechanisms
d) Behavioral economics models
e) Economic signals
Answer
a
Exercise \(4\)
1. Which of the following would be the best example of a default-contingent signal?
a) Advertising
b) Low-introductory prices
c) Warranties
d) Job-market signaling with a college education
Answer
c
Exercise \(5\)
1. Which of the following would be the best example of a default-independent signal?
a) Advertising
b) Low-introductory prices
c) Job-market signaling with a college education
d) All of the above
Answer
d
Exercise \(6\)
1. Asymmetric information means
a) One party to a transaction is better informed than another
b) That information is freely available to both parties but neither party has correct information
c) Both parties are about equally informed but each places a different value on the information
d) Choices (b) and (c) only
Answer
Exercise \(7\)
1. Provided there is a separating equilibrium, this mechanism can mitigate the adverse selection (lemons market) problem
1. An incentive based contract
2. An economic signal
3. A tit-for-tat responses
4. A 2nd degree price discrimination strategy
Answer
b
Exercise \(8\)
1. Which best describes a separating equilibrium
a) A partial equilibrium model
b) A situation where all firms signal regardless of quality
c) A situation where only firms providing high quality find it in their interest to signal
d) A situation where no firms signal
Answer
c | textbooks/socialsci/Economics/An_Interactive_Text_for_Food_and_Agricultural_Marketing_(Thomsen)/09%3A_Signals_and_Advertising/9.8%3A_Problem_Sets.txt |
The Magic of the Economy
The study of economics makes individuals cognizant of their environment and better decision makers.
Learning objectives
Explain how the study of economics provides knowledge to understand the system and policies that guide life.
Economics is a social science. This means that economics has two important attributes. Economics studies human activities and constructions in environments with scarce resources, and uses the scientific method and empirical evidence to build its base of knowledge.
The evaluation of human interactions as it relates to preferences, decision making, and constraints is a significant foundation of economic theory. The complexity of the dynamics of human motivation and systems has led to the establishment of assumptions that form the basis of the theory of consumer and firm behavior, both of which are used to model circular flow interactions within the economy.
Economics provides distilled frameworks to analyze complex societal interactions, as in the case of consumer and firm behavior. An understanding of how wages and consumption flow between consumers and producers provides agents with an ability to understand the symbiosis of the relationship rather than fixating on the contentious components that surface from time to time.
Economics also allows individual agents to balance expectations. An understanding of the ebb and flow of the economy through the boom and bust of the business cycles, creates the potential for emotional balance by reminding agents to limit desperation in downturns and exuberance in expansions.
By developing an understanding of the foundations of economics, individuals can become better decision makers with respect to their own lives and maintain a balance with respect to an externality that has the potential to supplement or deter their plans. Since economic theories are a basis of decision making and regulatory policy, being knowledgable about economics foundations allows an individual to be an active and aware participant rather than a passive economic agent.
Is Economics a Science?
Economics is a social science that has diverse applications.
Learning objectives
Explain how economic theory and analysis can be applied throughout society
Economics is a social science that assesses the relationship between the consumption and production of goods and services in an environment of finite resources. A focus of the subject is how economic agents behave or interact both individually (microeconomics) and in aggregate (macroeconomics).
Microeconomics examines the behavior individual consumers and firms within the market, including assessment of the role of preferences and constraints. Macroeconomics analyzes the entire economy and the issues affecting it. Primary focus areas are unemployment, inflation, economic growth, and monetary and fiscal policy.
The discipline of economics evolved in the mid-19th century through the combination of political economy, social science and philosophy and gained entrenchment with the increased scrutiny of the asymmetric financial and welfare distribution attributed to sovereign rule. Early writings are attributable to Jeremy Bentham, David Ricardo, John Stuart Mill and his son John Mill and are focused on human welfare and benefits rather than capitalism and free markets.
Founders of Economics: John Stuart Mill, along with David Ricardo, Jeremy Bentham and other political and social philosophers of the mid-nineteenth century are credited with the founding of the social-political theory that has evolved to be the discipline of economics.
As in other social sciences, economics does incorporate mathematics in the theoretical and analytics framework of the discipline. Formal economic modeling began in the 19th century with the use of differential calculus to represent and explain economic behavior, such as utility maximization, an early economic application of mathematical optimization in microeconomics. Economics utilizes mathematics to assess the relationships between economic actors in environments in which resources are finite.
The use of mathematics in economics increased the quantitative analysis inherent in the discipline; however, given the discipline’s essentially social science roots, many economists from John Maynard Keynes to Robert Heilbroner and others criticized the broad use of mathematical models for human behavior, arguing that some human choices can not be modeled or evaluated in a mathematical equation.
Economic theory and analysis may be applied throughout society, including business, finance, health care, and government. The underlying components of economic theory can also be applied to variety of other subjects, such as crime, education, the family, law, politics, religion, social institutions, war, and science.
Key Points
• Economics also allows individual agents to balance expectations.
• Economics provides distilled frameworks to analyze complex societal interactions, as in the case of consumer and firm behavior.
• Being knowledgable about economics foundations allows an individual to be an active and aware participant rather than a passive economic agent.
• Economics incorporates both qualitative and quantitative assessment.
• Economics is divided into two broad areas: microeconomics and macroeconomics.
• Economics can be applied throughout society from business to individual behavior with further application in the study of crime, family and other social institutions and interactions.
Key Terms
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• circular flow: A model of market economy that shows the flow of dollars between households and firms.
• social science: A branch of science that studies the society and human behavior in it, including anthropology, communication studies, criminology, economics, geography, history, political science, psychology, social studies, and sociology.
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Scarcity Leads to Tradeoffs and Choice
When scarce resources are used, actors are forced to make choices that have an opportunity cost.
Learning objectives
Give examples of economic trade-offs.
A fundamental concept in economics is that of scarcity. In contrast to its colloquial usage, scarcity in economics connotes not that something is nearly impossible to find, but simply that it is not unlimited. For example, the number of available hours in a day is a scarce resource: there is a finite amount of time available to you to do work, hang out with friends, and relax. Most resources are scarce in most situations.
Since resources tend to be scarce, anyone that uses the resource has to make a decision about how to use it. Suppose, for example, that you are a drink manufacturer. To produce a beverage, you have to use some scarce resources: the plastic for the bottle, the workers’ time, a machine to fill the bottles, etc. If you choose to make one bottle of water, you have chosen to not make a bottle of soda. Your scarce resources force you to make a choice and a trade-off producing one product or another.
Tradeoffs: Since resources are scarce for a drink manufacturer, it must make a tradeoff between producing bottles of water and bottles of soda.
Like producers, consumers also have to make choices. Often, consumers must choose between current consumption (“I want to buy an ice cream”) and future consumption (“I should rather save my money so I can buy an ice cream tomorrow”). Since consumers’ resources such as time, attention, and money are limited, they must choose how to best allocate them by making tradeoffs.
The concept of trade-offs due to scarcity is formalized by the concept of opportunity cost. The opportunity cost of a choice is the value of the best alternative forgone. In other words, if you can only produce bottles of soda and water, the opportunity cost of producing a bottle of water is the value of producing a bottle of soda. Similarly, there is an opportunity cost in everything: the opportunity cost of you reading this is what you could be doing with your time instead (say, watching a movie). When scarce resources are used (and just about everything is a scarce resource), people and firms are forced to make choices that have an opportunity cost.
Individuals Face Opportunity Costs
Individuals face opportunity costs when they choose one course of action over another.
Learning objectives
Distinguish between explicit costs and opportunity costs
When individuals make decisions, they are necessarily deciding between taking one course of action over another. In doing so, they are choosing both what to do and, by extension, what not to do. The value of the next best choice forgone is called the opportunity cost. In other words, the opportunity cost of a course of action is the value the of the option that the individual chose not to take.
Individuals face opportunity costs in both economic and non-economic decisions. One of the easiest way to imagine an individual’s opportunity costs is to imagine a student who decides to study. By choosing to study, the student is implicitly choosing to not go to a party, hang out with friends, or catch up on some much-needed sleep. In this example, the opportunity cost is not easily expressed in dollars and cents, but is just as real.
Opportunity Cost: By choosing to go to spend time and money on things like classes and computers, you are necessarily choosing not to spend it on something else, like going on vacation. This is an opportunity cost.
Rational individuals will try to minimize their opportunity costs. By doing so, individuals are maximizing the amount that they can get out of their resources (time, money, effort, etc.). This makes sense: individuals should seek to get the most and give up the least.
As economic actors, individuals face opportunity costs as well. For example, suppose you decide to purchase a new computer. You could have chosen to spend your money on books or rent or a spring break trip; whichever one of those options is most valuable to you (beside purchasing a new computer) is the opportunity cost.
Such logic applies for every economic decision: purchasing one good means that an individual has chosen to spend resources one way instead of another. Opportunity costs are an important consideration for economists and business people, but are faced by individuals even when they are not making classically economic decisions.
Individuals Make Decisions at the Margins
Individuals will choose the option that yields the greatest net marginal benefit.
Learning objectives
Apply the concepts of marginal analysis and utility to decision-making
When individuals make decisions, they do so by looking at the additional cost and benefit of the decision. The cost or benefit of the single decision is called the marginal cost or the marginal benefit. This is different from the total or average: net marginal benefit (marginal benefit minus marginal cost) is the amount that total benefit will change due to the single decision. For example, if the cost of making 9 pieces of pizza is \$90 and the cost of making 10 pieces is \$110, the marginal cost of producing the tenth piece of pizza is \$20. In theory, individuals will only choose an option if marginal benefit exceeds marginal cost.
Marginal and Total Utility: Marginal utility is the amount that a certain action will change total utility. Individuals use net marginal utility to make decisions.
Let’s take an example. Suppose you are buying a car and have three choices:
1. Car A, which costs \$10,000
2. Car B, which costs \$12,000
3. Car C, which costs \$15,000
The prices represent the marginal costs of each car; purchasing the car will add the cost of the car to your total costs. Also suppose Car A provides you \$15,000 worth of utility, Car B provides \$15,000, and Car C provides \$25,000. Those utilities, in dollar terms, are the marginal benefit of each car.
In order to make the decision, you look at the marginal cost and marginal benefit of each car. By subtracting the cost from the benefit, Car A offers \$5,000 of marginal benefit, Car B offers \$3,000, and Car C offers \$10,000. Obviously, Car C is the best choice because, at the margins, it offers the most benefit to you.
Note that you are concerned not with your total or average cost and benefit (assuming no resource or other external restrictions), but with the marginal cost and benefit. As a decision maker, you want to know how much the decision will change your current state, so you look at the margins, not the overall picture. That is not to say that things like the total cost are unimportant, but that, assuming there are enough resources, individuals will look at the marginal change each option will provide to his/her life or to the firm and chose the one with the greatest net marginal benefit.
Marginal Benefits and Costs for Pollution
The tools of marginal analysis can illustrate the marginal costs and the marginal benefits of reducing pollution. When the quantity of environmental protection is low (quantity QaQa) and pollution is extensive, there are cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At QaQa, it makes sense to allocate more resources to fight pollution.
However, as environmental protection increases, the cheap and easy ways of reducing pollution decrease, and pollution can only be reduced with costly methods. In other words, the largest marginal benefits are achieved first, followed by decreasing marginal benefits. As the quantity of environmental protection increases to QbQb, the gap between marginal benefits and marginal costs decreases. At point QcQc, the marginal costs will exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently, because too many resources are being given up to reduce pollution.
Marginal Costs and Marginal Benefits of Environmental Protection: Reducing pollution is costly—resources must be sacrificed. The marginal costs of reducing pollution are generally increasing, because the least expensive and easiest reductions can be made first, leaving the more expensive methods for later. The marginal benefits of reducing pollution are generally declining, because the steps that provide the greatest benefit can be taken first, and steps that provide less benefit can wait until later.
Individuals Respond to Incentives
Incentives are ways to encourage or discourage certain behaviors or choices.
Learning objectives
Predict how pay incentives will influence a person’s work performance
An incentive is something that motivates an individual to perform an action. The study of incentive structures is central to the study of all economic activities (both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure).
Perhaps the most notable incentive in economics is price. Price acts as a signal to suppliers to produce and to consumers to buy. For example, a sale is nothing more than a store providing an incentive to potential customers to buy. The lowering of the price makes the purchase a better idea for some customers; the sale seeks to persuade individuals to change their actions (namely, to buy the product).
Sales are Incentives: Sales are incentives for consumers to buy, because firms know consumers generally respond to lower prices by purchasing more.
Similarly, the increase in price acts as an incentive to suppliers to produce more of a good. If suppliers think they can sell their products for more, they will be inclined to produce more. The price acts, therefore, as an incentive to customers to buy and suppliers to produce.
Types of Incentives
Incentives come in many other forms, however. Broadly, most incentives can be grouped into one of four categories:
• Remunerative incentives: The incentive comes in the form of some sort of material reward – especially money – in exchange for acting in a particular way. Wages, prices, and bribery are all examples of remunerative incentives. This is the type of incentive that is typically associated with economics.
• Moral incentives: This occurs when a certain choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. Societies and cultures are two main sources of moral incentives.
• Coercive incentives: The incentive is a promise of some sort of punishment if the wrong decision is made. For example, the promise of imprisonment is a coercive incentive for people to not steal.
• Natural Incentives: Things such as curiosity, mental or physical exercise, admiration, fear, anger, pain, joy, the pursuit of truth, and a sense of control of people or oneself can cause individuals to make certain decisions.
Economics is mainly concerned with remunerative incentives, though when discussing government regulations, coercive incentives often come into play. By manipulating incentives, individuals (as well as businesses and governments) hope to encourage some behaviors and discourage others.
Incentives and Performance
Companies leverage incentives-based strategies to drive performance and optimize employee decision-making and behaviors through meaningful reward systems. While there are both advantages and drawbacks to this type of approach, remunerative (financial) incentives are highly attractive options for employers in a variety of industries and businesses. Providing incentives such as variable income, where an individual can obtain more personal rewards for successfully creating a product or making a sale, often drives up production for highly motivated employees.
An example of this would be a manufacturing facility making widgets. The floor manager shifts the wage system from an hourly wage perspective to a straight piece rate system. The more widgets a worker creates, the higher his or her prospective income will be. Under this incentive system less productive workers may stay the same, but highly productive workers will respond by increasing their production.
Key Points
• Scarce resources diminish as they are used and almost all resources are scarce.
• In order to use a scarce resource, you are inherently using the resource for one purpose and not an alternative.
• The cost of using a resource is called the opportunity cost: the value of the next best alternative that you could be using the resource for instead.
• The opportunity cost is the value of the next best alternative foregone.
• Every decision necessarily means giving up other options, which all have a value.
• The opportunity cost is the value one could have derived from using the same resources another way, though this is not always easily quantifiable.
• The marginal cost or benefit is the amount that a decision will change the total cost or benefit from where it is currently.
• Individuals will make choice that maximizes the net marginal benefit (marginal benefit – marginal cost).
• While total or average cost and benefit are important, provided enough resources, individuals will look only at the net marginal benefit.
• Price is one of the main incentives studied in economics. Price incentivizes producers to supply a certain amount, and consumers to purchase a certain amount.
• Economics is mainly concerned with studying remunerative incentives (those that concern material reward).
• Individuals, firms, and governments all change incentives in hopes of encouraging desired outcomes.
Key Terms
• Scarce: Insufficient to meet demand.
• Opportunity cost: The value of the best alternative forgone.
• Opportunity Costs: The value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources.
• marginal benefit: The additional benefit from taking a course of action.
• marginal cost: The additional cost from taking a course of action.
• incentive: Something that motivates an individual to perform an action.
• Incentive Structure: The cumulative set of promised rewards and/or punishments that encourage actors to make a set of decisions.
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Introducing the Firm
Firms allow an economy to operate more efficiently and reduce the transaction costs of coordinating production.
Learning objectives
Explain the importance of private companies and firms in the economy
“Firm” is simply another word for company or business. The basic economic marketplace consists of transactions between households and firms. Firms use factors of production – land, labor, and capital – to produce goods that are consumed by households. They may be organized in many different ways – corporations, partnerships, sole proprietorships, and collectives are all examples of firms. Economists who study the theory of the firm attempt to describe, explain, and predict the nature of a firm, including its existence, behavior, structure, and relationship to the market.
The Evolution of the Firm
Not all markets and societies involve firms. In many medieval cities, most production was done by individual craftsmen who were loosely organized into guilds, or by tenant farmers who rented family-sized plots of land. Transactions took place primarily between individuals.
Firms generally appear and become prevalent as an alternative to individual trade when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be too difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. While the advantages of consolidation for efficiency are potentially many and varied, the underlying concept is that integrating operational paradigms enables potential synergy via the construct of a firm.
Firms also allow economic growth, not only for the firm but for the broader society in which it resides. Through separating the business from the individual(s) who starts it, the funding, insurance and liability of a firm can function independently of a person. The separation of a firm from the individual also allows more specifically applicable regulations and laws, broader accumulation of investment capital and more complex strategic alliances. While the detailed implications of a firm and it’s relationship with individuals and society are complex, the important takeaway is that firms play an integral role in economic structure.
The Firm: Organizing production under firms reduces the transaction costs of coordinating production in the market.
The Transaction Theory of the Firm
According to Ronald Coase, people begin to organize their production in firms when the transaction cost of coordinating production through the market exchange is greater than within the firm. He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur … who directs production.” He asks why alternative methods of production (such as the price mechanism and economic planning), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.
For Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about division of surplus, particularly if there is asymmetric information and asset specificity, may be considerable. Organization into a firm can considerably reduce these costs.
Trade Leads to Gains
Producers and consumers trade because the exchange makes both parties better off.
Learning objectives
Explain why parties trade.
Producers and consumers trade because the exchange makes both parties better off. The benefit of exchange to producers is measured by the amount of profit – that is, the difference between the average cost of producing an item and the price received for that item. The benefit of exchange to a consumer is measured by net utility gained. This is measured by taking the difference between the maximum price a consumer is willing to pay and the actual price they do pay. To understand this, imagine purchasing a car. You would be willing to pay up to \$15,000 for a car in good condition, but you are able to buy one for only \$12,000. Since you value the car at \$3,000 more than you paid for it, \$3,000 is the benefit that you gained from the transaction.
Economists refer to these benefits from exchange as producer and consumer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.
The amount of consumer and producer surplus that is gained from a transaction can be seen on a standard supply and demand graph. Consumer surplus is the area (triangular if the supply and demand curves are linear) above the equilibrium price of the good and below the demand curve. This reflects the fact that consumers would have been willing to buy a single unit of the good at a price higher than the equilibrium price, a second unit at a price below that but still above the equilibrium price, etc., yet they in fact pay just the equilibrium price for each unit they buy.
Likewise, in the supply-demand diagram, producer surplus is the area below the equilibrium price but above the supply curve. This reflects the fact that producers would have been willing to supply the first unit at a price lower than the equilibrium price, the second unit at a price above that but still below the equilibrium price, etc., yet they in fact receive the equilibrium price for all the units they sell. The sum of consumer and producer surplus is called economic, or social, surplus, and reflects the total amount of benefit received by society when consumers and producers trade.
Consumer and Producer Surplus: Consumer surplus is the area between the demand line and the equilibrium price, and producer surplus is the area between the supply line and the equilibrium price.
Exchange and Pareto Optimality
An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off. For example, imagine that two individuals prefer peanut butter and jelly sandwiches to a sandwich with only peanut butter or only jelly. A distribution in which Individual A has all of the peanut butter and individual B has all of the jelly is not Pareto efficient, because both parties would be better off if they shared their resources.
Similarly, an action that makes at least one party better off without making any individual worse off is called a Pareto improvement. Any transaction in a free market always produces a Pareto improvement because it makes consumers and/or producers better off without making either party worse off (if this were not the case, the consumer and/or the producer would refuse to participate in the transaction in the first place). It is commonly assumed that outcomes that are not Pareto efficient are to be avoided, and if a Pareto improvement is possible it should always be implemented.
One way to look at whether a transaction is a Pareto improvement is to ask whether it increases consumer or producer surplus without decreasing either party’s surplus. Lowering an item’s price without changing the quantity sold, for example, may increase consumer surplus, but is not a Pareto improvement because producers suffer negative consequences.
Thinking about Efficiency
An efficient market maximizes total consumer and producer surplus.
Learning objectives
Define economic efficiency.
Every economic transaction has a buyer and a seller who will only participate is she is receiving at least a minimum benefit. These benefits are represented as consumer surplus and producer surplus, respectively. In the illustration below, both types of surpluses are displayed graphically. An efficient market maximizes total consumer and producer surplus.
Consumer and Producer Surplus: Consumer and producer surplus are maximized at the market equilibrium – that is, where supply and demand intersect.
The market shown in is one without any distortions such as regulations, taxes, or an inability for buyers to meet sellers. It is subject to what Adam Smith described as the invisible hand: if the price is anything except the equilibrium price, market forces will eventually return the market price to equilibrium.
Not all markets are efficient. There are a number of reasons why a market may be inefficient. Perhaps most well known is inefficiency caused by government intervention. Governments can institute any number of policies that prevent markets from achieving the free market equilibrium price and quantity: taxes raise prices, quotas limit the quantity sold, and regulations affect the supply and demand curves. Market inefficiency can also be caused by things such as irrational market actors and barriers to transactions, such as an inability for buyers and sellers to find one another.
Economists often seek to maximize efficiency, but it is important to contextualize such aims. Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds. Most commonly, efficiency is contrasted or paired with morality, particularly liberty, and justice. Some economic policies may be seen as increasing efficiency at a cost to other goals or values, though this is certainly not a universal tradeoff. For example, taxation will always cause some inefficiency in markets, but many individuals believe that the benefits of programs such as Social Security and public schooling are worth the loss in efficiency.
The Function and Nature of Markets
In a free market, the price and quantity of an item are determined by the supply and demand for that item.
Learning objectives
Summarize the defining characteristics of a free market economy
In economics, a market is defined as a system or institution whereby parties engage in exchange. A market economy is an economy in which decisions regarding investment, production, and distribution are based on supply and demand, and prices of goods and services are determined in a free price system. The major defining characteristic of a market economy is that decisions on investment and the allocation of producer goods are mainly made through markets. This is the opposite of a planned economy, where investment and production decisions are embodied in a plan of production.
A free market is a market structure that is not controlled by a designated authority. Free markets may have different structures: perfect competition, oligopolies, monopolistic competition, and monopolies are all types of markets that may exist in a capitalist economy. The most basic models in economics assume that markets are free and experience perfect competition – there are many buyers and sellers so no individual actor may affect a good’s price; there are no barriers to exit or entry; products are homogeneous; and all actors in the economy have perfect information.
Market Equilibrium
In a free market, the price and quantity of an item is determined by the supply and demand for that item. The market demand function describes the amount of a good that all consumers will purchase at a given price, while the market supply function expresses the amount that producers will supply at a given price. Consider the market for computers. At a price of \$1,200, the market may demand 8,000 computers, while producers are willing to supply 15,000 computers. This is not the equilibrium price because at \$1,200, supply exceeds demand. In order to reach equilibrium, the price must drop, causing demand to rise and supply to fall until the two are equal. This can be expressed graphically by drawing the market supply function and the market demand function and finding the point where the two curves intersect.
Market Supply and Demand: The market equilibrium exists where the market demand curve and the market supply curve intersect.
Changes to the market supply and market demand will cause changes in the equilibrium price and quantity of the good produced. For example, if a new technology is invented that allows producers to manufacture cars more efficiently, supply will rise and the market supply curve will shift to the right. The new market equilibrium will have a higher number of cars sold at a lower price. When markets are perfectly competitive, the equilibrium outcome of trade in the market is economically efficient. This means that the market is producing the largest net gain possible for society, given consumers’ utility functions and producers’ production functions.
Markets are Typically Efficient
A perfectly competitive market with full property rights is typically efficient.
Learning objectives
Define efficient markets.
An efficient market maximizes total consumer and producer surplus; there is no deadweight loss. An economic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society without using more resources. In absolute terms, a situation can be called economically efficient if:
Economic Inefficiency: A sign of economic inefficiency in a market is the presence of deadweight loss.
1. No one can be made better off without making someone else worse off (commonly referred to as Pareto efficiency),
2. No additional output can be obtained without increasing the amount of inputs, and
3. Production proceeds at the lowest possible per-unit cost.
Economists refer to two types of market efficiency. A market has productive efficiency when units of goods are being supplied at the lowest possible average cost. This condition is satisfied if the equilibrium quantity is at the minimum point of the average total cost curve. For example, if a farm can produce 10,000 bushels of corn with 20 employees, but is currently producing 10,000 bushels with 25 employees, it is not achieving productive efficiency.
A market has allocative efficiency if the price of a product that the market is supplying is equal to the value consumers place on it. This is equivalent to saying that the marginal cost of an item is equal to its price. If a market is not allocatively efficient, then it is creating too much of something that consumers value less than other goods, or not enough of something that consumers value more. A market that produces 500 loaves of bread but only one gallon of milk is probably not allocatively efficient.
As you study economics further, it is usually safe to assume that markets are efficient unless you’re dealing with a distortion (e.g. regulations, imperfect information sharing).
It is important to note that achieving economic efficiency is not always the most important goal for a society. A market can be perfectly efficient but highly unequal, for example. If 1% of the population controls virtually all the income, then the market will efficiently allocate virtually all of its production to those same people. While this is economically efficient, many would argue that it is not desirable. Efficient markets may have negative effects on those that exist outside of the market; for example, the energy market may cause environmental harm that is not captured in the economic notion of efficiency.
Government Intervention May Fix Inefficient Markets
Governments can intervene to make a market more efficient when a market failure, such as externalities or asymmetric information, exists.
Learning objectives
Discuss the role of government in addressing common market failures
In an efficient market, firms can produce goods at the lowest possible cost while individuals can access the goods and services they desire, all while utilizing the least resources possible. A market can be said to be economically efficient if it has certain qualities:
• perfectly competitive
• mobile resources
• accurate and freely available information
• individuals directly receive the costs and benefits of their transactions
Market failure is the name for when a market is not efficient; that is, when it deviates from one or more of the above conditions. However, in reality no market is perfectly efficient. In general, minor inefficiencies do not dramatically affect society. But when society is adversely affected by economic inefficiency, such as when a monopoly firm raises prices to a point where people cannot afford a basic good, the government will sometimes intervene.
Consider the problem of externalities, the phenomenon of when a transaction occurs that affects people who were not directly involved. For example, when a coal plant producing electricity causes pollution, there is a transaction between the company and the resident who purchases the product. But if you live near the coal plant and suffer from asthma due to the smog it produces, you are encountering a negative externality. You had no choice in the transaction, but are experiencing its effects.
Externalities are an example of economic inefficiency, since those involved in the economic transaction do not bear the full costs of the transaction. In this case, governments can intervene by taxing the transaction and using the money to negate the harmful effects or to compensate those affected by the negative externality. Similarly, when a transaction produces positive externalities, efficiency is achieved when the government subsidizes the transaction. Education is an example of a transaction that has a positive effect on society.
Another case in which markets do not operate efficiently on their own is the market for public goods. Public goods are nonrival, which means that more than one (and sometimes many!) individual can use the good at one time. They are also nonexcludable, which means that their use cannot be prevented. For example, consider a beautiful fountain in a public park. The company that built the fountain cannot force people to pay money in order to enjoy it, since its in a public area; and since one person looking at the fountain doesn’t prevent others from looking at it, it is a nonrival good.
Free markets will generally produce less than the optimal amount when a good is nonexcludable and nonrivalrous, which means that a government can make the market more efficient by producing the public good itself. By using tax revenue, governments can avoid the problem of free riders and produce an efficient quantity of public goods even when the free market cannot.
National Defense as a Public Good: National defense is a classic example of a good that is nonexcludable and nonrivalrous. It will be under-produced unless the government provides it.
Full Economy Interactions
Variables that describe the full economy, such as GDP and unemployment, are determined by the decisions of individual economic actors.
Learning objectives
Explain how the macroeconomy is the sum of many individual economic actors’ decisions.
In the most basic economic model, the economy consists of interactions between households, which provide labor and purchase goods, and firms, which employ labor and produce goods. Macroeconomics studies the aggregate effects of the actions of many individual households and firms. While microeconomists might study how a market with one producer and one consumer reaches equilibrium, macroeconomists combine the demand of all consumers in a market (aggregate demand) and the supply from all producers in a market (aggregate supply) to look at the way these groups interact on a large scale.
Circular Flow: The economy consists of interactions between firms and households.
Consider the market for CDs. Each individual consumer has a demand function for CDs that determines how many he will buy at a particular price – for example, one consumer may only buy a single album if they cost \$15 each, but would buy two if the price dropped to \$10 each. Likewise, each producer has a production function that determines how many CDs it will produce at a given price; it may produce 10,000 CDs if they can be sold for \$10, but will increase production to 12,000 if the price rises to \$15. In order to understand the entire market for CDs, economists add the demand of all consumers at each possible price, creating an aggregate demand curve, and the total quantity supplied by producers at each possible price, creating an aggregate supply curve. The point at which these two curves intersect shows the market equilibrium for CDs.
The Macroeconomy
Just as the choices made by individual consumers and producers can be aggregated to describe an entire industry, their combined effects can also influence a nation’s overall economic activity. Macroeconomists study a variety of these effects, but three are central to macroeconomic research:
• Gross domestic product (GDP) – the size of an entire economy’s output – is measured by adding together all the production undertaken by a nation’s firms. Individual firms affect GDP every time they choose to produce more or less. Consumers affect GDP whenever they increase or decrease demand for goods.
• Inflation occurs when many individual consumers increase demand for a good, raising the equilibrium price for the economy as a whole.
• Unemployment rises when firms choose to produce less or when consumers decrease their demand at a given price.
Key Points
• Firms generally appear and become prevalent as an alternative to individual trade when it is more efficient to produce in a non-market environment.
• Limited liability separates the management of a firm from its ownership, allowing companies to raise money easily because owners do not need to risk everything in the case of bankruptcy.
• Most industries experience increasing returns to scale up to a point, which means that more goods can be produced using fewer resources.
• According to Ronald Coase, the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism.
• The benefit of exchange to producers is measured by the profit the producer makes. The benefit of exchange to a consumer is measured by net utility gained.
• Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay.
• Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.
• An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off.
• Economists assume that firms seek to maximize their profits – defined as the difference between total revenue and total cost – while consumers seek to maximize their utility – which is roughly defined as the total satisfaction gained from goods, services, or actions.
• An efficient allocation of resources maximizes total consumer and producer surplus.
• Because they produce efficient outcomes, the seemingly haphazard workings of the marketplace can promote the common good.
• Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds.
• A market is defined as a system or institution whereby parties engage in exchange. A market economy is an economy in which decisions regarding investment, production, and distribution are based on supply and demand, and prices of goods and services are determined in a free price system.
• In a perfectly competitive market there are many buyers and sellers so no individual actor may affect a good’s price; there are no barriers to exit or entry; products are homogeneous; and all actors in the economy have perfect information.
• Changes to the market supply and market demand will cause changes in the equilibrium price and quantity of the good produced.
• When markets are perfectly competitive, the equilibrium outcome of trade in the market is economically efficient. This means that the market is producing the largest net gain possible for society, given consumers’ utility functions and producers’ production functions.
• A market has productive efficiency when units of goods are being supplied at the lowest possible average cost.
• A market has allocative efficiency if the price of a product that the market is supplying is equal to the value consumers place on it.
• It is important to note that achieving economic efficiency is not always the most important goal for a society. A market can be perfectly efficient but highly unequal.
• A smoothly functioning market requires that producers possess property rights to the goods and services they produce and that consumers possess property rights to the goods and services they buy.
• Economic efficiency occurs under the following conditions: competitive markets with accurate exchange of information and mobile resources, in which individuals bear the full costs and benefits of their transactions.
• The criteria for economic efficiency are rarely fully met.
• If a transaction affects individuals not involved in the transaction (either positively or negatively), that transaction is said to have an externality.
• Governments can intervene by taxing negative externalities or subsidizing positive externalities.
• Free markets will generally produce less than the optimal amount when a good is nonexcludable and nonrivalrous, which means that a government can make the market more efficient by producing the public good itself.
• Macroeconomists combine the demand of all consumers in a market ( aggregate demand ) and the supply from all producers in a market ( aggregate supply ) to look at the way these groups interact on a large scale.
• Just as the choices made by individual consumers and producers can be aggregated to describe an entire industry, their combined effects can also influence a nation’s overall economic activity.
• GDP is measured by adding together all the production undertaken by a nation’s firms. Individual firms affect GDP every time they choose to produce more or less. Consumers affect GDP whenever they increase or decrease demand for goods.
Key Terms
• increasing returns to scale: The characteristic of production in which output increases by more than the proportional increase in inputs.
• firm: A business enterprise, however organized.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• consumer surplus: The difference between the maximum price a consumer is willing to pay and the actual price they do pay.
• producer surplus: The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.
• producer surplus: The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.
• consumer surplus: The difference between the maximum price a consumer is willing to pay and the actual price they do pay.
• market economy: An economy in which goods and services are exchanged in a free market, as opposed to a state-controlled or socialist economy; a capitalistic economy.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• Pareto efficiency: The state in which no one can be made better off by making another worse off.
• public good: A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• free rider: One who obtains benefit from a public good without paying for it directly.
• inflation: An increase in the general level of prices or in the cost of living.
• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
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Production Outputs
A firm’s production outputs are what it creates using its resources: goods or services.
Learning objectives
Identify how suppliers determine what and how much to supply
Production outputs are the goods and services created in a given time period, by a firm, industry or country. These goods can either be consumed or used for further production. Production outputs can be anything from crops to technological devices to accounting services. Producing these outputs incur costs which must be considered when determining how much of a good should be produced.
Determining what to produce and how much to produce can be difficult. Microeconomics assumes that firms and businesses are profit-seeking. This means that above all else they will produce goods and services to the degree that maximizes their profits. In economic theory, the profit-maximizing amount of output in occurs when the marginal cost of producing another unit equals the marginal revenue received from selling that unit. When the product’s marginal costs exceeds marginal revenue, the firm should stop production.
Production Conditions: A firm will seek to produce such that its marginal cost (MC) is equal to marginal revenue (MR, which is equal to the price and demand). It is not produced based on average total cost (ATC).
Once a firm has established what its profit-maximizing output is, the next step it must consider is whether to produce the good given the current market price. There are several key terms to be familiar with prior to addressing this question.
• Fixed costs are those expenses that remain constant regardless of the amount of good that is produced. For example, no matter how much of a good you produce, you will still have to pay the same amount of rent for your factory or storage units.
• Variable costs are only those expenses that are directly tied to the production of more units; fixed costs are not included.
• Opportunity costs are the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the cost equals the most valuable forgone alternative.
• Average total cost is the all expenses incurred to produce the product, including fixed costs and opportunity costs, divided by the number of the units of the good produced.
There are four different types of conditions that generally describe a firm’s profit as described in:
• Economic Profit: The firm’s average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
• Normal Profit: The average total cost equals the price at the profit-maximizing output. In this case, the economic profit equals zero. In this scenario, the firm should produce of the product.
• Loss-minimizing condition: The firm’s product price is between the average total cost and the average variable cost. The firm should still continue to produce because additional sales would offset a portion of fixed costs. If the manufacturer stopped production, it would sustain all the fixed costs as a loss.
• Shutdown: The price is below average variable cost at the profit-maximizing output. Production should be shutdown because every unit produced increases loss. The revenue gained from sales of these products do not offset variable and fixed costs. If it does not produce goods, the firm suffers a loss due to fixed costs, but it does not incur any variable costs.
Production Inputs and Process
Labor, capital, and land are the three necessary inputs for any production process.
Learning objectives
Explain the use of capital and labor in production
The process of production generates output, otherwise referred to as good and services. Production processes require three inputs: land, capital and labor. Land is simply the place where you produce your product, whether it is a factory or a farm, and may included capital if the output being created is a service. In most scenarios, the inputs in the production process are primarily capital and labor.
Capital
Capital, otherwise known as capital assets, are manufactured goods that are used in production of goods or services. Control of these assets are the primary means of creating wealth. Included in capital is anything that has been manufactured that can be used to enhance a person’s ability to perform economically useful work. For a caveman, a stick or a stone would have been considered capital. For a post-industrial worker, a laptop, computer, and cellphone would be considered capital.
Girls running warping machines in Loray Mill, Gastonia, N.C. by Lewis Hine, 1908.: Any tool or machine that could be used to improve someone’s ability to work would be included in capital.
In regards to production, it also is important to know what capital is not. While capital may refer to funds invested in a business in other disciplines such as accounting, cash is not included in capital in terms of a production input in economics. Homes and personal automobiles are also not included in capital because these items are not directly tied to the production of goods or services.
Labor
Labor is a measure of the work done by human beings to create a manufactured output. Producers demand labor because it aids in producing output which can then be sold. In production, a worker will only be hired when the marginal revenue s/he brings in exceeds or equals the marginal cost of hiring that worker. The cost of one worker is the wage.
The value of labor varies based on the skills and talents that the individual worker brings to that job. If the job involves designing and building a computer, an engineer’s labor is more valuable than a tailor. If the job requires the manufacture of a suit, an employer would prefer the tailor. Other elements that influence the perception of the value of a specific type of labor in production include the amount of training necessary to execute the task and the barriers to conducting that type of work.
Production Recipients
The process of producing and distributing a good or service is called a supply chain, and it is composed of many economic actors.
Learning objectives
Identify the market actors involved in taking a product from the original producer to the consumer
A supply chain is a system of organizations, people, activities, information and resources involved in moving a product or service from supplier to customer. The company’s supply chain illustrates the total process of transforming raw materials into a finished product, and then selling that finished product to consumers.
Supply Chain: This represents the typical supply chain for a computer. The right half of the chart represents the steps it takes from producing the final product to the consumers.
The purpose of a supply chain is to act as an integrating function that links major business functions and processes into a cohesive business model. When designed well, a supply chain is able to respond to shifts in demand and changes in the marketplace. Based on these shifts, the supply chain is able to alter production levels accordingly so that supply can meet demand so that the firm is able to maximize its profit.
Supply chains vary based on industry, the resources of the manufacturer, and market conditions. Some typical elements and actors in a supply chain include:
• Extraction/Acquisition of Raw Materials or Components. Before the production of a good can be initiated, you need to have all of the necessary elements. These elements could be unrefined raw materials that the company transforms into components or pre-assembled parts. A firm may have subsidiaries or divisions that obtain raw materials or it might acquire those elements from a third party.
• Production. This is the process that transforms the elements acquired from the prior step into the finished good. Economic actors involved in this step include product designers, assembly-line workers, and floor management.
• Inventory. Once the good is completed, it is generally placed into a centralized inventory location while decisions are made by inventory managers and a firm’s sales division.
• Transportation. Finished goods must be transported to stores and other locations where consumers can obtain the good. Depending on the type of business, goods may be transferred to smaller regional inventory depots, merchants, or directly to a consumer.
• Wholesaler. A wholesaler is someone who sells a good to smaller stores, who in turn sells the good to consumers.
• Retailer. The retailer buys the product in bulk and sells individual or smaller groups of units to the end consumer.
Differences Between Centrally Planned and Market Economies
The key difference between centrally planned and market economies is the degree of individual autonomy.
Learning objectives
Compare the characteristics of capitalist and socialist economic systems
While there are many different variations of national economies, the two dominant economic coordination mechanisms are centrally planned and market based. Before you can analyze any national economy, you need to understand these two opposing viewpoints on how to run an economy. The key difference between the two is the amount of individual autonomy within the two systems.
Centrally Planned Economy
A pure planned economy has one person or group who controls what is produced; all businesses work together to produce goods and services that are planned and distributed by the government. These economies are also called command economies because everyone must follow specific guidelines set up by the controlling authority. The reason behind this type of planning is to make sure that everything needed is produced and that everyone’s needs are fulfilled. Since most peoples’ needs are provided for in a centrally planned economy, compensation is primarily morally based. Most assets are owned by the state.
Planned economies have several advantages. Ideally, there is no unemployment and needs never go unfulfilled. Because the government knows how much food, medicine, and other goods is needed, it can produce enough for all. But achieving these outcomes depends on the group that organizes production and distribution to accurately identify what the consumers will need, determine what it would take to meet those goals, and anticipate all possible situations. This means there are a lot of opportunities to make a mistake. Realistically, these systems tend to suffer from large inefficiencies and are overall not as successful as other types of economic systems.
V.I. Lenin: The Soviet Union, as established by V.I. Lenin, is an example of a country that tried to establish a pure centrally planned economy.
Market Based Economy
A pure market economy, or capitalist system, is one perfectly free from external control. Individuals may decide what to produce, who to work for, and how to get the things they need. They are compensated with material goods for their work, and most assets are privately owned. This type of economy, though it may be chaotic at times, allows people to change along with the shifting market conditions to maximize their profits. Although they avoid many of the inadequacies of planned economies, market economies are not free of their own problems and downfalls. Perhaps the greatest problem is that business firms may refuse to produce goods that unprofitable for them. For instance, in 2000 there was a shortage of tetanus vaccine in the United States. Because it was expensive to make, most companies were unwilling to start production themselves, leaving only one firm struggling to keep up with demand. In a planned economy, this shortage would not happen because the government would boost production of the vaccine if it were needed.
Because there is no regulation to ensure equality and fairness, market economies may be burdened with unemployment and even those with jobs can never be certain that they will make enough to provide for all of their needs. Despite these and other problems, market economies come with many advantages, chief among which is speed. Because they do not need to wait for word from the government before changing their output, companies under market economies can quickly keep up with fluctuations in the economy, tending to be more efficient than regulated markets. Also, individuals have more freedom and opportunities to do the jobs they want and to profit by them.
Mixed Economies
A mixed economy is a system that embraces elements of centrally planned and free market systems.
Learning objectives
Explain the characteristics of a mixed economy
A mixed economy is a system that embraces elements of centrally planned and free market systems. While there is no single definition of a mixed economy, it generally involves a degree of economic freedom mixed with government regulation of markets. Most modern economies are mixed, including the United States and Cuba. Countries hope that by embracing elements of both systems they can gain the benefits of both while minimizing the systems disadvantages.
In general, most of the means of production in a mixed economy are privately owned. There are some exceptions to this general rule, such as some hospitals and businesses. The mostly private ownership of all means of production allows the market to quickly respond to changing circumstances and economic factors. As a result, the market is generally the dominant form of economic coordination. However, to mitigate the negative influence that a pure market economy has on fairness and distribution, the government strongly influences the economy through direct intervention in a mixed economy. Different ways a government directly intervenes in an economy include:
• granting a business a monopoly,
• granting a subsidy to a sector,
• creating and enforcing regulation,
• direct participation in the market, or
• providing money and other resources segments of its populations, such as through a welfare program.
Most government intervention in mixed economy is limited to minimizing the negative consequences of economic events, such as unemployment in recessions, to promote social welfare.
While mixed economies vary based on their degree of government intervention, some elements are consistent. Generally, individuals in mixed economies are able to:
• participate in managerial decisions,
• travel,
• buy and sell items privately,
• hire and fire employees,
• organize organizations,
• communicate, and
• protest peacefully.
However, the government in mixed economies generally subsidizes public goods, such as roads and libraries, and provide welfare services such as social security. These governments also regulate labor and protect intellectual property.
Key Points
• The profit -maximizing amount of output occurs when the marginal cost of producing another unit equals the marginal revenue received from selling that unit.
• Output are the quantity of goods or services produced in a given time period, by a firm, industry or country.
• There are four types of market scenario that a firm may encounter when making a production decision: economic profit, normal profit, loss-minimizing condition, and shutdown. The firm should always produce unless it encounters a shutdown scenario.
• Capital, otherwise known as capital assets, are manufactured goods that are used in production of goods or services.
• Cash is not included in capital in terms of a production input. Homes and personal automobiles are also not included in capital because these items are not directly tied to the production of goods or services.
• Labor is a measure of the work done by human beings to create a manufactured output.
• Supply chains vary based on industry, the resources of the manufacturer, and market conditions.
• The purpose of a supply chain is to act as an integrating function that links major business functions and processes into a cohesive business model.
• Typical steps in a supply chain include: extraction of raw materials; acquisition of components; production; inventory; transportation; wholesaler; and retailer.
• A pure planned economy has one person or group who controls what is produced; all businesses work together to produce goods and services that are planned and distributed by the government.
• Planned economies have several advantages. Ideally, there is no unemployment, and needs never go unfulfilled; because the government knows how much food, medicine, and other goods is needed, it can produce enough for all.
• Realistically, these systems tend to suffer from large inefficiencies and are overall not as successful as other types of economic systems.
• A pure market economy is one perfectly free of external control. Individuals are left up to themselves to decide what to produce, who to work for, and how to get the things they need.
• Because there is no regulation ensuring equality and fairness, market economies are burdened with unemployment, and even those with jobs can never be certain that they will make enough to provide for all of their needs.
• Because they do not need to wait for word from the government before changing their output, companies under market economies can quickly keep up with fluctuations in the economy, tending to be more efficient than regulated markets.
• Most of the means of production in a mixed economy are privately owned in a mixed economy.
• The government strongly influences the economy through direct intervention in a mixed economy, such as through subsidies and regulation of the markets.
• Most government intervention in mixed economy is limited to minimizing the negative consequences of economic events, such as unemployment in recessions, to promote social welfare.
Key Terms
• marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
• variable cost: A cost that changes with the change in volume of activity of an organization.
• average total cost: Average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q).
• fixed costs: A cost of business which does not vary with output or sales; overheads.
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
• labor: The workers used to manufacture the output.
• input: Something fed into a process with the intention of it shaping or affecting the outputs of that process.
• supply chain: A system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer.
• Centrally planned economy: When the government is responsible for setting the amount produced.
• autonomy: Self-government; freedom to act or function independently.
• market economy: An economy in which goods and services are exchanged in a free market, as opposed to a state-controlled or socialist economy; a capitalistic economy.
• mixed economy: A system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.
• monopoly: A market where one company is the sole supplier.
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Math Review
Mathematical economics uses mathematical methods, such as algebra and calculus, to represent theories and analyze problems in economics.
Learning objectives
Review basic algebra and calculus’ concepts relevant in introductory economics
As a social science, economics analyzes the production, distribution, and consumption of goods and services. The study of economics requires the use of mathematics in order to analyze and synthesize complex information.
Mathematical Economics
Mathematical economics is the application of mathematical methods to represent theories and analyze problems in economics. Using mathematics allows economists to form meaningful, testable propositions about complex subjects that would be hard to express informally. Math enables economists to make specific and positive claims that are supported through formulas, models, and graphs. Mathematical disciplines, such as algebra and calculus, allow economists to study complex information and clarify assumptions.
Algebra
Algebra is the study of operations and their application to solving equations. It provides structure and a definite direction for economists when they are analyzing complex data. Math deals with specified numbers, while algebra introduces quantities without fixed numbers (known as variables). Using variables to denote quantities allows general relationships between quantities to be expressed concisely. Quantitative results in science, economics included, are expressed using algebraic equations.
Concepts in algebra that are used in economics include variables and algebraic expressions. Variables are letters that represent general, non-specified numbers. Variables are useful because they can represent numbers whose values are not yet known, they allow for the description of general problems without giving quantities, they allow for the description of relationships between quantities that may vary, and they allow for the description of mathematical properties. Algebraic expressions can be simplified using basic math operations including addition, subtraction, multiplication, division, and exponentiation.
In economics, theories need the flexibility to formulate and use general structures. By using algebra, economists are able to develop theories and structures that can be used with different scenarios regardless of specific quantities.
Calculus
Calculus is the mathematical study of change. Economists use calculus in order to study economic change whether it involves the world or human behavior.
Calculus has two main branches:
• Differential calculus is the study of the definition, properties, and applications of the derivative of a function (rates of change and slopes of curves). By finding the derivative of a function, you can find the rate of change of the original function.
• Integral calculus is the study of the definitions, properties, and applications of two related concepts, the indefinite and definite integral (accumulation of quantities and the areas under curves).
Calculus is widely used in economics and has the ability to solve many problems that algebra cannot. In economics, calculus is used to study and record complex information – commonly on graphs and curves. Calculus allows for the determination of a maximal profit by providing an easy way to calculate marginal cost and marginal revenue. It can also be used to study supply and demand curves.
Common Mathematical Terms
Economics utilizes a number of mathematical concepts on a regular basis such as:
• Dependent Variable: The output or the effect variable. Typically represented as yy, the dependent variable is graphed on the yy-axis. It is the variable whose change you are interested in seeing when you change other variables.
• Independent or Explanatory Variable: The inputs or causes. Typically represented as x1x1, x2x2, x3x3, etc., the independent variables are graphed on the xx-axis. These are the variables that are changed in order to see how they affect the dependent variable.
• Slope: The direction and steepness of the line on a graph. It is calculated by dividing the amount the line increases on the yy-axis (vertically) by the amount it changes on the xx-axis (horizontally). A positive slope means the line is going up toward the right on a graph, and a negative slope means the line is going down toward the right. A horizontal line has a slope of zero, while a vertical line has an undefined slope. The slope is important because it represents a rate of change.
• Tangent: The single point at which two curves touch. The derivative of a curve, for example, gives the equation of a line tangent to the curve at a given point.
Assumptions
Economists use assumptions in order to simplify economics processes so that they are easier to understand.
Learning objectives
Assess the benefits and drawbacks of using simplifying assumptions in economics
As a field, economics deals with complex processes and studies substantial amounts of information. Economists use assumptions in order to simplify economic processes so that it is easier to understand. Simplifying assumptions are used to gain a better understanding about economic issues with regards to the world and human behavior.
Simple indifference curve: An indifference curve is used to show potential demand patterns. It is an example of a graph that works with simplifying assumptions to gain a better understanding of the world and human behavior in relation to economics.
Economic Assumptions
Neo-classical economics works with three basic assumptions:
1. People have rational preferences among outcomes that can be identified and associated with a value.
2. Individuals maximize utility (as consumers) and firms maximize profit (as producers).
3. People act independently on the basis of full and relevant information.
Benefits of Economic Assumptions
Assumptions provide a way for economists to simplify economic processes and make them easier to study and understand. An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding. Good simplification will allow the economists to focus only on the most relevant variables. Later, the theory can be applied to more complex scenarios for additional study.
For example, economists assume that individuals are rational and maximize their utilities. This simplifying assumption allows economists to build a structure to understand how people make choices and use resources. In reality, all people act differently. However, using the assumption that all people are rational enables economists study how people make choices.
Criticisms of Economic Assumptions
Although, simplifying assumptions help economists study complex scenarios and events, there are criticisms to using them. Critics have stated that assumptions cause economists to rely on unrealistic, unverifiable, and highly simplified information that in some cases simplifies the proofs of desired conclusions. Examples of such assumptions include perfect information, profit maximization, and rational choices. Economists use the simplified assumptions to understand complex events, but criticism increases when they base theories off the assumptions because assumptions do not always hold true. Although simplifying can lead to a better understanding of complex phenomena, critics explain that the simplified, unrealistic assumptions cannot be applied to complex, real world situations.
Hypotheses and Tests
Economics, as a science, follows the scientific method in order to study data, observe patterns, and predict results of stimuli.
Learning objectives
Apply the steps of the scientific method to economic questions
Economics, as a science, follows the scientific method in order to study data, observe patterns, and predict results of stimuli.
There are specific steps that must be followed when using the scientific method. Economics follows these steps in order to study data and build principles:
Scientific Method: The scientific method is used in economics to study data, observe patterns, and predict results.
1. Identify the problem – in the case of economics, this first step of the scientific method involves determining the focus or intent of the work. What is the economist studying? What is he trying to prove or show through his work?
2. Gather data – economics involves extensive amounts of data. For this reason, it is important that economists can break down and study complex information. The second step of the scientific method involves selecting the data that will be used in the study.
3. Hypothesis – the third step of the scientific method involves creating a model that will be used to make sense of all of the data. A hypothesis is simply a prediction. What does the economist think the overall outcome of the study will be?
4. Test hypothesis – the fourth step of the scientific method involves testing the hypothesis to determine if it is true. This is a critical stage within the scientific method. The observations must be tested to make sure they are unbiased and reproducible. In economics, extensive testing and observation is required because the outcome must be obtained more than once in order for it to be valid. It is not unusual for testing to take some time and for economists to make adjustments throughout the testing process.
5. Analyze the results – the final step of the scientific method is to analyze the results. First, an economist will ask himself if the data agrees with the hypothesis. If the answer is “yes,” then the hypothesis was accurate. If the answer is “no,” then the economist must go back to the original hypothesis and adjust the study accordingly. A negative result does not mean that the study is over. It simply means that more work and analysis is required.
Observation of data is critical for economists because they take the results and interpret them in a meaningful way. Cause and effect relationships are used to establish economic theories and principles. Over time, if a theory or principle becomes accepted as universally true, it becomes a law. In general, a law is always considered to be true. The scientific method provides the framework necessary for the progression of economic study. All economic theories, principles, and laws are generalizations or abstractions. Through the use of the scientific method, economists are able to break down complex economic scenarios in order to gain a deeper understanding of critical data.
Economic Models
A model is simply a framework that is designed to show complex economic processes.
Learning objectives
Recognize the uses and limitations of economic models
Economic Models
In economics, a model is defined as a theoretical construct that represents economic processes through a set of variables and a set of logical or quantitative relationships between the two. A model is simply a framework that is designed to show complex economic processes. Most models use mathematical techniques in order to investigate, theorize, and fit theories into economic situations.
Uses of an Economic Model
Economists use models in order to study and portray situations. The focus of a model is to gain a better understanding of how things work, to observe patterns, and to predict the results of stimuli. Models are based on theory and follow the rules of deductive logic.
Economic model diagram: In economics, models are used in order to study and portray situations and gain a better understand of how things work.
Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study. Economic processes are known to be enormously complex, so simplification to gain a clearer understanding is critical. Selecting the correct data is also very important because the nature of the model will determine what economic facts are studied and how they will be compiled.
Examples of the uses of economic models include: professional academic interest, forecasting economic activity, proposing economic policy, presenting reasoned arguments to politically justify economic policy, as well as economic planning and allocation.
Constructing a Model
The construction and use of a model will vary according to the specific situation. However, creating a model does have two basic steps: 1) generate the model, and 2) checking the model for accuracy – also known as diagnostics. The diagnostic step is important because a model is only useful if the data and analysis is accurate.
Limitations of a Model
Due to the complexity of economic models, there are obviously limitations that come into account. First, all of the data provided must be complete and accurate in order for the analysis to be successful. Also, once the data is entered, it must be analyzed correctly. In most cases, economic models use mathematical or quantitative analysis. Within this realm of observation, accuracy is very important. During the construction of a model, the information will be checked and updated as needed to ensure accuracy. Some economic models also use qualitative analysis. However, this kind of analysis is known for lacking precision. Furthermore, models are fundamentally only as good as their founding assumptions.
The use of economic models is important in order to further study and understand economic processes. Steps must be taken throughout the construction of the model to ensure that the data provided and analyzed is correct.
Normative and Positive Economics
Positive economics is defined as the “what is” of economics, while normative economics focuses on the “what ought to be”.
Learning objectives
Contrast normative and positive statements about economic policy
Positive and normative economic thought are two specific branches of economic reasoning. Although they are associated with one another, positive and normative economic thought have different focuses when analyzing economic scenarios.
Positive Economics
Positive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships. It focuses primarily on facts and cause-and-effect behavioral relationships, including developing and testing economic theories. As a science, positive economics focuses on analyzing economic behavior. It avoids economic value judgments. For example, positive economic theory would describe how money supply growth impacts inflation, but it does not provide any guidance on what policy should be followed. “The unemployment rate in France is higher than that in the United States” is a positive economic statement. It gives an overview of an economic situation without providing any guidance for necessary actions to address the issue.
Normative Economics
Normative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be. Many normative judgments are conditional. They are given up if facts or knowledge of facts change. In this instance, a change in values is seen as being purely scientific. Welfare economist Amartya Sen explained that basic (normative) judgments rely on knowledge of facts.
An example of a normative economic statement is “The price of milk should be \$6 a gallon to give dairy farmers a higher living standard and to save the family farm. ” It is a normative statement because it reflects value judgments. It states facts, but also explains what should be done. Normative economics has subfields that provide further scientific study including social choice theory, cooperative game theory, and mechanism design.
Relationship Between Positive and Normative Economics
Positive economics does impact normative economics because it ranks economic policies or outcomes based on acceptability (normative economics). Positive economics is defined as the “what is” of economics, while normative economics focuses on the “what ought to be. ” Positive economics is utilized as a practical tool for achieving normative objectives. In other words, positive economics clearly states an economic issue and normative economics provides the value-based solution for the issue.
Debt Increases: This graph shows the debt increases in the United States from 2001-2009. Positive economics would provide a statement saying that the debt has increased. Normative economics would state what needs to be done in order to work towards resolving the issue of increasing debt.
Key Points
• Using mathematics allows economists to form meaningful, testable propositions about complex subjects that would be hard to express informally.
• Algebra is the study of operations and their application to solving equations. It provides structure and a definite direction for economists when they are analyzing complex data.
• Concepts in algebra that are used in economics include variables and algebraic expressions.
• Calculus is the mathematical study of change. Economists use calculus in order to study economic change whether it involves the world or human behavior.
• In economics, calculus is used to study and record complex information – commonly on graphs and curves.
• Neo-classical economics employs three basic assumptions: people have rational preferences among outcomes that can be identified and associated with a value, individuals maximize utility and firms maximize profit, and people act independently on the basis of full and relevant information.
• An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding. Later, the theory can be applied to more complex scenarios for additional study.
• Critics have stated that assumptions cause economists to rely on unrealistic, unverifiable, and highly simplified information that in some cases simplifies the proofs of desired conclusions.
• Although simplifying can lead to a better understanding of complex phenomena, critics explain that the simplified, unrealistic assumptions cannot be applied to complex, real world situations.
• The scientific method involves identifying a problem, gathering data, forming a hypothesis, testing the hypothesis, and analyzing the results.
• A hypothesis is simply a prediction.
• In economics, extensive testing and observation is required because the outcome must be obtained more than once in order to be valid.
• Cause and effect relationships are used to establish economic theories and principles. Over time, if a theory or principle becomes accepted as universally true, it becomes a law. In general, a law is always considered to be true.
• The scientific method provides the framework necessary for the progression of economic study.
• Many models use mathematical techniques in order to investigate, theorize, and fit theories into economic situations.
• Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study.
• Creating a model has two basic steps: 1) generate the model, and 2) checking the model for accuracy – also known as diagnostics.
• Examples of the uses of economic models include: professional academic interest, forecasting economic activity, proposing economic policy, presenting reasoned arguments to politically justify economic policy, as well as economic planning and allocation.
• Positive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships.
• Positive economics clearly states an economic issue and normative economics provides the value-based solution for the issue.
• Normative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be.
• Positive economics does impact normative economics because it ranks economic polices or outcomes based on acceptability (normative economics).
Key Terms
• quantitative: Of a measurement based on some number rather than on some quality.
• variable: something whose value may be dictated or discovered.
• assumption: The act of taking for granted, or supposing a thing without proof; a supposition; an unwarrantable claim.
• simplify: To make simpler, either by reducing in complexity, reducing to component parts, or making easier to understand.
• hypothesis: An assumption taken to be true for the purpose of argument or investigation.
• deductive: Based on inferences from general principles.
• diagnostics: The process of determining the state of or capability of a component to perform its function(s).
• qualitative: Based on descriptions or distinctions rather than on some quantity.
• normative economics: Economic thought in which one applies moral beliefs, or judgment, claiming that an outcome is “good” or “bad”.
• positive economics: The description and explanation of economic phenomena and their causal relationships.
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Macroeconomics
Macroeconomics is the study of the performance, structure, behavior and decision-making of an economy as a whole.
Learning objectives
Define macroeconomics and identify the main users of macroeconomics
Macroeconomics is the study of the performance, structure, behavior and decision-making of an economy as a whole. Macroeconomists focus on the national, regional, and global scales. For most macroeconomists, the purpose of this discipline is to maximize national income and provide national economic growth. Economists hope that this growth translates to increased utility and an improved standard of living for the economy’s participants. While there are variations between the objectives of different national and international entities, most follow the ones detailed below:
Circulation in Macroeconomics: Macroeconomics studies the performance of national or global economies and the interaction of certain entities at the these level.
• Sustainability occurs when an economy achieves a rate of growth which allows an increase in living standards without undue structural and environmental difficulties.
• Full employment occurs when those who are able and willing to have a job can get one. Most economists believe that there will always be a certain amount of frictional, seasonal and structural unemployment (referred to as the natural rate of unemployment). As a result, full employment does not mean zero unemployment.
• Price stability occurs when prices remain largely stable and there is not rapid inflation or deflation. Price stability is not necessarily zero inflation; steady levels of low-to-moderate inflation is often regarded as ideal.
• External balance occurs when exports roughly equal imports over the long run.
• Equitable distribution of income and wealth among the economy’s participants. This does not, however, mean that income and wealth are the same for everyone.
• Increasing Productivity over time throughout the national economy.
To achieve these goals, macroeconomists develop models that explain the relationship between factors such as national income, output, consumption, unemployment, inflation, savings, investment and international trade. These models rely on aggregated economic indicators such as GDP, unemployment, and price indices.
On the national level, macroeconomists hope that their models help address two key areas of research:
• the causes and consequences of short-run fluctuations in national income, otherwise known as the business cycle, and
• what determines long-run economic growth.
Microeconomics
Microeconomics deals with the economic interactions of a specific person, a single entity or a company; it is the study of markets.
Learning objectives
Define Microeconomics, Identify the main users of microeconomics
Microeconomics deals with the economic interactions of a specific person, a single entity, or a company. These interactions, which mainly are buying and selling goods, occur in markets. Therefore, microeconomics is the study of markets. The two key elements of this economic science are the interaction between supply and demand and scarcity of goods.
Supply and Demand Graph: Microeconomics is based on the study of supply and demand at the personal and corporate level.
One of the major goals of microeconomics is to analyze the market and determine the price for goods and services that best allocates limited resources among the different alternative uses. This study is especially important for producers as they decide what to manufacture and the appropriate selling price. Microeconomics assumes businesses are rational and produce goods that maximizes their profit. If each firm takes the most profitable path, the principles of microeconomics state that the market’s limited resources will be allocated efficiently.
The science of microeconomics covers a variety of specialized areas of study including:
• Industrial Organization: the entry and exit of firms, innovation, and the role of trademarks.
• Labor Economics: wages, employment, and labor market dynamics.
• Financial Economics: topics such as optimal portfolios, the rate of return to capital, and corporate financial behavior.
• Public Economics: the design of government tax and expenditure policies.
• Political Economics: the role of political institutions in policy.
• Health Economics: the organization of health care system.
• Urban Economics: challenges faced by cities, such as sprawl, traffic congestion, and poverty.
• Law and Economics: applies economic principles to the selection and enforcement of legal regimes.
• Economic History: the history and evolution of the economy.
Key Differences
Microeconomics focuses on individual markets, while macroeconomics focuses on whole economies.
Learning objectives
Recognize questions addressed by microeconomics and macroeconomics
Stemming from Adam Smith’s seminal book, The Wealth of Nations, microeconomic and macroeconomics both focus on the allocation of scarce resources. Both disciplines study how the demand for certain resources interacts with the ability to supply that good to determine how to best distribute and allocate that resource among many consumers. Both disciplines are about maximization: microeconomics is about maximizing profit for firms, and surplus for consumers and producers, while macroeconomics is about maximizing national income and growth.
Adam Smith, Founding Father of Economics: Adam Smith’s book, Wealth of Nations, was the basis of both microeconomic and macroeconomic study.
The main difference between microeconomics and macroeconomics is scale. Microeconomics studies the behavior of individual households and firms in making decisions on the allocation of limited resources. Another way to phrase this is to say that microeconomics is the study of markets.
In contrast macroeconomics involves the sum total of economic activity, dealing with the issues such as growth, inflation, and unemployment. Macroeconomics is the study of economies on the national, regional or global scale.
This key difference alters how the two approach economic situations. Microeconomics does consider how macroeconomic forces impact the world, but it focuses on how those forces impact individual firms and industries. While macroeconomists study the economy as a whole, microeconomists are concerned with specific firms or industries.
Many economic events that are of great interest to both microeconomist and macroeconomists, though they differ in how they analyze those events. A shift in tax policy would interest economists in both disciplines. A microeconomist might focus on how the tax might shift supply in a specific market or influence a firm’s decision making, while the macroeconomist will consider whether the tax will translate into an improved standard of living for all of the economy’s participants.
Key Points
• For most macroeconomists, the purpose of this discipline is to maximize national income and provide national economic growth.
• The most common macroeconomic topics of study for national entities are sustainability, full employment, price stability, external balance, equitable distribution of income and wealth, and increasing productivity.
• Macroeconomists hope that their models help address two key areas of research: the causes and consequences of short-run fluctuations in national income (otherwise known as the business cycle) and what determines long-run economic growth.
• One of the major goals of microeconomics is to analyze the market and determine the price for goods and services that best allocates limited resources among the different alternative uses.
• Microeconomics assumes businesses are rational and produce goods that maximize their profit.
• The science of microeconomics covers a variety of specialized areas of study including: industrial organization, labor economics, financial economics, public economics, political economy, health economics, urban economics, law and economics, and economic history.
• Microeconomics and macroeconomics both focus on the allocation of scarce resources. Both disciplines study how the demand for certain resources interacts with the ability to supply that good to determine how to best distribute and allocate that resource among many consumers.
• Microeconomics studies the behavior of individual households and firms in making decisions on the allocation of limited resources. Another way to phrase this is to say that microeconomics is the study of markets.
• Macroeconomics is generally focused on countrywide or global economics. It studies involves the sum total of economic activity, dealing with the issues such as growth, inflation, and unemployment.
• There are some economic events that are of great interest to both microeconomists and macroeconomists, but they will differ in how and why they analyze the events.
Key Terms
• deflation: A decrease in the general price level, that is, in the nominal cost of goods and services.
• Macroeconomics: The study of the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.
• inflation: An increase in the general level of prices or in the cost of living.
• microeconomics: That field that deals with the small-scale activities such as that of the individual or company.
• Scarcity: an inadequate amount of something; a shortage
• inflation: An increase in the general level of prices or in the cost of living.
• microeconomics: The study of the behavior of individual households and firms in making decisions on the allocation of limited resources.
• Macroeconomics: The study of the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.
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Definition of Perfect Competition
Perfect competition is a market structure that leads to the Pareto-efficient allocation of economic resources.
Learning Objectives
• Describe degrees of competition in different market structures
Market structure is determined by the number and size distribution of firms in a market, entry conditions, and the extent of product differentiation. The major types of market structure include the following:
• Monopoly: An industry structure where a single firm produces a product for which there are no close substitutes. Monopolists are price makers. Barriers to entry and exit exist, and, in order to ensure profits, a monopoly will attempt to maintain them.
• Monopolistic competition: A market structure in which there is a large number of firms, each having a small portion of the market share and slightly differentiated products. There are close substitutes for the product of any given firm, so competitors have slight control over price. There are relatively insignificant barriers to entry or exit, and success invites new competitors into the industry.
• Oligopoly: An industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated. Each firm is large enough to influence the industry. Barriers to entry exist.
• Perfect competition: An industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.
Perfect competition leads to the Pareto-efficient allocation of economic resources. Because of this it serves as a natural benchmark against which to contrast other market structures. However, in practice, very few industries can be described as perfectly competitive. Nevertheless, it is used because it provides important insights.
A perfectly competitive market has several important characteristics:
• All producers contribute insignificantly to the market. Their own production levels do not change the supply curve.
• All producers are price takers. They cannot influence the market. If a firm tries to raise its price consumers would buy from a competitor with a lower price instead.
• Products are homogeneous. The characteristics of a good or service do not vary between suppliers.
• Producers enter and exit the market freely.
• Both buyers and sellers have perfect information about the price, utility, quality, and production methods of products.
• There are no transaction costs. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
• Producers earn zero economic profits in the long run.
Conditions of Perfect Competition
A firm in a perfectly competitive market may generate a profit in the short-run, but in the long-run it will have economic profits of zero.
Learning Objectives
• Calculate total revenue, average revenue, and marginal revenue for a firm in a perfectly competitive market
The concept of perfect competition applies when there are many producers and consumers in the market and no single company can influence the pricing. A perfectly competitive market has the following characteristics:
• There are many buyers and sellers in the market.
• Each company makes a similar product.
• Buyers and sellers have access to perfect information about price.
• There are no transaction costs.
• There are no barriers to entry into or exit from the market.
All goods in a perfectly competitive market are considered perfect substitutes, and the demand curve is perfectly elastic for each of the small, individual firms that participate in the market. These firms are price takers–if one firm tries to raise its price, there would be no demand for that firm’s product. Consumers would buy from another firm at a lower price instead.
Firm Revenues
A firm in a competitive market wants to maximize profits just like any other firm. The profit is the difference between a firm’s total revenue and its total cost. For a firm operating in a perfectly competitive market, the revenue is calculated as follows:
• Total Revenue = Price * Quantity
• AR (Average Revenue) = Total Revenue / Quantity
• MR (Marginal Revenue) = Change in Total Revenue / Change in Quantity
The average revenue (AR) is the amount of revenue a firm receives for each unit of output. The marginal revenue (MR) is the change in total revenue from an additional unit of output sold. For all firms in a competitive market, both AR and MR will be equal to the price.
Profit Maximization
In order to maximize profits in a perfectly competitive market, firms set marginal revenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve, which is also equal to the demand curve (D) and price (P). In the short-term, it is possible for economic profits to be positive, zero, or negative. When price is greater than average total cost, the firm is making a profit. When price is less than average total cost, the firm is making a loss in the market.
Perfect Competition in the Short Run: In the short run, it is possible for an individual firm to make an economic profit. This scenario is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost denoted by C.
Over the long-run, if firms in a perfectly competitive market are earning positive economic profits, more firms will enter the market, which will shift the supply curve to the right. As the supply curve shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will decrease until they become zero.
When price is less than average total cost, firms are making a loss. Over the long-run, if firms in a perfectly competitive market are earning negative economic profits, more firms will leave the market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As the price goes up, economic profits will increase until they become zero.
In sum, in the long-run, companies that are engaged in a perfectly competitive market earn zero economic profits. The long-run equilibrium point for a perfectly competitive market occurs where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve.
Perfect Competition in the Long Run: In the long-run, economic profit cannot be sustained. The arrival of new firms in the market causes the demand curve of each individual firm to shift downward, bringing down the price, the average revenue and marginal revenue curve. In the long-run, the firm will make zero economic profit. Its horizontal demand curve will touch its average total cost curve at its lowest point.
The Demand Curve in Perfect Competition
A perfectly competitive firm faces a demand curve is a horizontal line equal to the equilibrium price of the entire market.
Learning Objectives
• Describe the demand for goods in perfectly competitive markets
In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the fact that as the price of an ordinary good increases, the quantity demanded of that good decreases. Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition. Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price (keep in mind the key conditions of perfect competition). The demand curve for an individual firm is thus equal to the equilibrium price of the market.
Demand Curve for a Firm in a Perfectly Competitive Market: The demand curve for an individual firm is equal to the equilibrium price of the market. The market demand curve is downward-sloping.
The demand curve for a firm in a perfectly competitive market varies significantly from that of the entire market.The market demand curve slopes downward, while the perfectly competitive firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above market price, it would not sell any products.
A strategy often used to increase market share is to offer a firm’s product at a lower price than the competitors. In a perfectly competitive market, firms cannot decrease their product price without making a negative profit. Instead, assuming that the firm is a profit-maximizer, it will sell its goods at the market price.
Key Points
• The major types of market structure include monopoly, monopolistic competition, oligopoly, and perfect competition.
• Perfect competition is an industry structure in which there are many firms producing homogeneous products. None of the firms are large enough to influence the industry.
• The characteristics of a perfectly competitive market include insignificant contributions from the producers, homogenous products, perfect information about products, no transaction costs, and no long-term economic profits.
• In practice, very few industries can be described as perfectly competitive, though agriculture comes close.
• A perfectly competitive market is characterized by many buyers and sellers, undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect information about the price of a good.
• The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). The average revenue is calculated by dividing total revenue by quantity. Marginal revenue is calculated by dividing the change in total revenue by change in quantity.
• A firm in a competitive market tries to maximize profits. In the short-run, it is possible for a firm’s economic profits to be positive, negative, or zero. Economic profits will be zero in the long-run.
• In the short-run, if a firm has a negative economic profit, it should continue to operate if its price exceeds its average variable cost. It should shut down if its price is below its average variable cost.
• In a perfectly competitive market individual firms are price takers. The price is determined by the intersection of the market supply and demand curves.
• The demand curve for an individual firm is different from a market demand curve. The market demand curve slopes downward, while the firm’s demand curve is a horizontal line.
• The firm’s horizontal demand curve indicates a price elasticity of demand that is perfectly elastic.
Key Terms
• monopoly: A situation, by legal privilege or other agreement, in which solely one party (company, cartel etc. ) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.
• Monopolistic competition: A market structure in which there is a large number of firms, each having a small proportion of the market share and slightly differentiated products.
• oligopoly: An economic condition in which a small number of sellers exert control over the market of a commodity.
• economic profit: The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm.
• Perfectly elastic: Describes a situation when any increase in the price, no matter how small, will cause demand for a good to drop to zero.
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Relationship Between Output and Revenue
Output is the amount of a good produced; revenue is the amount of income made from sales minus all business expenses.
learning objectives
• Describe the relationship between output and revenue
Output
In economics, output is defined as the quantity of goods or services produced in a certain period of time by a firm, industry, or country. Output can be consumed or used for further production. Output is important on a business and national scale because it is output, not large sums of money, that makes a company or country wealthy.
There are many factors that influence the level of output including changes in labor, capital, and the efficiency of the factors of production. Anything that causes one of the factors to increase or decrease will change the output in the same manner.
Revenue
Revenue, also known as turnover, is the income that a company receives from normal business activities, usually from the sale of goods and services. Revenue is the money that is made as a result of output, or amount of goods produced. Companies can also receive revenue from interest, royalties, and other fees.
Revenue can refer to general business income, but it can also refer to the amount of money made during a specific time period. When companies produce a certain quantity of a good (output), the revenue is the amount of income made from sales during a set time period.
Businesses analyze revenue in their financial statements. The performance of a company is determined by how its asset inflows (revenues) compare with its asset outflows (expenses). Revenue is an important financial indiator, though it is important to note that companies are profit maximizers, not revenue maximizers.
Importance of Output and Revenue
In order for a company or firm to be successful, it must focus on both the output and revenue. The quantity of goods produced must meet public demand, but the company must also be able to sell those goods in order to generate revenue. The production of goods carries a cost, so companies want to find a level of output that maximizes profit, not revenue.
Output and Revenue: Krispy Kreme’s output is donuts. It generates revenue by selling its output. It is however, a profit maximizer, not an output or revenue maximizer.
Marginal Cost Profit Maximization Strategy
In order to maximize profit, the firm should set marginal revenue (MR) equal to the marginal cost (MC).
learning objectives
• Calculate marginal costs and marginal revenues
Marginal Cost
Marginal cost is the change in the total cost that occurs when the quantity produced is increased by one unit. It is the cost of producing one more unit of a good. When more goods are produced, the marginal cost includes all additional costs required to produce the next unit. For example, if producing one more car requires the building of an additional factory, the marginal cost of producing the additional car includes all of the costs associated with building the new factory.
Marginal cost curve: This graph shows a typical marginal cost (MC) curve with marginal revenue (MR) overlaid.
Marginal cost is the change in total cost divided by the change in output.
An example of marginal cost is evident when the cost of making one pair of shoes is \$30. The cost of making two pairs of shoes is \$40. Therefore the marginal cost of the second shoe is \$40 -\$30=\$10.
Marginal Revenue
Marginal revenue is the additional revenue that will be generated by increasing product sales by one unit. In a perfectly competitive market, the price of the product stays the same when another unit is produced. Marginal revenue is calculated by dividing the change in total revenue by the change in output quantity.
For example, if the price of a good in a perfectly competitive market is \$20, the marginal revenue of selling one additional unit is \$20.
Marginal Cost-Marginal Revenue Perspective
Profit maximization is the short run or long run process by which a firm determines the price and output level that will result in the largest profit. Firms will produce up until the point that marginal cost equals marginal revenue. This strategy is based on the fact that the total profit reaches its maximum point where marginal revenue equals marginal profit. This is the case because the firm will continue to produce until marginal profit is equal to zero, and marginal profit equals the marginal revenue (MR) minus the marginal cost (MC).
Marginal profit maximization: This graph shows profit maximization using the marginal cost perspective.
Another way of thinking about the logic is of producing up until the point of MR=MC is that if MR>MC, the firm should make more units: it is earning a profit on each. If MR<MC, then the firm should produce less: it is making a loss on each additional product it sells.
Shut Down Case
A firm will implement a production shutdown if the revenue from the sale of goods produced cannot cover the variable costs of production.
learning objectives
• Apply shutdown conditions to determine a firm’s production status
Economic Shutdown
A firm will choose to implement a production shutdown when the revenue received from the sale of the goods or services produced cannot cover the variable costs of production. In this situation, a firm will lose more money when it produces goods than if it does not produce goods at all. Producing a lower output would only add to the financial losses, so a complete shutdown is required. If a firm decreased production it would still acquire variable costs not covered by revenue as well as fixed costs (costs inevitably incurred). By stopping production the firm only loses the fixed costs.
Shutdown Condition: Firms will produce as long as marginal revenue (MR) is greater than average total cost (ATC), even if it is less than the variable, or marginal cost (MC)
Economic shutdown occurs within a firm when the marginal revenue is below average variable cost at the profit-maximizing output. The goal of a firm is to maximize profits and minimize losses. When a shutdown is required the firm failed to achieve a primary goal of production by not operating at the level of output where marginal revenue equals marginal cost.
The Shutdown Rule
In the short run, a firm that is operating at a loss (where the revenue is less that the total cost or the price is less than the unit cost) must decide to operate or temporarily shutdown. The shutdown rule states that “in the short run a firm should continue to operate if price exceeds average variable costs. ”
When determining whether to shutdown a firm has to compare the total revenue to the total variable costs. If the revenue the firm is making is greater than the variable cost (R>VC) then the firm is covering it’s variable costs and there is additional revenue to partially or entirely cover the fixed costs. One the other hand, if the variable cost is greater than the revenue being made (VC>R) then the firm is not even covering production costs and it should be shutdown immediately.
Implications of a Shutdown
The decision to shutdown production is usually temporary. It does not automatically mean that a firm is going out of business. If the market conditions improve, due to prices increasing or production costs falling, then the firm can resume production. Shutdowns are short run decisions. When a firm shuts down it still retains capital assets, but cannot leave the industry or avoid paying its fixed costs.
A firm cannot incur losses indefinitely which impacts long run decisions. When a shutdown last for an extended period of time, a firm has to decide whether to continue to business or leave the industry. The decision to exit is made over a period of time. A firm that exits an industry does not earn any revenue, but is also does not incur fixed or variable costs.
The Supply Curve in Perfect Competition
The total revenue-total cost perspective and the marginal revenue-marginal cost perspective are used to find profit maximizing quantities.
learning objectives
• Use cost curves to find profit-maximizing quantities
Cost Curve
In economics, a cost curve is a graph that shows the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (minimizing cost). By locating the optimal point of production, firms can decide what output quantities are needed. The various types of cost curves include total, average, marginal curves. Some of the cost curves analyze the short run, while others focus on the long run.
Profit Maximization
Profit maximization is the short run or long run process that a firm uses to determine the price and output level that returns the greatest profit when producing a good or service.
Graphing Profit Maximization
There are two ways in which cost curves can be used to find profit maximizing quantities: the total revenue-total cost perspective and the marginal revenue-marginal cost perspective.
The total revenue-total cost perspective recognizes that profit is equal to the total revenue (TR) minus the total cost (TC). When a table of costs and revenues is available, a firm can plot the data onto a profit curve. The profit maximizing output is the one at which the profit reaches its maximum.
Total cost curve: This graph depicts profit maximization on a total cost curve.
The marginal revenue-marginal cost perspective relies on the understanding that for each unit sold, the marginal profit equals the marginal revenue (MR) minus the marginal cost (MC). If the marginal revenue is greater than the marginal cost, then the marginal profit is positive and a greater quantity of the good should be produced. Likewise, if the marginal revenue is less than the marginal cost, the marginal profit is negative and a lesser quantity of the good should be produced.
Marginal cost curve: This graph shows profit maximization using a marginal cost curve.
Profit maximization is directly impacts the supply and demand of a product. Supply curves are used to show an estimation of variables within a market economy, one of which is the general price level of the product.
Short Run Firm Production Decision
The short run is the conceptual time period where at least one factor of production is fixed in amount while other factors are variable.
learning objectives
• Compare factors that lead to short-run shut downs or long-run exits
Short Run Profit
In an economic market all production in real time occurs in the short run. The short run is the conceptual time period where at least one factor of production is fixed in amount while other factors are variable in amount. Fixed costs have no impact on a firm’s short run decisions. However, variable costs and revenues affect short run profits. In the short run, a firm could potentially increase output by increasing the amount of the variable factors. An example of a variable factor being increased would be increasing labor through overtime.
In the short run, a firm that is maximizing its profits will:
• Increase production if the marginal cost is less than the marginal revenue.
• Decrease production if marginal cost is greater than marginal revenue.
• Continue producing if average variable cost is less than price per unit.
• Shut down if average variable cost is greater than price at each level of output.
Transition from Short Run to Long Run Profit
When a firm is transitioning from the short run to the long run it will consider the current and future equilibrium for supply and demand. The firm will also take adjustments into account that can disturb equilibrium such as the sales tax rate. The transition involves analyzing the current state of the market as well as revenue and combining the results with long run market projections.
Short Run Shutdown vs. Long Run Exit
The goal of a firm is to maximize profits by minimizing losses. In economics, a firm will implement a production shutdown when the revenue coming in from the sale of goods cannot cover the variable costs of production. The firm would experience higher loss if it kept producing goods than if it stopped production for a period of time. Revenue would not cover the variable costs associated with production. Instead, during a shutdown the firm is only paying the fixed costs.
A short run shutdown is designed to be temporary: it does not mean that the firm is going out of business. If market conditions improve, due to prices increasing or production costs falling, the firm can restart production. When a firm is shut down in the short run, it still has to pay fixed costs and cannot leave the industry. However, a firm cannot incur losses indefinitely. Exiting an industry is a long term decision. If market conditions do not improve a firm can exit the market. By exiting the industry, the firm earns no revenue but incurs no fixed or variable costs.
Short Run Supply Curve
In a perfectly competitive market, the short run supply curve is the marginal cost (MC) curve at and above the shutdown point. The portions of the marginal cost curve below the shutdown point are no part of the supply curve because the firm is not producing in that range. The short run supply curve is used to graph a firm’s short run economic state.
Short run supply curve: This graph shows a short run supply curve in a perfect competitive market. The short run supply curve is the marginal cost curve at and above the shutdown point. The portions of the marginal cost curve below the shutdown point are not part of the supply curve because the firm is not producing in that range.
Key Points
• In economics, output is defined as the quantity of goods or services produce in a certain period of time by a firm, industry, or country. Output can be consumed or used for further production.
• Revenue, also known as turnover, is the income that a company receives from normal business activities, usually from the sale of goods and services. Companies can also receive revenue from interest, royalties, and other fees.
• The performance of a company is determined by how its asset inflows (revenues) compare with its asset outflows (expenses). Revenue is a direct indication of earning quality.
• Marginal cost is the increase in total cost from producing one additional unit.
• The marginal revenue is the increase in revenue from the sale of one additional unit.
• One way to determine how to generate the largest profit is to use the marginal revenue-marginal cost perspective. This strategy is based on the fact that the total profit reaches its maximum point where marginal revenue equals marginal profit.
• Economic shutdown occurs within a firm when the marginal revenue is below average variable cost at the profit -maximizing output.
• When a shutdown is required the firm failed to achieve a primary goal of production by not operating at the level of output where marginal revenue equals marginal cost.
• If the revenue the firm is making is greater than the variable cost (R>VC) then the firm is covering it’s variable costs and there is additional revenue to partially or entirely cover the fixed costs.
• If the variable cost is greater than the revenue being made (VC>R) then the firm is not even covering production costs and it should be shutdown.
• The decision to shutdown production is usually temporary. If the market conditions improve, due to prices increasing or production costs falling, then the firm can resume production.
• When a shutdown last for an extended period of time, a firm has to decide whether to continue to business or leave the industry.
• In a free market economy, firms use cost curves to find the optimal point of production (minimizing cost).
• Profit maximization is the process that a firm uses to determine the price and output level that returns the greatest profit when producing a good or service.
• The total revenue -total cost perspective recognizes that profit is equal to the total revenue (TR) minus the total cost (TC).
• The marginal revenue – marginal cost perspective relies on the understanding that for each unit sold, the marginal profit equals the marginal revenue (MR) minus the marginal cost (MC).
• Fixed costs have no impact on a firm ‘s short run decisions. However, variable costs and revenues affect short run profits.
• When a firm is transitioning from short run to long run it will consider the current and future equilibrium for supply and demand.
• A firm will implement a production shutdown when the revenue coming in from the sale of goods cannot cover the variable costs of production.
• A short run shutdown is designed to be temporary. When a firm is shutdown for the short run, it still has to pay fixed costs and cannot leave the industry. However, a firm cannot incur losses indefinitely. Exiting an industry is a long term decision.
Key Terms
• revenue: The total income received from a given source.
• output: Production; quantity produced, created, or completed.
• marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
• marginal revenue: The additional profit that will be generated by increasing product sales by one unit.
• variable cost: A cost that changes with the change in volume of activity of an organization.
• Total Revenue: The profit from each item multiplied by the number of items sold.
• profit: Total income or cash flow minus expenditures. The money or other benefit a non-governmental organization or individual receives in exchange for products and services sold at an advertised price.
• shutdown: The action of stopping operations; a closing, of a computer, business, event, etc.
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Long Run Supply Decisions
The long-run supply curve in a perfectly competitive market has three parts; a downward sloping curve, a flat portion, and an upwards sloping curve.
learning objectives
• Describe the long-run market supply curve of a perfectly competitive market
The long-run supply curve of a market is the sum of a series of short-run supply curves in the market (). Prior to determining how the long-run supply curve looks, its important to understand short-run supply curves.
Long-run Supply Curve: As the chart demonstrates, a market’s long-run supply curve is the sum of a series of short-run supply curves in a given market.
Short-Run Supply Curves
While most people focus on the second half of a supply curve, which has a positive slope, that is not how the supply and pricing decision works in practice. As you can see from the chart, the first items that are produced start out with a very high price. This is because it is very expensive for a producer to manufacture one item. The producer has to incur fixed costs, such as learning the necessary skills to produce the item and purchasing new tools. These initial fixed costs make the cost of producing one good very expensive.
However, as more goods are produced, those initial fixed costs are spread out over more items. This decreases the price of per unit of each good produced for a period of time. As a result, in the early stages of production the supply curve is sloping downward as you can see in the chart. This period of supply is known as “increasing returns to scale,” because a proportional increase in resources yields a greater proportional increase in output.
At some point, the per unit share of fixed costs becomes less than the variable costs of producing one more item. Variable expenses include purchasing more raw materials to manufacture another item. When this occurs, the supply curve slopes upward. Thus, in the short-run, a market’s supply curve looks like an oddly shaped “u.” This period of supply is known as “decreasing returns to scale,” because a proportional increase in resources yields a smaller proportional increase in its amount in output. Between these two periods is the “constant returns to scale,” where a proportion increase in resources yields an equal proportional increase in the amount of output.
Long-Run Supply Curves
A market’s long-run supply curve is the sum of the market’s short-run supply curves taken at different points of time. As a result, a long-run supply curve for a market will look very similar to short-run supply curves for a market, but more stretched out; the long-term market curve will a wider “u.” A long-run supply curve connects the points of constant returns to scales of a markets’ short-run supply curves.; the bottom of each short-term supply curve’s “u.” Consider the attached chart.
The first short-run supply curve reflects what happens when a firm enters into a new market for the first time. When it does, it should make an economic profit. In a perfectly competitive market, firms can freely enter and exit an industry. When other business notice that the first firm is making it profit, they will enter the market to capture some of that profit and because there is nothing preventing them from doing so. In the early stages of the market, where only one or a few firms are producing goods, the market experiences increasing returns to scale, similar to what an individual firm would experience.
As more firms enter the market and time passes, production yields less and less returns in comparison to the production. Eventually the market reaches a state of constant returns to scale. How long this period of constant returns is varies by industry. Agriculture has a longer period of constant returns while technology has shorter.
Eventually, production of goods in a market yields less of a return than the amount of goods that go into product, which causes the market to enter into a period of decreasing returns to scale and the market’s supply curve slopes upward.
Long Run Market Equilibrium
The long-run equilibrium of a perfectly competitive market occurs when marginal revenue equals marginal costs, which is also equal to average total costs.
learning objectives
• Describe the long-run market equilibrium
The long-run is the period of time where there are no fixed variables of production. As with any other economic equilibrium, it is defined by demand and supply.
Demand
In a perfect market, demand is perfectly elastic. The demand curve also represents marginal revenue, which is important to remember later when we calculate quantity supplied. That means regardless of how much is produced by the suppliers, the price will remain constant.
Perfectly Elastic Demand: In a perfectly competitive market, demand is perfectly elastic.
Supply
In a perfectly competitive market, it is assumed that all of the firms participating in production are trying to maximize their profits. So a firm will produce goods until the marginal costs of production equal the marginal revenues from sales. In a perfectly competitive market in the long-term, this is taken one step further. In a perfectly competitive market, long-run equilibrium will occur when the marginal costs of production equal the average costs of production which also equals marginal revenue from selling the goods. So the equilibrium will be set, graphically, at a three-way intersection between the demand, marginal cost and average total cost curves.
Repercussions of Equilibrium
A perfectly competitive market in equilibrium has several important characteristics.
• Firms can’t make economic profit; the best they can do is break even so that their revenues equals their costs.
• The market is productively and allocatively efficient. This means that not only is the market using all of its resources efficiently, it is using its resources in a way that maximizes the social welfare.
• Economic surplus is maximized, which means there is no deadweight loss. Attempting to improve the conditions of one group would harm the interests of the other.
Productive Efficiency
Productive efficiency occurs when production of a good is achieved at the lowest resource cost possible, given the level of production of other goods.
Learning objectives
• Describe the efficiency of production in perfectly competitive markets
Productive efficiency occurs when the economy is getting maximum output from its resources. The concept is illustrated on a production possibility frontier (PPF) where all points on the curve are points of maximum productive efficiency (i.e., no more output can be achieved from the given inputs). An equilibrium may be productively efficient without being allocatively efficient. In other words, just because a market maximizes the output it generates, that doesn’t mean that social welfare is maximized.
Production Possibilities on Frontier Curve: This chart shows production possibilities for production of guns and butter. Points B, C, and D are productively efficient and point A is not. Point X is only possible if the means of production improve.
Production efficiency occurs when production of one good is achieved at the lowest resource (input) cost possible, given the level of production of the other good(s). Another way to define productive efficiency is that it occurs when the highest possible output of one good is produced, given the production level of the other good(s). In long-run equilibrium for perfectly competitive markets, productive efficiency occurs at the base of the average total cost curve, or where marginal cost equals average total cost. Productive efficiency requires that all firms operate using best-practice technological and managerial processes. By improving these processes, an economy or business can extend its production possibility frontier outward, so that efficient production yields more output.
Monopolistic companies may not be productively efficient because companies operating in a monopoly have less of an incentive to maximize output due to lack of competition. However, due to economies of scale, it may be possible for the profit-maximizing level of output of monopolistic companies to occur with a lower price to the consumer than perfectly competitive companies. So, consumers may pay less with a monopoly, but a monopolistic market would not achieve productive efficiency.
Allocative Efficiency
Free markets iterate towards higher levels of allocative efficiency, aligning the marginal cost of production with the marginal benefit for consumers.
Learning objectives
• Explain resource allocation in terms of consumer and producer surplus and market equilibrium
Allocative efficiency is the degree to which the marginal benefits consumers receive from goods are as close as possible to the marginal costs of producing them. At the optimal level of allocative efficiency in a given market, the last unit’s marginal cost would be perfectly equal to the marginal benefit it provides consumers, resulting in no deadweight loss.
The amount of value generated in a market that efficient equals the social value of the produced output minus the value of resources used in production. Optimal efficiency is higher in free markets, though reality always has some limitations and imperfections to detract from completely perfect allocative efficiency. Markets are not efficient if it is subject to:
Final goods: When an economy has allocative efficiency, it produces goods and services that have the highest demand and that society finds most desirable. For example, for the U.S. to achieve an allocative efficient market, it would need to produce a lot of coffee.
• monopolies,
• monopsonies,
• externalities,
• public goods which construe market failure, or
• price controls which construe government failure in addition to taxation.
Allocative efficiency is the main means to measure the degree markets and public policy improve or harm society or other specific subgroups.
Although there are different standards of evaluation for the concept of allocative efficiency, the basic principle asserts that in any economic system, choices in resource allocation produce both “winners” and “losers” relative to the choice being evaluated. The principles of rational choice, individual maximization, utilitarianism, and market theory further suppose that the outcomes for winners and losers can be identified, compared, and measured.
Under these basic premises, the goal of maximizing allocative efficiency can be defined according to some neutral principle where some allocations are objectively better than others. For example, an economist might say that a change in policy increases allocative efficiency as long as those who benefit from the change (winners) gain more than the losers lose.
Entry and Exit of Firms
The absence of barriers of entry and exit is a necessary condition for a market to be perfectly competitive.
Learning objectives
• Explain the entry and exit of firms in perfectly competitive markets.
Barriers to entry and exit are an important characteristics to consider when analyzing a market. In perfectly competitive markets, there are no barriers to entry or exit. This is a critical characteristic of perfectly competitive markets because firms are able to freely enter and exit in response to potential profit. Therefore, in the long-run firms cannot make economic profit but can only break even.
However, in most other types of markets barriers do exist. These types of barriers, defined below, prevent free entry to or exit from markets.
Barriers to Entry
Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry. Barriers can also be obstacles an individual faces in trying to gain entrance to a profession, such as education or licensing requirements.
Because barriers to entry protect incumbent firms and restrict competition in a market, they can distort prices. Monopolies are often aided by barriers to entry. Examples of barriers to entry include:
• Capital: need the capital to start up such as equipment, building, and raw materials.
• Customer loyalty: Large incumbent firms may have existing customers loyal to established products. The presence of established strong brands within a market can be a barrier to entry in this case.
• Economy of scale: The increase in efficiency of production as the number of goods being produced increases. Cost advantages can sometimes be quickly reversed by advances in technology.
• Intellectual property: Potential entrant requires access to equally efficient production technology as the combatant monopolist in order to freely enter a market. Patents give a firm the legal right to stop other firms producing a product for a given period of time, and so restrict entry into a market. Patents are intended to encourage invention and technological progress by guaranteeing proceeds as an incentive. Similarly, trademarks and service marks may represent a kind of entry barrier for a particular product or service if the market is dominated by one or a few well-known names.
A patent is an example of an intangible asset with a limited life: Patents are an example of intellectual property. If a firm does not own intellectual property relevant to the industry, that could prove to be a significant barrier to entry into that market.
Barriers to Exit
Barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it doing so. If the barriers of exit are significant; a firm may be forced to continue competing in a market, as the costs of leaving may be higher than those incurred if they continue competing in the market. The factors that may form a barrier to exit include:
• High investment in non-transferable fixed assets: This is particularly common for manufacturing companies that invest heavily in capital equipment which is specific to one task.
• High redundancy costs: If a company has a large number of employees, employees with high salaries, or contracts with employees which stipulate high redundancy payments, then the firm may face significant cost if it wishes to leave the market.
• Other closure costs: Contract contingencies with suppliers or buyers and any penalty costs incurred from cutting short tenancy agreements.
• Potential upturn:Firms may be influenced by the potential of an upturn in their market that may reverse their current financial situation.
Key Points
• The long-run supply curves of a market is the sum of a series of that market’s short-run supply curves.
• Most supply curves are composed of three periods of production: a period of increasing returns to scale, constant returns to scale, and decreasing returns to scale.
• A long-run supply curve connects the points of constant returns to scales of a markets’ short-run supply curves.
• In a perfectly competitive market, demand is perfectly elastic. This means the demand curve is a horizontal line.
• Once equilibrium has been achieved, firms in a perfectly competitive market can’t achieve economic profit; it can only break even.
• A perfectly competitive market in equilibrium is productively and allocatively efficient.
• An equilibrium may be productively efficient without being allocatively efficient.
• Another way to define productive efficiency is that it occurs when the highest possible output of one good is produced, given the production level of the other good(s).
• Productive efficiency requires that all firms operate using best-practice technological and managerial processes.
• Allocative efficiency occurs where a good or service’s marginal benefit is equal to its marginal cost. At this point the social surplus is maximized with no deadweight loss.
• Free markets that are perfectly competitive are generally allocatively efficient.
• Allocative efficiency is the main means to measure the degree markets and public policy improve or harm society or other specific subgroups.
• Under these basic premises, the goal of maximizing allocative efficiency can be defined according to some neutral principle where some allocations are objectively better than others.
• Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry. Barriers can be obstacles an individual faces in trying to enter into a profession, such as education or licensing requirements.
• Because firms are able to freely enter and exit in response to potential profit, this means that in the long-run firms cannot make economic profit; they can only break even.
• Barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector.
Key Terms
• constant returns to scale: Changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRS).
• decreasing returns to scale: Changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by less than the proportional change then there are decreasing returns to scale.
• increasing returns to scale: The characteristic of production in which output increases by more than the proportional increase in inputs.
• long-run: The conceptual time period in which there are no fixed factors of production.
• Productive Efficiency: An economic status that occurs when when the highest possible output of one good is produced, given the production level of the other good(s).
• Allocative efficiency: A state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing.
• Barriers to entry: Obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry, such as government regulation, or a large, established firm taking advantage of economies of scale.
• barriers to exit: Obstacles in the path of a firm that want to leave a market or industrial sector.
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Defining Monopoly
A monopoly is an economic market structure where a specific person or enterprise is the only supplier of a particular good.
learning objectives
• Differentiate monopolies and competitive markets
A monopoly is a specific type of economic market structure. A monopoly exists when a specific person or enterprise is the only supplier of a particular good. As a result, monopolies are characterized by a lack of competition within the market producing a good or service.
Monopoly: The graph shows a monopoly and the price (P) and change in price (P reg) as well as the output (Q) and output change (Q reg).
Characteristics of a Monopoly
A monopoly can be recognized by certain characteristics that set it aside from the other market structures:
• Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm can charge a set price above what would be charged in a competitive market, thereby maximizing its revenue.
• Price maker: the monopoly decides the price of the good or product being sold. The price is set by determining the quantity in order to demand the price desired by the firm (maximizes revenue).
• High barriers to entry: other sellers are unable to enter the market of the monopoly.
• Single seller: in a monopoly one seller produces all of the output for a good or service. The entire market is served by a single firm. For practical purposes the firm is the same as the industry.
• Price discrimination: in a monopoly the firm can change the price and quantity of the good or service. In an elastic market the firm will sell a high quantity of the good if the price is less. If the price is high, the firm will sell a reduced quantity in an elastic market.
Sources of Monopoly Power
In a monopoly, specific sources generate the individual control of the market. Sources of power include:
• Economies of scale
• Capital requirements
• Technological superiority
• No substitute goods
• Control of natural resources
• Network externalities
• Legal barriers
• Deliberate actions
Monopoly vs. Competitive Market
Monopolies and competitive markets mark the extremes in regards to market structure. There are a few similarities between the two including: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.
However, there are noticeable differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve. The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.
Key Points
• A monopoly market is characterized by the profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Monopoly characteristics include profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Sources of monopoly power include economies of scale, capital requirements, technological superiority, no substitute goods, control of natural resources, legal barriers, and deliberate actions.
• There are a few similarities between a monopoly and competitive market: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.
• Differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve.
• The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.
Key Terms
• monopoly: A market where one company is the sole supplier.
• differentiation: The act of distinguishing a product from the others in the market.
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Resource Control
Control over a natural resource that is critical to the production of a final good is one source of monopoly power.
Learning Objectives
• Explain the relationship between resource control and monopolies
Control over natural resources that are critical to the production of a good is one source of monopoly power. Single ownership over a resource gives the owner of the resource the power to raise the market price of a good over marginal cost without losing customers to competitors. In other words, resource control allows the controller to charge economic rent. This is a classic outcome of imperfectly competitive markets.
A classic example of a monopoly based on resource control is De Beers. De Beers Consolidated Mines were founded in 1888 in South Africa as an amalgamation of a number of individual diamond mining operations. De Beers had a monopoly over the production of diamonds for most of the 20th century, and it used its dominant position to manipulate the international diamond market. It convinced independent producers to join its single channel monopoly. In instances when producers refused to join, De Beers flooded the market with diamonds similar to the ones they were producing. De Beers also purchased and stockpiled diamonds produced by other manufacturers in order to control prices through supply. The De Beers model changed at the turn of the 21st century, when diamond producers from Russia, Canada, and Australia started to distribute diamonds outside of the De Beers channel. The sale of diamonds also suffered from rising awareness about blood diamonds. De Beers’ market share fell from as high as 90 percent in the 1980s to less than 40 percent in 2012.
Diamonds: For most of the 20th century, De Beers had monopoly power over the world market for diamonds.
In practice, monopolies rarely arise because of control over natural resources. Economies are large, usually with multiple people owning resources. International trade is an additional source of competition for owners of natural resources.
Economies of Scale and Network Externalities
Economies of scale and network externalities discourage potential competitors from entering a market.
Learning Objectives
• Define Economies of Scale., Explain why economies of scale are desirable for monopolies
Economies of scale and network externalities are two types of barrier to entry. They discourage potential competitors from entering a market, and thus contribute to the monopolistic power of some firms.
Economies of scale are cost advantages that large firms obtain due to their size.They occur because the cost per unit of output decreases with increasing scale, as fixed costs are spread over more units of output. Economies of scale are also gained through bulk-buying of materials with long-term contracts, the increased specialization of managers, ability to obtain lower interest rates when borrowing from banks, access to a greater range of financial instruments, and spreading the cost of marketing over a greater range of output. Each of these factors contributes to reductions in the long-run average cost of production.
Economies of Scale: Large firms obtain economies of scale in part because fixed costs are spread over more units of output.
A natural monopoly arises as a result of economies of scale. For natural monopolies, the average total cost declines continually as output increases, giving the monopolist an overwhelming cost advantage over potential competitors. It becomes most efficient for production to be concentrated in a single firm.
Network externalities (also called network effects) occur when the value of a good or service increases as a result of many people using it. Because of network effects, certain goods or services that are adopted widely will appear to be much more attractive to new customers than competing goods or services. This is evident in online social networks. Social networks with the largest memberships are more attractive to new users, because new users know that their friends or colleagues are more likely to be on these networks. It is also evident with certain software programs. For example, most people use Microsoft word processing software. While other word processing programs may be available, an individual would risk running into compatibility problems when sending files to people or machines using the mainstream software. This makes it difficult for new companies to enter the market and to gain market share.
Government Action
here are two types of government-initiated monopoly: a government monopoly and a government-granted monopoly.
Learning objectives
• Discuss different types of monopolies initiated by government
Monopoly Creation
There are instances in which the government initiates monopolies, creating a government-granted monopoly or a government monopoly. Government-granted monopolies often closely resemble government monopolies in many respects, but the two are distinguished by the decision-making structure of the monopolist. In a government monopoly, the holder of the monopoly is formally the government itself and the group of people who make business decisions is an agency under the government’s direct authority. In a government-granted monopoly, on the other hand, the monopoly is enforced through the law, but the holder of the monopoly is formally a private firm, which makes its own business decisions.
Government-Granted Monopoly
In a government-granted monopoly, the government gives a private individual or a firm the right to be a sole provider of a good or service. Potential competitors are excluded from the market by law, regulation, or other mechanisms of government enforcement. Intellectual property rights such as copyright and patents are government-granted monopolies. Additionally, the Dutch East India Company provides a historical example of a government-granted monopoly. It was granted exclusive trading privileges with colonial possessions under mercantilist economic policy.
Government Monopoly
In a government monopoly, an agency under the direct authority of the government itself holds the monopoly, and the monopoly is sustained by the enforcement of laws and regulations that ban competition or reserve exclusive control over factors of production to the government. The state-owned petroleum companies that are common in oil-rich developing countries (such as Aramco in Saudi Arabia or PDVSA in Venezuela) are examples of government monopolies created through nationalization of resources and existing firms. The United States Postal Service is another example of a government monopoly. It was created through laws that ban potential competitors from offering certain types of services, such as first-class and standard mail delivery. Around the world, government monopolies on public utilities, telecommunications systems, and railroads have historically been common.
Postal Service: The postal service operates as a government monopoly in many countries, including the United States.
Legal Barriers
The government creates legal barriers through patents, copyrights, and granting exclusive rights to companies.
Learning objectives
• Identify the legal conditions that lead to monopolistic power.
In some cases, the government will grant a person or firm exclusive rights to produce a good or service, enabling them to monopolize the market for this good or service. Intellectual property rights, including copyright and patents, are an important example of legal barriers that give rise to monopolies.
Copyright
Copyright gives the creator of an original creative work (such as a book, song, or film) exclusive rights to it, usually for a limited time, with the intention of enabling the creator to be compensated for his or her work. The intent behind copyright is to promote the creation of new works by providing creators the opportunity to profit from their works. The copyright holder receives the right to be credited for the work, to determine who may adapt the work to other forms, who may perform the work, and who may financially benefit from it, along with other related rights. When the copyright on a work expires, the work is transferred to the public domain, enabling others to repurpose and build on the work.
Copyright: Copyright is an example of a temporary legal monopoly granted to creators of original creative works.
Patent
A patent is a limited property right the government gives inventors in exchange for their agreement to share the details of their invention with the public. During the term of the patent, the patent holder has the right to exclude others from making, using, or selling the patented invention. The patent provides incentives (1) to invent in the first place, (2) to disclose the invention once it is made, (3) to make the necessary investments in research and development, production, and bringing the invention to market, and (4) to innovate by designing around or improving upon earlier patents. When a patent expires and the invention enters the public domain, others can build on the invention.
For example, when a pharmaceutical company first markets a drug, it is usually under a patent, and only the pharmaceutical company can sell it until the patent expires. This allows the company to recoup the cost of developing this particular drug. After the patent expires, any pharmaceutical company can manufacture and sell a generic version of the drug, bringing down the price of the original drug to compete with new versions.
Government Granted Monopoly
It is also possible that there is a monopoly because the government has granted a single company exclusive or special rights. The water utility company, for example, is a monopoly in your area because it is the only organization granted the right to provide water. Another example is that the Digital Millenium Copyright Act the proprietary Macrovision copy prevention technology is required for analog video recorders. Though other forms of copy prevention aren’t prohibited, requiring Macrovision effectively gives it a monopoly and prevents more effective copy prevention methods from being developed.
Natural Monopolies
Natural monopolies occur when a single firm can serve the entire market at a lower cost than a combination of two or more firms.
Learning Obejectives
• Demonstrate an understanding of how a natural monopoly is created
Natural monopolies occur when a single firm is able to serve the entire market demand at a lower cost than any combination of two or more smaller firms. For example, imagine there are two firms in a natural monopoly’s market and each of them produces half of the quantity that the monopoly produces. The total cost of the natural monopoly is lower than the sum of the total costs of two firms producing the same quantity.
Natural Monopoly: The total cost of the natural monopoly’s production is lower than the sum of the total costs of two firms producing the same quantity.
Cost Structure
A natural monopoly’s cost structure is very different from that of most industries. In other industries, the marginal cost initially decreases due to economies of scale, then increases as the company experiences growing pains (as employees become overworked, the firm’s bureaucracy expands, etc.). Along with this, the average cost of production decreases and then increases. In contrast, a natural monopoly will have a marginal cost that is constant or declining, and an average total cost that drops as the quantity of output increases.
Fixed Costs
Natural monopolies tend to form in industries where there are high fixed costs. A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment. As it gains market share and increases its output, the fixed cost is divided among a larger number of customers. Therefore, in industries with large initial investment requirements, average total costs decline as output increases. Once a natural monopoly has been established, there will be high barriers to entry for other firms because of the large initial cost and because it would be difficult for the entrant to capture a large enough part of the market to achieve the same low costs as the monopolist.
Examples of natural monopolies are water and electricity services. For both of these, fixed costs of building the necessary infrastructure are high. The cost of constructing a competing transmission network and delivering service will be so high that it effectively bars potential competitors from entering the monopolist’s market.
Other Barriers to Entry
Firms gain monopolistic power as a result of markets’ barriers to entry, which discourage potential competitors.
Learning Obejectives
• Identify the common conditions that lead to monopolistic power
Monopolies derive their market power from barriers to entry: circumstances that prevent or greatly impede a potential competitor’s ability to compete in the market. There are several different types of barriers to entry.
Control Over Natural Resources
The supply of natural resources such as precious metals or oil deposits is limited, giving their owners monopoly powers. For example, De Beers controls the vast majority of the world’s diamond reserves, allowing only a certain number of diamonds to be mined each year and keeping the price of diamonds high.
Diamond: De Beers controls the majority of the world’s diamond reserves, preventing other players from entering the industry and setting a high price for diamonds.
High Capital Requirements
Some production processes require large investments in capital or large research and development costs that make it difficult for new companies to enter an industry. Examples include steel production, pharmaceuticals, and space transport.
Economies of Scale
Monopolies exhibit decreasing costs as output increases. Decreasing costs coupled with large initial costs give monopolies a cost advantage in production over would-be competitors. Market entrants have not yet achieved economies of scale, so their output simply costs so much more than the incumbent firms that market entry is difficult.
Network Effects
The use of a product by other people can increase its value to a person. One example is Microsoft spreadsheet and word processing software, which is still used widely. This is because when a person uses software that is used by so many others, he or she is less likely to run into compatibility problems in the course of work or other activities. This tendency to use what everyone else is using makes it difficult for new companies to develop and sell competing software.
Facebook: Network effects are one reason why it’s so difficult for new companies to compete against Facebook: they simply will have difficulty establishing a network of users to compete.
Legal Barriers
Legal rights can provide an opportunity to monopolize a market for a good. Intellectual property rights, such as patents and copyright, give the rights holder exclusive control over the production and sale of certain goods. Property rights may give a company exclusive control of the materials necessary to produce a good. The granting of permits or professional licenses can also favor certain firms, while setting standards that are difficult for new firms to meet.
Government Backing
There are cases in which a government agency is the sole provider of a particular good or service and competition is prohibited by law. For example, in many countries, the postal system is run by the government with competition forbidden by law in some or all services. Government monopolies in public utilities, telecommunications systems, and railroads have also historically been common. In other instances, the government may be an invested partner in a monopoly rather than a sole owner. This will still make it difficult for competitors to operate on equal footing.
Key Points
• Single ownership over a resource gives the owner the power to raise the market price of a good over marginal cost without losing customers to competitors.
• De Beers is a classic example of a monopoly based on a natural resource. De Beers had a lot of market power in the world market for diamonds over the course of the 20th century, keeping the price of diamonds high.
• In practice, monopolies rarely arise because of control over natural resources.
• Economies of scale are cost advantages that large firms gain because of their size.
• Natural monopolies arise as a result of economies of scale. Natural monopolies have overwhelming cost advantages over potential competitors.
• Network effects occur when the value of a good or service increases because many other people are using it. This makes competing goods or services with lower levels of adoption unattractive to new customers.
• Government-granted monopolies and government monopolies differ in the decision-making structure of the monopolist. In a government-granted monopoly, business decisions are made by a private firm. In a government monopoly, decisions are made by a government agency.
• In a government-granted monopoly, the government gives a private individual or a firm the right to be a sole provider of a good or service.
• In a government monopoly, an agency under the direct authority of the government itself holds the monopoly.
• In both types of government-initiated monopoly competition is kept out of the market through laws, regulations, and other mechanisms of government enforcement.
• Intellectual property rights are an example of legal barriers that give rise to monopolies.
• A copyright gives the creator of an original creative work exclusive rights to it for a limited time. This provides an incentive for the continued creation of innovative goods.
• A patent is a limited property right the government gives inventors in exchange for the details of their invention being made public.
• The government can provide exclusive or special rights to companies that legally allow them to be monopolies.
• A natural monopoly ‘s cost structure is very different from that of most industries. For a natural monopoly, the average total cost continues to shrink as output increases.
• Natural monopolies tend to form in industries where there are high fixed costs. A firm with high fixed costs requires a large number of customers in order to have a meaningful return on investment.
• Other firms are discouraged from entering the market because of the high initial costs and the difficulty of obtaining a large enough market share to achieve the same low costs as the monopolist.
• There are several different types of barriers to entry, including a firm ‘s control over scarce natural resources, high capital requirements for an industry, economies of scale, network effects, legal barriers, and government backing.
• Some industries require large investments in capital or research and development, making it difficult for new firms to enter.
• Monopolies benefit from economies of scale, which give them a cost advantage over their competitors.
• The legal system can grant firms monopoly rights over a resource or production of a good.
Key Terms
• market power: The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.
• economic rent: The portion of income paid to a factor of production in excess of its opportunity cost.
• economies of scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.
• Network externalities: Are evident when the value of a product or service is dependent on the number of other people using it.
• Natural monopoly: Occurs when a firm is able to serve the entire market demand at a lower cost than any combination of two or more smaller, more specialized firms.
• Government monopoly: A form of monopoly in which a government agency is the sole provider of a particular good or service and competition is prohibited by law.
• Government-granted monopoly: A form of monopoly in which a government grants exclusive rights to a private individual or firm to be the sole provider of a good or service.
• Copyright: A legal concept that gives the creator of an original work exclusive rights to it, usually for a limited time, with the intention of enabling the creator to be compensated for his or her work.
• patent: A declaration issued by a government agency declaring the inventor of a new product has the privilege of stopping others from making, using or selling the claimed invention for a limited time.
• Barriers to entry: Circumstances that prevent or greatly impede a potential competitor’s ability to compete in the market.
• Network effects: When the value of a product or service is dependent on the number of people using it.
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Market Differences Between Monopoly and Perfect Competition
Monopolies, as opposed to perfectly competitive markets, have high barriers to entry and a single producer that acts as a price maker.
learning objectives
• Distinguish between monopolies and competitive firms
A market can be structured differently depending on the characteristics of competition within that market. At one extreme is perfect competition. In a perfectly competitive market, there are many producers and consumers, no barriers to enter and exit the market, perfectly homogeneous goods, perfect information, and well-defined property rights. This produces a system in which no individual economic actor can affect the price of a good – in other words, producers are price takers that can choose how much to produce, but not the price at which they can sell their output. In reality there are few industries that are truly perfectly competitive, but some come very close. For example, commodity markets (such as coal or copper) typically have many buyers and multiple sellers. There are few differences in quality between providers so goods can be easily substituted, and the goods are simple enough that both buyers and sellers have full information about the transaction. It is unlikely that a copper producer could raise their prices above the market rate and still find a buyer for their product, so sellers are price takers.
A monopoly, on the other hand, exists when there is only one producer and many consumers. Monopolies are characterized by a lack of economic competition to produce the good or service and a lack of viable substitute goods. As a result, the single producer has control over the price of a good – in other words, the producer is a price maker that can determine the price level by deciding what quantity of a good to produce. Public utility companies tend to be monopolies. In the case of electricity distribution, for example, the cost to put up power lines is so high it is inefficient to have more than one provider. There are no good substitutes for electricity delivery so consumers have few options. If the electricity distributor decided to raise their prices it is likely that most consumers would continue to purchase electricity, so the seller is a price maker.
Electricity Distribution: The cost of electrical infrastructure is so expensive that there are few or no competitors for electricity distribution. This creates a monopoly.
Sources of Monopoly Power
Monopoly power comes from markets that have high barriers to entry. This can be caused by a variety of factors:
• Increasing returns to scale over a large range of production
• High capital requirements or large research and development costs
• Production requires control over natural resources
• Legal or regulatory barriers to entry
• The presence of a network externality – that is, the use of a product by a person increases the value of that product for other people
Monopoly Vs. Perfect Competition
Monopoly and perfect competition mark the two extremes of market structures, but there are some similarities between firms in a perfectly competitive market and monopoly firms. Both face the same cost and production functions, and both seek to maximize profit. The shutdown decisions are the same, and both are assumed to have perfectly competitive factors markets.
However, there are several key distinctions. In a perfectly competitive market, price equals marginal cost and firms earn an economic profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive economic profit. Perfect competition produces an equilibrium in which the price and quantity of a good is economically efficient. Monopolies produce an equilibrium at which the price of a good is higher, and the quantity lower, than is economically efficient. For this reason, governments often seek to regulate monopolies and encourage increased competition.
Marginal Revenue and Marginal Cost Relationship for Monopoly Production
For monopolies, marginal cost curves are upward sloping and marginal revenues are downward sloping.
learning objectives
• Analyze how marginal and marginal costs affect a company’s production decision
Profit Maximization
In traditional economics, the goal of a firm is to maximize their profits. This means they want to maximize the difference between their earnings, i.e. revenue, and their spending, i.e. costs. To find the profit maximizing point, firms look at marginal revenue (MR) – the total additional revenue from selling one additional unit of output – and the marginal cost (MC) – the total additional cost of producing one additional unit of output. When the marginal revenue of selling a good is greater than the marginal cost of producing it, firms are making a profit on that product. This leads directly into the marginal decision rule, which dictates that a given good should continue to be produced if the marginal revenue of one unit is greater than its marginal cost. Therefore, the maximizing solution involves setting marginal revenue equal to marginal cost.
This is relatively straightforward for firms in perfectly competitive markets, in which marginal revenue is the same as price. Monopoly production, however, is complicated by the fact that monopolies have demand curves and MR curves that are distinct, causing price to differ from marginal revenue.
Monopoly: In a monopoly market, the marginal revenue curve and the demand curve are distinct and downward-sloping. Production occurs where marginal cost and marginal revenue intersect.
Perfect Competition: In a perfectly competitive market, the marginal revenue curve is horizontal and equal to demand, or price. Production occurs where marginal cost and marginal revenue intersect.
Monopoly Profit Maximization
The marginal cost curves faced by monopolies are similar to those faced by perfectly competitive firms. Most will have low marginal costs at low levels of production, reflecting the fact that firms can take advantage of efficiency opportunities as they begin to grow. Marginal costs get higher as output increases. For example, a pizza restaurant can easily double production from one pizza per hour to two without hiring additional employees or buying more sophisticated equipment. When production reaches 50 pizzas per hour, however, it may be difficult to grow without investing a lot of money in more skilled employees or more high-tech ovens. This trend is reflected in the upward-sloping portion of the marginal cost curve.
The marginal revenue curve for monopolies, however, is quite different than the marginal revenue curve for competitive firms. While competitive firms experience marginal revenue that is equal to price – represented graphically by a horizontal line – monopolies have downward-sloping marginal revenue curves that are different than the good’s price.
Profit Maximization Function for Monopolies
Monopolies set marginal cost equal to marginal revenue in order to maximize profit.
learning objectives
• Explain the monopolist’s profit maximization function
Monopolies have much more power than firms normally would in competitive markets, but they still face limits determined by demand for a product. Higher prices (except under the most extreme conditions) mean lower sales. Therefore, monopolies must make a decision about where to set their price and the quantity of their supply to maximize profits. They can either choose their price, or they can choose the quantity that they will produce and allow market demand to set the price.
Since costs are a function of quantity, the formula for profit maximization is written in terms of quantity rather than in price. The monopoly’s profits are given by the following equation:
\[π=p(q)q−c(q)\]
In this formula, p(q) is the price level at quantity q. The cost to the firm at quantity q is equal to c(q). Profits are represented by π. Since revenue is represented by pq and cost is c, profit is the difference between these two numbers. As a result, the first-order condition for maximizing profits at quantity q is represented by:
\[0=∂q=p(q)+qp′(q)−c′(q)\]
The above first-order condition must always be true if the firm is maximizing its profit – that is, if \(p(q)+qp′(q)−c′(q)\) is not equal to zero, then the firm can change its price or quantity and make more profit.
Marginal revenue is calculated by \(p(q)+qp′(q)\), which is derived from the term for revenue, \(pq\). The term \(c′(q)\) is marginal cost, which is the derivative of c(q). Monopolies will produce at quantity q where marginal revenue equals marginal cost. Then they will charge the maximum price \(p(q)\) that market demand will respond to at that quantity.
Consider the example of a monopoly firm that can produce widgets at a cost given by the following function:
\[c(q)=2+3q+q^2\]
If the firm produces two widgets, for example, the total cost is \(2+3(2)+2^2=12\). The price of widgets is determined by demand:
\[p(q)=24-2p\]
When the firm produces two widgets it can charge a price of \(24-2(2)=20\) for each widget. The firm’s profit, as shown above, is equal to the difference between the quantity produces multiplied by the price, and the total cost of production: \(p(q)q−c(q)\). How can we maximize this function?
Using the first order condition, we know that when profit is maximized, \(0=p(q)+qp′(q)−c′(q)\). In this case:
\[0=(24-2p)+q(-2)-(3+2q)=21-6q\]
Rearranging the equation shows that \(q=3.5\). This is the profit maximizing quantity of production.
Consider the diagram illustrating monopoly competition. The key points of this diagram are fivefold.
1. First, marginal revenue lies below the demand curve. This occurs because marginal revenue is the demand, p(q), plus a negative number.
2. Second, the monopoly quantity equates marginal revenue and marginal cost, but the monopoly price is higher than the marginal cost.
3. Third, there is a deadweight loss, for the same reason that taxes create a deadweight loss: The higher price of the monopoly prevents some units from being traded that are valued more highly than they cost.
4. Fourth, the monopoly profits from the increase in price, and the monopoly profit is illustrated.
5. Fifth, since—under competitive conditions—supply equals marginal cost, the intersection of marginal cost and demand corresponds to the competitive outcome.
We see that the monopoly restricts output and charges a higher price than would prevail under competition.
Monopoly Diagram: This graph illustrates the price and quantity of the market equilibrium under a monopoly.
Monopoly Production Decision
To maximize output, monopolies produce the quantity at which marginal supply is equal to marginal cost.
learning objectives
• Explain how to identify the monopolist’s production point
Monopoly Production
A pure monopoly has the same economic goal of perfectly competitive companies – to maximize profit. If we assume increasing marginal costs and exogenous input prices, the optimal decision for all firms is to equate the marginal cost and marginal revenue of production. Nonetheless, a pure monopoly can – unlike a firm in a competitive market – alter the market price for its own convenience: a decrease of production results in a higher price. Because of this, rather than finding the point where the marginal cost curve intersects a horizontal marginal revenue curve (which is equivalent to good’s price), we must find the point where the marginal cost curve intersect a downward-sloping marginal revenue curve.
Monopoly Production Point
Like non-monopolies, monopolists will produce the at the quantity such that marginal revenue (MR) equals marginal cost (MC). However, monopolists have the ability to change the market price based on the amount they produce since they are the only source of products in the market. When a monopolist produces the quantity determined by the intersection of MR and MC, it can charge the price determined by the market demand curve at the quantity. Therefore, monopolists produce less but charge more than a firm in a competitive market.
Monopoly Production: Monopolies produce at the point where marginal revenue equals marginal costs, but charge the price expressed on the market demand curve for that quantity of production.
In short, three steps can determine a monopoly firm’s profit-maximizing price and output:
1. Calculate and graph the firm’s marginal revenue, marginal cost, and demand curves
2. Identify the point at which the marginal revenue and marginal cost curves intersect and determine the level of output at that point
3. Use the demand curve to find the price that can be charged at that level of output
Monopoly Price and Profit
Monopolies can influence a good’s price by changing output levels, which allows them to make an economic profit.
learning objectives
• Analyze the final price and resulting profit for a monopolist
Monopolies, unlike perfectly competitive firms, are able to influence the price of a good and are able to make a positive economic profit. While a perfectly competitive firm faces a single market price, represented by a horizontal demand/marginal revenue curve, a monopoly has the market all to itself and faces the downward-sloping market demand curve. An important consequence is worth noticing: typically a monopoly selects a higher price and lesser quantity of output than a price-taking company; again, less is available at a higher price.
Imagine that the market demand for widgets is \(Q=30-2P\). This says that when the price is one, the market will demand 28 widgets; when the price is two, the market will demand 26 widgets; and so on. The monopoly’s total revenue is equal to the price of the widget multiplied by the quantity sold: \(P(30-2P)\). This can also be rearranged so that it is written in terms of quantity: total revenue equals \(Q(30-Q)/2\).
The firm can produce widgets at a total cost of \(2Q^2\), that is, it can produce one widget for \$2, two widgets for \$8, three widgets for \$18, and so on. We know that all firms maximize profit by setting marginal costs equal to marginal revenue. Finding this point requires taking the derivative of total revenue and total cost in terms of quantity and setting the two derivatives equal to each other. In this case:
\[\dfrac{dTR}{dQ}=\dfrac{(30−2Q)}{2}\]
\[\dfrac{dTC}{dQ}=4Q\]
Setting these equal to each other: \(15−Q=4Q\)
So the profit maximizing point occurs when \(Q=3\).
At this point, the price of widgets is \$13.50, the monopoly’s total revenue is \$40.50, the total cost is \$18, and profit is \$22.50. For comparison, it is easy to see that if the firm produced two widgets price would be \$14 and profit would be \$20; if it produced four widgets price would be \$13 and profit would again be \$20. Q=3 must be the profit-maximizing output for the monopoly.
Graphically, one can find a monopoly’s price, output, and profit by examining the demand, marginal cost, and marginal revenue curves. Again, the firm will always set output at a level at which marginal cost equals marginal revenue, so the quantity is found where these two curves intersect. Price, however, is determined by the demand for the good when that quantity is produced. Because a monopoly’s marginal revenue is always below the demand curve, the price will always be above the marginal cost at equilibrium, providing the firm with an economic profit.
Monopoly Pricing: Monopolies create prices that are higher, and output that is lower, than perfectly competitive firms. This causes economic inefficiency.
Key Points
• In a perfectly competitive market, there are many producers and consumers, no barriers to exit and entry into the market, perfectly homogenous goods, perfect information, and well-defined property rights.
• Perfectly competitive producers are price takers that can choose how much to produce, but not the price at which they can sell their output.
• A monopoly exists when there is only one producer and many consumers.
• Monopolies are characterized by a lack of economic competition to produce the good or service and a lack of viable substitute goods.
• Firm typically have marginal costs that are low at low levels of production but that increase at higher levels of production.
• While competitive firms experience marginal revenue that is equal to price – represented graphically by a horizontal line – monopolies have downward-sloping marginal revenue curves that are different than the good’s price.
• For monopolies, marginal revenue is always less than price.
• The first-order condition for maximizing profits in a monopoly is 0=∂q=p(q)+qp′(q)−c′(q), where q = the profit-maximizing quantity.
• A monopoly’s profits are represented by π=p(q)q−c(q), where revenue = pq and cost = c.
• Monopolies have the ability to limit output, thus charging a higher price than would be possible in competitive markets.
• Unlike a competitive company, a monopoly can decrease production in order to charge a higher price.
• Because of this, rather than finding the point where the marginal cost curve intersects a horizontal marginal revenue curve (which is equivalent to good’s price), we must find the point where the marginal cost curve intersect a downward-sloping marginal revenue curve.
• Monopolies have downward sloping demand curves and downward sloping marginal revenue curves that have the same y-intercept as demand but which are twice as steep.
• The shape of the curves shows that marginal revenue will always be below demand.
• Typically a monopoly selects a higher price and lesser quantity of output than a price-taking company.
• A monopoly, unlike a perfectly competitive firm, has the market all to itself and faces the downward-sloping market demand curve.
• Graphically, one can find a monopoly’s price, output, and profit by examining the demand, marginal cost, and marginal revenue curves.
Key Terms
• perfect competition: A type of market with many consumers and producers, all of whom are price takers
• network externality: The effect that one user of a good or service has on the value of that product to other people
• perfect information: The assumption that all consumers know all things, about all products, at all times, and therefore always make the best decision regarding purchase.
• marginal revenue: The additional profit that will be generated by increasing product sales by one unit.
• marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
• first-order condition: A mathematical relationship that is necessary for a quantity to be maximized or minimized.
• deadweight loss: A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.
• economic profit: The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm.
• demand: The desire to purchase goods and services.
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Reasons for Efficiency Loss
A monopoly generates less surplus and is less efficient than a competitive market, and therefore results in deadweight loss.
learning objectives
• Evaluate the economic inefficiency created by monopolies
Monopoly
A monopoly exists when a specific enterprise is the only supplier of a particular commodity. Monopolies have little to no competition when producing a good or service. A monopoly is a business entity that has significant market power (the power to charge high prices).
Inefficiency in a Monopoly
In a monopoly, the firm will set a specific price for a good that is available to all consumers. The quantity of the good will be less and the price will be higher (this is what makes the good a commodity). The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. The deadweight loss is the potential gains that did not go to the producer or the consumer. As a result of the deadweight loss, the combined surplus (wealth) of the monopoly and the consumers is less than that obtained by consumers in a competitive market. A monopoly is less efficient in total gains from trade than a competitive market.
Monopolies can become inefficient and less innovative over time because they do not have to compete with other producers in a marketplace. For private monopolies, complacency can create room for potential competitors to overcome entry barriers and enter the market. Also, long term substitutes in other markets can take control when a monopoly becomes inefficient.
Market Failure
When a market fails to allocate its resources efficiently, market failure occurs. In the case of monopolies, abuse of power can lead to market failure. Market failure occurs when the price mechanism fails to take into account all of the costs and/or benefits of providing and consuming a good. As a result, the market fails to supply the socially optimal amount of the good. A monopoly is an imperfect market that restricts output in an attempt to maximize profit. Market failure in a monopoly can occur because not enough of the good is made available and/or the price of the good is too high. Without the presence of market competitors it can be challenging for a monopoly to self-regulate and remain competitive over time.
Imperfect competition: This graph shows the short run equilibrium for a monopoly. The gray box illustrates the abnormal profit, although the firm could easily be losing money. A monopoly is an imperfect market that restricts the output in an attempt to maximize its profits.
Understanding and Finding the Deadweight Loss
In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal.
learning objectives
• Define deadweight loss, Explain how to determine the deadweight loss in a given market.
Deadweight Loss
In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal. When a good or service is not Pareto optimal, the economic efficiency is not at equilibrium. As a result, when resources are allocated, it is impossible to make any one individual better off without making at least one person worse off. When deadweight loss occurs, there is a loss in economic surplus within the market. Deadweight loss implies that the market is unable to naturally clear.
Causes of Deadweight Loss
Deadweight loss is the result of a market that is unable to naturally clear, and is an indication, therefore, of market inefficiency. The supply and demand of a good or service are not at equilibrium. Causes of deadweight loss include:
• imperfect markets
• externalities
• taxes or subsides
• price ceilings
• price floors
Determining Deadweight Loss
In order to determine the deadweight loss in a market, the equation P=MC is used. The deadweight loss equals the change in price multiplied by the change in quantity demanded. This equation is used to determine the cause of inefficiency within a market.
For example, in a market for nails where the cost of each nail is \$0.10, the demand will decrease from a high demand for less expensive nails to zero demand for nails at \$1.10. In a perfectly competitive market, producers would charge \$0.10 per nail and every consumer whose marginal benefit exceeds the \$0.10 would have a nail. However, if one producer has a monopoly on nails they will charge whatever price will bring the largest profit. If they charge \$0.60 per nail, every party who has less than \$0.60 of marginal benefit will be excluded. When equilibrium is not achieved, parties who would have willingly entered the market are excluded due to the non-market price.
An example of deadweight loss due to taxation involves the price set on wine and beer. If a glass of wine is \$3 and a glass of beer is \$3, some consumers might prefer to drink wine. If the government decides to place a tax on wine at \$3 per glass, consumers might choose to drink the beer instead of the wine. At times, policy makers will place a binding constraint on items when they believe that the benefit from the transfer of surplus outweighs the adverse impact of deadweight loss.
Deadweight loss: This graph shows the deadweight loss that is the result of a binding price ceiling. Policy makers will place a binding price ceiling when they believe that the benefit from the transfer of surplus outweighs the adverse impact of the deadweight loss.
Key Points
• The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers.
• Monopolies can become inefficient and less innovative over time because they do not have to compete with other producers in a marketplace.
• In the case of monopolies, abuse of power can lead to market failure. Market failure occurs when the price mechanism fails to take into account all of the costs and/or benefits of providing and consuming a good.
• A monopoly is an imperfect market that restricts output in an attempt to maximize profit. Without the presence of market competitors it can be challenging for a monopoly to self-regulate and remain competitive over time.
• When deadweight loss occurs, there is a loss in economic surplus within the market.
• Causes of deadweight loss include imperfect markets, externalities, taxes or subsides, price ceilings, and price floors.
• In order to determine the deadweight loss in a market, the equation P=MC is used. The deadweight loss equals the change in price multiplied by the change in quantity demanded.
Key Terms
• monopoly: A market where one company is the sole supplier.
• market failure: A concept within economic theory describing when the allocation of goods and services by a free market is not efficient.
• inefficient: Incapable of, or indisposed to, effective action; habitually slack or remiss; effecting little or nothing; as, inefficient workers; an inefficient administrator.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• deadweight loss: A loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal.
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Elasticity Conditions for Price Discrimination
In a competitive market, price discrimination occurs when identical goods and services are sold at different prices by the same provider.
learning objectives
• Examine the use of price discrimination in competitive markets
Price Discrimination
In a competitive market, price discrimination occurs when identical goods and services are sold at different prices by the same provider. In pure price discrimination, the seller will charge the buyer the absolute maximum price that he is willing to pay. Companies use price discrimination in order to make the most revenue possible from every customer. This allows the producer to capture more of the total surplus by selling to consumers at prices closer to their maximum willingness to pay.
Price discrimination: A producer that can charge price Pa to its customers with inelastic demand and Pb to those with elastic demand can extract more total profit than if it had charged just one price.
An example of price discrimination would be the cost of movie tickets. Prices at one theater are different for children, adults, and seniors. The prices of each ticket can also vary based on the day and chosen show time. Ticket prices also vary depending on the portion of the country as well.
Industries use price discrimination as a way to increase revenue. It is possible for some industries to offer retailers different prices based solely on the volume of products purchased. Price discrimination can also be based on age, location, desire for the product, and customer wage.
Forms of Price Discrimination
There are a variety of ways in which industries legally use price discrimination. It is not important that pricing information be restricted, or that the price discriminated groups be unaware that others are being charged different prices:
• Coupons: coupons are used in retail as a way to distinguish customers by their reserve price. The assumption is that individuals who collect coupons are more sensitive to a higher price than those who don’t. By offering coupons, a producer can charge a higher price to price-insensitive customers and provide a discount to price-sensitive individuals.
• Premium pricing: premium products are priced at a level that is well beyond their marginal cost. For example, a regular cup of coffee might be priced at \$1, while a premium coffee is \$2.50.
• Discounts based on occupation: many businesses offer reduced prices to active military members. This can increase sales to the target group and provide positive publicity for the business which leads to increased sales. Less publicized discounts are also offered to off duty service workers such as police.
• Retail incentives: retail incentives are used to increase market share or revenues. They include rebates, bulk and quantity pricing, seasonal discounts
• Gender based discounts: gender based discounts are offered in some countries including the United States. Examples include free drinks at bars for women on “Ladies Night,” men often receive lower prices at the dry cleaners and hair salons than women because women clothes and hair generally take more time to work with. In contrast, men usually have higher car insurance rates than women based on the likelihood of being in an accident based on their age.
• Financial aid: financial aid is offered to college students based on either the student and/or the parents economic situation.
• Haggling: haggling is a form of price negotiation that requires knowledge and confidence from the customer.
Industries that Use Price Discrimination
The airline industry uses price discrimination regularly when they sell travel tickets simultaneously to different market segments. Price discrimination is evident within individual airlines, but also in the industry as a whole. Tickets vary based on the location within the plane, the time and day of the flight, the time of year, and what city the aircraft is traveling to. Prices can vary greatly within an airline and also among airlines. Customers must search for the best priced ticket based on their needs. Airlines do offer other forms of price discrimination including discounts, vouchers, and member perks for individuals with membership cards.
The pharmaceutical industry experiences international price discrimination. Drug manufacturers charge more for drugs in wealthier countries than in poor ones. For example, the United States has the highest drug prices in the world. On average, Europeans pay 56% less than Americans do for the same prescription medications. However, in many countries with lower drug costs, the difference in price is absorbed into the taxes which results in lower average salaries when compared to those in the United States.
Academic textbooks are another industry known for price discrimination. Textbooks in the United States are more expensive than they are overseas. Because most of the textbooks are published in the United States, it is obvious that transportation costs do not raise the price of the books. In the United States price discrimination on textbooks is due to copyright protection laws. Also, in the United States textbooks are mandatory where as in other countries they are viewed as optional study aids.
Analysis of Price Discrimination
Price discrimination is present in commerce when sellers adjust the price on the same product in order to make the most revenue possible.
learning objectives
• Analyze the use of price discrimination in commerce
Price Discrimination
Price discrimination exists within a market when the sales of identical goods or services are sold at different prices by the same provider. The goal of price discrimination is for the seller to make the most profit possible. Although the cost of producing the products is the same, the seller has the ability to increase the price based on location, consumer financial status, product demand, etc.
Sales Revenue: These graphs shows the difference in sales revenue with and without price discrimination. The intent of price discrimination is for the seller to make the most profit possible.
Price Discrimination Criteria
Within commerce there are specific criteria that must be met in order for price discrimination to occur:
• The firm must have market power.
• The firm must be able to recognize differences in demand.
• The firm must have the ability to prevent arbitration, or resale of the product.
Types of Price Discrimination
In commerce there are three types of price discrimination that exist. The exact price discrimination method that is used depends on the factors within the particular market.
• First degree price discrimination: the monopoly seller of a good or service must know the absolute maximum price that every consumer is willing to pay and can charge each customer that exact amount. This allows the seller to obtain the highest revenue possible.
• Second degree price discrimination: the price of a good or service varies according to the quantity demanded. Larger quantities are available at a lower price (higher discounts are given to consumers who buy a good in bulk quantities).
• Third degree price discrimination: the price varies according to consumer attributes such as age, sex, location, and economic status.
Examples of Price Discrimination
Price discrimination is a driving force in commerce. It is evident throughout markets and generates the highest revenue possible by shifting the price of a product based on the consumer’s willingness to pay, quantity demanded, and consumer attributes. Many examples of price discrimination are present throughout commerce including:
• Travel industry: airlines and other travel companies use price discrimination regularly in order to generate commerce. Prices vary according to seat selection, time of day, day of the week, time of year, and how close a purchase is made to the date of travel.
• Coupons: coupons are used in commerce to distinguish consumers by their reserve price. A manufacturer can charge a higher price for a product which most consumers will pay. Coupons attract sensitive consumers to the same product by offering a discount. By using price discrimination, the seller makes more revenue, even off of the price sensitive consumers.
• Premium pricing: uses price discrimination to price products higher than the marginal cost of production. Regular coffee is priced at \$1 while premium coffee is \$2.50. The marginal cost of production is only \$0.90 and \$1.25. The difference in price results in increased revenue because consumers are willing to pay more for the specific product.
• Gender based prices: uses price discrimination based on gender. For example, bars that have Ladies Nights are price discriminating based on gender.
• Retail incentives: uses price discrimination to offer special discounts to consumers in order to increase revenue. Incentives include rebates, bulk pricing, seasonal discounts, and frequent buyer discounts.
Examples of Price Discrimination
The purpose of price discrimination is to capture the market’s consumer surplus and generate the most revenue possible for a good.
learning objectives
• Give examples of price discrimination in common industries
Price Discrimination
Price discrimination occurs when identical goods or services are sold at different prices from the same provider. There are three types of price discrimination:
• First degree – the seller must know the absolute maximum price that every consumer is willing to pay.
• Second degree – the price of the good or service varies according to quantity demanded.
• Third degree – the price of the good or service varies by attributes such as location, age, sex, and economic status.
The purpose of price discrimination is to capture the market’s consumer surplus. Price discrimination allows the seller to generate the most revenue possible for a good or service.
Price discrimination: These graphs show multiple market price discrimination. Instead of supplying one price and taking the profit (labelled “(old profit)”), the total market is broken down into two sub-markets, and these are priced separately to maximize profit. The graph shows how a seller wants to generate the most revenue possible for a good or service. The elasticity of a market influences the profit.
Examples of Price Discrimination
There are industries that conduct a substantial portion of their business using price discrimination:
• Travel industry: airlines and other travel companies use differentiated pricing often. Travel products and services are marketed to specific social segments. Airlines usually assign specific capacity to various booking classes. Also, prices fluctuate based on time of travel (time of day, day of the week, time of year). Prices fluctuate between companies as well as within each company.
• Pharmaceutical industry: price discrimination is common in the pharmaceutical industry. Drug-makers charge more for drugs in wealthier countries. For example, drug prices in the United States are some of the highest in the world. Europeans, on average, pay only 56% of what Americans pay for the same prescription drugs.
• Textbooks (physical ones, not your Boundless one!): price discrimination is also prevalent within the publishing industry. Textbooks are much higher in the United States despite the fact that they are produced in the country. Copyright protection laws increase the price of textbooks. Also, textbooks are mandatory in the United States while schools in other countries see them as study aids.
Price discrimination is prevalent in varying degrees throughout most markets. Methods of price discrimination include:
• Coupons: coupons are used to distinguish consumers by their reserve price. Companies increase the price of a good and individuals who are not price sensitive will pay the higher price. Coupons allow price sensitive consumers to receive a discount. At the same time the seller is still making increased revenue.
• Age discounts: age discounts are a form of price discrimination where the price of a good or admission to an event is based on age. Age discounts are usually broken down by child, student, adult, and senior. In some cases, children under a certain age are given free admission or eat for free. Examples of places where age discounts are given include restaurants, movies, and other forms of entertainment.
• Occupational discounts: price discrimination is present when individuals receive certain discounts based on their occupation. An example is when active military members receive discounts.
• Retail incentives: this includes rebates, discount coupons, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.
• Gender based prices: in certain markets prices are set based on gender. For example, a Ladies Night at a bar is a form of price discrimination.
Key Points
• In pure price discrimination, the seller will charge the buyer the absolute maximum price that he is willing to pay. Companies use price discrimination in order to make the most revenue possible from every customer.
• Price discrimination is used throughout industries and includes coupons, premium pricing, discounts based on occupation, retail incentives, gender based discounts, financial aid, and haggling.
• Industries known for using price discrimination to maximize revenue include airlines, pharmaceutical manufacturers, and textbook publishers.
• Three factors that must be met for price discrimination to occur: the firm must have market power, the firm must be able to recognize differences in demand, and the firm must have the ability to prevent arbitration, or resale of the product.
• First degree price discrimination – the monopoly seller of a good or service must know the absolute maximum price that every consumer is willing to pay.
• Second degree price discrimination – the price of a good or service varies according to the quantity demanded.
• Third degree price discrimination – the price varies according to consumer attributes such as age, sex, location, and economic status.
• Price discrimination is present throughout commerce. Examples include airline and travel costs, coupons, premium pricing, gender based pricing, and retail incentives.
• Price discrimination occurs when identical goods or services are sold at different prices from the same provider.
• Industries that commonly use price discrimination include the travel industry, pharmaceutical industry, and textbook publishers.
• Examples of forms of price discrimination include coupons, age discounts, occupational discounts, retail incentives, gender based pricing, financial aid, and haggling.
Key Terms
• incentive: Something that motivates, rouses, or encourages.
• price discrimination: The practice of selling identical goods or services at different prices from the same provider.
• revenue: The total income received from a given source.
• surplus: That which remains when use or need is satisfied, or when a limit is reached; excess; overplus.
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Social Impacts of Monopoly
A monopoly can diminish consumer choice, reduce incentives to innovate, and control supply to enforce inequitable prices in a society.
learning objectives
• Outline the effect of a monopoly on producer, consumer, and total surplus
The Value of Competition
To understand why trends towards consolidation are so dangerous it is useful to frame why competition is of such critical value to equitable markets, particular from a consumer perspective. In a perfectly competitive market, the antithesis of a monopoly, demand is completely elastic and the production quantity and price point align perfectly with marginal costs and actual costs. This allows for revenues, costs, price, and quantity to achieve a balance where the consumer is provided with the optimal amount of a good at the most equitable price.
Perfect Competition Economics: This is a graphical illustration of economics within the context of a perfectly competitive market (theoretically). Note that the overall returns derived, costs incurred, quantity produced, and price point all align perfectly to generate an equitable market position. While this is an idealistic representation of markets, it is useful as a frame of reference to identify departures from ideal competitive circumstances.
However, perfect competition is more of a theoretical competitive framework because markets will naturally deviate to varying degrees (in order to capture profitable returns). As such, the perfect competition model is most useful in identifying and measuring deviations or departures from the competitive ideal. The farther an industry or market moves from a perfectly competitive model the more value is potentially migrating from the consumers to the suppliers. In order to ensure that suppliers do not take on too much power (such as the case of monopolies and oligopolies), government regulations and antitrust laws are a necessary component of the economic perspective.
Societal Risks of Monopolies
The accumulation of power and leverage on behalf of the suppliers largely revolves around the fact that monopolies can ultimately control supply in its entirety for a specified product or service. Through utilizing this control strategically, a profit-maximizing monopoly could create the following societal risks:
• Price Discrimination: This concept is often strongly emphasized as a potential economic risk of monopolies and the economic justification is easily illustrated. Picture a supply and demand chart, where supply and demand intersect to generate a fair price point and overall quantity provided. Now assume one company has the entire supply under it’s control, and can discriminate prices along the demand curve to capture higher prices than the available supply should allow. This allows monopolies to charge customers with a higher willingness to pay a higher price, while still charging consumers with a lower willingness to pay the standard prices. This is unfair to consumers, who will be forced to pay whatever is asked as a result of no alternative options.
• Reduced Efficiency: A less direct societal risk of monopolies is the fact that competition is closely linked to incentives. As a result, no competition will provide the monopoly very little reason to improve internal inefficiencies or cut costs. A competitive market will see constant strives to reduce costs in order to capture higher market share and provide goods at lower prices, while monopolies do not have this incentive.
• Reduced Innovation: A monopoly will also have limited motivation to innovate, as there is little value in differentiation in a thoroughly controlled market (for the only incumbent). As a result there is reduced improvements that could substantially improve the ability of the firm to fulfill the needs of the consumer.
• Deadweight Loss: A monopoly will choose to produce less and charge more than would occur in a perfectly competitive market. As a result, a monopoly causes deadweight loss, an inefficient economic outcome.
In summarizing these various societal drawbacks, monopolies pose the risk of reducing consumer choice and consumer power to incentivize companies to innovate and reduce costs, as there is limited prospective returns on investment. A monopoly with total control over the supply can charge any price that the consumer is willing to pay, and therefore can generate excessive margins while doing very little to improve their product/service or relevant processes.
Antitrust Laws
Antitrust laws ensure that competitive environments are preserved in order to maintain an efficient and equitable capitalistic system.
learning objectives
• Discuss antitrust laws aimed to improve competition and prevent monopolies from becoming more powerful
Antitrust laws perform the critical task of ensuring that competitive environments are preserved in order to maintain an efficient and equitable capitalistic system for firms to operate in. The concept of antitrust largely revolves around governmental restrictions that limit incumbents in any given industry from consolidating too much power.
The worst case scenario of consolidation results in a monopoly, which is when one company or organization becomes the sole supplier of a given product or service. In such a situation it is relatively easy for that provider to erect barriers to entry for new entrants and dictate price points through manipulating the supply. The adverse effects of these manipulations can be seen in, which underlines the economic threat monopolies pose the end consumer. Antitrust law is in place to ensure such circumstances do not arise, or when they do that they are regulated appropriate to minimize adverse societal effects.
Regulating Competition
The regulation of competitive markets has roots as far back as the Roman Empire, resulting in increasingly complex models as capitalism has evolved over time. Indeed, due to the increasingly international focus for many large corporations, antitrust laws and other competitive regulations must function not only at the country level but on a global level. Organizations such as the World Trade Organization (WTO) attempt to garner international support for the establishment of global standards in competitive markets in conjunction with the internal competitive laws which govern each nation individually. While these antitrust laws differ from nation to nation, they can loosely be summarized in three components:
• Actively ensuring that no agreements in place are counter to a competitive market. This revolves largely around avoiding cartels, or collaboration between the big players which would allow for market manipulation.
• Regulating against strategic actions that may result in diminishing the competitive elements of a market. This is usually targeted at dominate players in an industry, who may have a tendency to price gauge or other manipulations.
• Overseeing mergers, acquisitions, joint ventures and other strategic alliances to avoid consolidation that may be damaging to free markets.
Relevant Statutes
European Union (EU) – In the EU, competition law began in 1951 with the European Coal and Steel Community (ECSC), which included France, Italy, Belgium and the Netherlands. The purpose of this was to reduce the ability for one country/region to gain a monopoly on critical natural resources. Shortly after, in 1957, the European Economic Community (ECC) was established as a part of the Treaty of Rome. This document enacted provisions to eliminate anti-competitive agreements. This was more recently updated via the Treaty of Lisbon, which further addresses mergers and acquisitions and bans price fixing and collusion.
United States (U.S.) – In the U.S., antitrust policy finds its roots in 1890 with the Sherman Antitrust Act. While the basic premise was the same as modern day competitive law, it was fairly rudimentary in scale and scope. The Sherman Act dealt with avoiding or limiting the power of trusts, or essentially the creation of price-controlling cartels. This act was expanded upon in 1914, with two more competitive laws: The Clayton Antitrust Act and the Federal Trade Commission Act. Both of these acts sought to organize a governmental body equipped to protect consumers from unfair competitive practices.
Regulation of Natural Monopoly
Natural monopolies are conducive to industries where the largest supplier derives cost advantages and must be regulated to minimize risks.
learning objectives
• Discuss the reasons for government regulation of monopolies
A monopoly is a business or organization that maintains exclusivity of the supply of a particular product or service, and can evolve naturally or be designed specifically based on the nature of a particular market or industry. Monopolies on the whole are governed under antitrust laws, both on a national level in most countries and on an international level via institutions such as the World Trade Organization (WTO).
The evolution of a monopoly is a critical component in recognizing which industries are at high risk of monopolization, and how these risks may be realized operationally. A natural monopoly is defined by an incumbent in an industry where the largest supplier can theoretically create the lowest production prices, generally through economies of scale or economies of scope. In this type of circumstance, the industry naturally lends itself to providing advantages for the single largest provider at the cost of allowing for competitive forces. Natural monopolistic conditions are therefore at high risk of creating actual monopolies, and society benefits from regulating these situations to even the playing field.
Price Advantage for Natural Monopolies: While monopolies are generally poor economic constructs for creating value, natural monopolies are predicated on the fact that a single supplier can achieve the greatest economies of scale (cost advantages). This graph demonstrates this concept.
Regulating Natural Monopolies
The consolidation of an industry into one sole supplier can represent a substantial threat to free markets and their consumers, as price can be easily manipulated through a thorough control of the supply. As a result, monopolies are generally viewed as illegal entities. Regulating industries to minimize monopolization and maintain competitive equality can be pursued in a number of ways:
• Average cost pricing: As the name implies, this regulatory approach is defined as enforcing a price point for a given product or service that matches the overall costs incurred by the company producing or providing. This reduces the pricing flexibility of a company and ensures that the monopoly cannot capture margins above and beyond what is reasonable.
• Price ceiling: Another way a natural monopoly may be regulated is through the enforcement of a maximum potential price being charged. A price ceiling is a regulatory strategy of stating a specific product or service cannot be sold for above a certain price.
• Rate of return regulations: This is quite similar to average cost pricing, but deviates via allowing a model that can create consistent returns for the company involved. The percentage net profit brought in a by company must be below a government specified percentage to insure compliance with this regulatory approach (i.e. 5%).
• Tax or subsidy:The last way a governmental body can alleviate a natural monopoly is through higher taxes on larger players or subsidies for smaller players. In short, the government can provide financial support via subsidies to new entrants to ensure the competitive environment is more equitable.
As with most regulatory approaches, none of these are perfect solutions and consolidation within industries conducive to a natural monopoly will continue to arise. Antitrust laws and the careful control of mergers, acquisitions, joint ventures, and other strategic alliances are critical in the regulation of natural monopolies. In extreme circumstances it is also a viable option for governments to break up monopolies through the legal processes.
When A Monopoly Works
While the concept of a monopoly is generally perceived as a threat to free markets, there are specific circumstances where natural monopolies are either pragmatically useful (cost effective) or virtually unavoidable. In these circumstances the regulatory approaches above (price ceilings, average cost pricing, etc.) are even more critical to ensuring consumers are protected. AT&T is a classic example of a government-backed monopoly in the middle of the 20th century, as the fixed investment of land lines for phones at that time was substantial. It was not practical to foster competition as a result, and the government recognized the necessity for a monopoly (until 1984, when AT&T was divested).
Key Points
• In a perfectly competitive market, the antithesis of a monopoly, demand is completely elastic and the production quantity and price point align perfectly with marginal costs and actual costs.
• Perfect competition is a theoretical competitive framework. However, markets will naturally deviate to varying degrees (in order to capture profitable returns). As such, the perfect competition model is most useful in identifying and measuring deviations or departures from the competitive ideal.
• The accumulation of power and leverage on behalf of the suppliers largely revolves around the fact that monopolies can ultimately control supply in its entirety for a specified product or service.
• A monopoly with total control over the supply can charge any price that the consumer is willing to pay, and therefore can generate excessive margins while doing very little to improve their product/service or relevant processes.
• The concept of antitrust largely revolves around governmental restrictions that limit incumbents in any given industry from consolidating too much power.
• Organizations such as the World Trade Organization (WTO) attempt to garner international support for the establishment of global standards in competitive markets in conjunction with the internal competitive laws which govern each nation individually.
• In the U.S., antitrust policy finds its roots in 1890 with the Sherman Antitrust Act, and saw substantial expansion in 1914 via the Clayton Antitrust Act and the Federal Trade Commission Act.
• As capitalistic markets evolve they show some tendency towards consolidation, and this consolidation puts consumers at risk of hugely powerful corporate suppliers. Antitrust policy is designed to intervene on behalf of the consumer.
• As capitalistic markets evolve they show some tendency towards consolidation, and this consolidation puts consumers at risk of hugely powerful corporate suppliers. Antitrust policy is designed to intervene on behalf of the consumer.
• A natural monopoly is defined by an incumbent in an industry where the largest supplier can theoretically create the lowest production prices, generally through economies of scale or economies of scope.
• Natural monopolistic conditions are therefore at high risk of creating actual monopolies, and society benefits from regulating these situations to even the playing field.
• Regulating industries to minimize monopolization and maintain competitive equality can be pursued through average cost pricing, price ceilings, rate of return regulations, taxes and subsidies.
• While the concept of a monopoly is generally perceived as a threat to free markets, there are specific circumstances where natural monopolies are either pragmatically useful (cost effective) or virtually unavoidable.
Key Terms
• price discrimination: The practice of selling identical goods or services at different prices from the same provider.
• Antitrust: A law opposed to or against the establishment or existence of trusts (monopolies), usually referring to legislation.
• monopoly: A situation, by legal privilege or other agreement, in which solely one party (company, cartel etc. ) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.
• consolidation: The combination of multiple businesses.
• economies of scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long run average cost of each unit.
• subsidy: Government assistance to a business or economic sector.
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Defining Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another.
learning objectives
• Evaluate the characteristics and outcomes of markets with imperfect competition
Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.
Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities.
Clothing: The clothing industry is monopolistically competitive because firms have differentiated products and market power.
Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market. The demand is inelastic and the market is inefficient.
Monopolistic competitive markets:
• have products that are highly differentiated, meaning that there is a perception that the goods are different for reasons other than price;
• have many firms providing the good or service;
• firms can freely enter and exits in the long-run;
• firms can make decisions independently;
• there is some degree of market power, meaning producers have some control over price; and
• buyers and sellers have imperfect information.
Sources of Market Inefficiency
Markets that have monopolistic competition are inefficient for two reasons. The first source of inefficiency is due to the fact that at its optimum output, the firm charges a price that exceeds marginal costs. The monopolistic competitive firm maximizes profits where marginal revenue equals marginal cost. A monopolistic competitive firm’s demand curve is downward sloping, which means it will charge a price that exceeds marginal costs. The market power possessed by a monopolistic competitive firm means that at its profit maximizing level of production there will be a net loss of consumer and producer surplus.
The second source of inefficiency is the fact that these firms operate with excess capacity. The firm’s profit maximizing output is less than the output associated with minimum average cost. All firms, regardless of the type of market it operates in, will produce to a point where demand or price equals average cost. In a perfectly competitive market, this occurs where the perfectly elastic demand curve equals minimum average cost. In a monopolistic competitive market, the demand curve is downward sloping. In the long run, this leads to excess capacity.
Product Differentiation
Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.
learning objectives
• Define product differentiation
One of the defining traits of a monopolistically competitive market is that there is a significant amount of non- price competition. This means that product differentiation is key for any monopolistically competitive firm. Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.
Kool-Aid: Kool-Aid is an individual brand that competes with Kraft’s other brand (Tang).
Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences; differentiation is not the process of creating the differences between the products. Product differentiation is done in order to demonstrate the unique aspects of a firm’s product and to create a sense of value.
In economics, successful product differentiation is inconsistent with the conditions of perfect competition, which require products of competing firms to be perfect substitutes.
Consumers do not need to know everything about the product for differentiation to work. So long as the consumers perceive that there is a difference in the products, they do not need to know how or why one product might be of higher quality than another. For example, a generic brand of cereal might be exactly the same as a brand name in terms of quality. However, consumers might be willing to pay more for the brand name despite the fact that they cannot identify why the more expensive cereal is of higher “quality.”
There are three types of product differentiation:
• Simple: the products are differentiated based on a variety of characteristics;
• Horizontal: the products are differentiated based on a single characteristic, but consumers are not clear on which product is of higher quality; and
• Vertical: the products are differentiated based on a single characteristic and consumers are clear on which product is of higher quality.
Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it. The major sources of product differentiation are as follows:
• Differences in quality, which are usually accompanied by differences in price;
• Differences in functional features or design;
• Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing;
• Sales promotion activities of sellers, particularly advertising; and
• Differences in availability (e.g. timing and location).
The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition. A successful product differentiation strategy will move the product from competing on price to competing on non-price factors.
Demand Curve
The demand curve in a monopolistic competitive market slopes downward, which has several important implications for firms in this market.
learning objectives
• Explain how the shape of the demand curve affects the firms that exist in a market with monopolistic competition
The demand curve of a monopolistic competitive market slopes downward. This means that as price decreases, the quantity demanded for that good increases. While this appears to be relatively straightforward, the shape of the demand curve has several important implications for firms in a monopolistic competitive market.
Monopolistic Competition: As you can see from this chart, the demand curve (marked in red) slopes downward, signifying elastic demand.
Market Power
The demand curve for an individual firm is downward sloping in monopolistic competition, in contrast to perfect competition where the firm’s individual demand curve is perfectly elastic. This is due to the fact that firms have market power: they can raise prices without losing all of their customers. In this type of market, these firms have a limited ability to dictate the price of its products; a firm is a price setter not a price taker (at least to some degree). The source of the market power is that there are comparatively fewer competitors than in a competitive market, so businesses focus on product differentiation, or differences unrelated to price. By differentiating its products, firms in a monopolistically competitive market ensure that its products are imperfect substitutes for each other. As a result, a business that works on its branding can increase its prices without risking its consumer base.
Inefficiency in the Market
Monopolistically competitive firms maximize their profit when they produce at a level where its marginal costs equals its marginal revenues. Because the individual firm’s demand curve is downward sloping, reflecting market power, the price these firms will charge will exceed their marginal costs. Due to how products are priced in this market, consumer surplus decreases below the pareto optimal levels you would find in a perfectly competitive market, at least in the short run. As a result, the market will suffer deadweight loss. The suppliers in this market will also have excess production capacity.
Short Run Outcome of Monopolistic Competition
Monopolistic competitive markets can lead to significant profits in the short-run, but are inefficient.
learning objectives
• Examine the concept of the short run and how it applies to firms in a monopolistic competition
In terms of production and supply, the “short run” is the time period when one factor of production is fixed in terms of costs while the other elements of production are variable. The most common example of this is the production of a good that requires a factory. If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows. This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory. You could sell the factory, but again that would take a significant amount of time. The “short run” is defined by how long it would take to alter that “fixed” aspect of production.
In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.
Setting a Price and Determining Profit
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good.
Short Run Equilibrium Under Monopolistic Competition: As you can see from the chart, the firm will produce the quantity (Qs) where the marginal cost (MC) curve intersects with the marginal revenue (MR) curve. The price is set based on where the Qs falls on the average revenue (AR) curve. The profit the firm makes in the short term is represented by the grey rectangle, or the quantity produced multiplied by the difference between the price and the average cost of producing the good.
Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer’s point of view, is desirable because it allows them to earn a profit and increase their producer surplus.
Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.
Long Run Outcome of Monopolistic Competition
In the long run, firms in monopolistic competitive markets are highly inefficient and can only break even.
learning objectives
• Explain the concept of the long run and how it applies to a firms in monopolistic competition
In terms of production and supply, the “long-run” is the time period when there is no factor that is fixed and all aspects of production are variable and can therefore be adjusted to meet shifts in demand. Given a long enough time period, a firm can take the following actions in response to shifts in demand:
• Enter an industry;
• Exit an industry;
• Increase its capacity to produce more; and
• Decrease its capacity to produce less.
In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.
Setting a Price and Determining Profit
Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.
While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run. Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit.
Long Run Equilibrium of Monopolistic Competition: In the long run, a firm in a monopolistic competitive market will product the amount of goods where the long run marginal cost (LRMC) curve intersects marginal revenue (MR). The price will be set where the quantity produced falls on the average revenue (AR) curve. The result is that in the long-term the firm will break even.
Monopolistic Competition Compared to Perfect Competition
The key difference between perfectly competitive markets and monopolistically competitive ones is efficiency.
learning objectives
• Differentiate between monopolistic competition and perfect competition
Perfect competition and monopolistic competition are two types of economic markets.
Similarities
One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases. The two only differ in degree. Firm’s individual demand curves in perfectly competitive markets are perfectly elastic, which means that an incremental increase in price will cause demand for a product to vanish ). Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers.
Demand curve in a perfectly competitive market: This is the demand curve in a perfectly competitive market. Note how any increase in price would wipe out demand.
Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services.
Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.
Differences
One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient. This means that the price is Pareto optimal, which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus, which is the sum of the producer and consumer surpluses, is maximized. The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service.
In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power. This decreases the consumer surplus, and by extension the market’s economic surplus, and creates deadweight loss.
Another key difference between the two is product differentiation. In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated. In fact, firms work hard to emphasize the non-price related differences between their products and their competitors’.
A final difference involves barriers to entry and exit. Perfectly competitive markets have no barriers to entry and exit; a firm can freely enter or leave an industry based on its perception of the market’s profitability. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market.
Efficiency of Monopolistic Competition
Monopolistic competitive markets are never efficient in any economic sense of the term.
learning objectives
• Discuss the effect monopolistic competition has on overall market efficiency
Monopolistically competitive markets are less efficient than perfectly competitive markets.
Producer and Consumer Surplus
In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms. Both types of firms’ profit maximizing production levels occur when their marginal revenues equals their marginal costs. This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity.
Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.This price exceeds the firm’s marginal costs and is higher than what the firm would charge if the market was perfectly competitive. This means two things:
• Consumers will have to pay a higher price than they would in a perfectly competitive market, leading to a significant decline in consumer surplus; and
• Producers will sell less of their goods than they would have in a perfectly competitive market, which could offset their gains from charging a higher price and could result in a decline in producer surplus.
Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus.
Inefficiency in Monopolistic Competition: Monopolistic competition creates deadweight loss and inefficiency, as represented by the yellow triangle. The quantity is produced when marginal revenue equals marginal cost, or where the green and blue lines intersect. The price is determined based on where the quantity falls on the demand curve, or the red line. In the short run, the monopolistic competition market acts like a monopoly.
Productive and Allocative Efficiency
Productive efficiency occurs when a market is using all of its resources efficiently. This occurs when a product’s price is set at its marginal cost, which also equals the product’s average total cost. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient.
Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. This occurs when a product’s price equals its marginal benefits, which is also equal to the product’s marginal costs. Again, since a good’s price in a monopolistic competitive market always exceeds its marginal cost, the market can never be allocatively efficient.
Advertising and Brand Management in Monopolistic Competition
Advertising and branding help firms in monopolistic competitive markets differentiate their products from those of their competitors.
learning objectives
• Evaluate whether advertising is beneficial or detrimental to consumers
One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Advertising is generally used by businesses to cultivate a brand. A brand is a company’s reputation in relation to products or services sold under a specific name or logo.
Listerine advertisement, 1932: From 1921 until the mid-1970s, Listerine was also marketed as preventive and a remedy for colds and sore throats. In 1976, the Federal Trade Commission ruled that these claims were misleading, and that Listerine had “no efficacy” at either preventing or alleviating the symptoms of sore throats and colds. Warner-Lambert was ordered to stop making the claims and to include in the next \$10.2 million dollars of Listerine ads specific mention that “contrary to prior advertising, Listerine will not help prevent colds or sore throats or lessen their severity. “
Benefits of Advertising and Branding
The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. A brand and the associated reputation are built on advertising and consumers’ past experiences with the products associated with that brand.
Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality. This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.
Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Advertising and brands can help minimize the costs of choosing between different products because of consumers’ familiarity with the firms and their quality.
Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.
Costs of Advertising and Branding
There are some concerns about how advertising can harm consumers and society as well. Some believe that advertising and branding induces customers to spend more on products because of the name associated with them rather than because of rational factors. Further, there is no guarantee that advertisements accurately describe products; they can mislead consumers. Finally, advertising can have negative societal effects such as the perpetuation of negative stereotypes or the nuisance of “spam. ”
Key Points
• Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market.
• Markets that have monopolistic competition are inefficient for two reasons. First, at its optimum output the firm charges a price that exceeds marginal costs. The second source of inefficiency is the fact that these firms operate with excess capacity.
• Monopolistic competitive markets have highly differentiated products; have many firms providing the good or service; firms can freely enter and exits in the long-run; firms can make decisions independently; there is some degree of market power; and buyers and sellers have imperfect information.
• Differentiation occurs because buyers perceive a difference between products. Causes of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.
• Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.
• There are three types of product differentiation: simple, horizontal, and vertical.
• The “short run” is the time period when one factor of production is fixed in terms of costs, while the other elements of production are variable.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run.
• Also like a monopoly, a monopolastic competitive firm will maximize its profits when its marginal revenues equals its marginal costs.
• In terms of production and supply, the ” long-run ” is the time period when all aspects of production are variable and can therefore be adjusted to meet shifts in demand.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run.
• Like a monopoly, a monopolastic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs.
• In the long-run, the demand curve of a firm in a monopolistic competitive market will shift so that it is tangent to the firm’s average total cost curve. As a result, this will make it impossible for the firm to make economic profit; it will only be able to break even.
• Perfectly competitive markets have no barriers of entry or exit. Monopolistically competitive markets have a few barriers of entry and exit.
• The two markets are similar in terms of elasticity of demand, a firm ‘s ability to make profits in the long-run, and how to determine a firm’s profit maximizing quantity condition.
• In a perfectly competitive market, all goods are substitutes. In a monopolistically competitive market, there is a high degree of product differentiation.
• Because a good is always priced higher than its marginal cost, a monopolistically competitive market can never achieve productive or allocative efficiency.
• Suppliers in monopolistically competitive firms will produce below their capacity.
• Because monopolistic firms set prices higher than marginal costs, consumer surplus is significantly less than it would be in a perfectly competitive market. This leads to deadweight loss and an overall decrease in economic surplus.
• A company’s brand can help promote quality in that company’s products.
• Advertising helps inform consumers about products, which decreases selection costs.
• Costs associated with advertising and branding include higher prices, customers mislead by false advertisements, and negative societal affects such as perpetuating stereotypes and spam.
Key Terms
• monopoly: A market where one company is the sole supplier.
• Monopolistic competition: A type of imperfect competition such that one or two producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location).
• product differentiation: Perceived differences between the product of one firm and that of its rivals so that some customers value it more.
• short-run: The conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount.
• long-run: The conceptual time period in which there are no fixed factors of production.
• perfect competition: A type of market with many consumers and producers, all of whom are price takers
• consumer surplus: The difference between the maximum price a consumer is willing to pay and the actual price they do pay.
• producer surplus: The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.
• brand: The reputation of an organization, a product, or a person among some segment of the population.
• advertising: Communication with the purpose of influencing potential customers about products and services
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Few Sellers
An oligopoly – a market dominated by a few sellers – is often able to maintain market power through increasing returns to scale.
learning objectives
• Explain how increasing returns to scale will cause a higher prevalence of oligopolies
Oligopoly Structure
In an oligopoly market structure, a few large firms dominate the market, and each firm recognizes that every time it takes an action it will provoke a response among the other firms. These actions, in turn, will affect the original firm. Each firm, therefore, recognizes that it is interdependent with the other firms in the industry. This interdependence is unique to the oligopoly market structure; in perfect and monopolistic competition, we assume that each firm is small enough that the rest of the market will ignore its actions.
Increasing Returns to Scale
The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market. One source of this power is increasing returns to scale. Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output. Increasing returns to scale implies that larger firms will face lower average costs than smaller firms because they are able to take advantage of added efficiency at higher levels of production.
Types of Returns to Scale
Most industries exhibit different types of returns to scale in different ranges of output. Typically in competitive markets, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges. Monopolies and oligopolies, however, often form when an industry has increasing returns to scale at relatively high output levels. When a few large firms already exist in this type of market, any new competitor will be smaller and therefore have higher average costs of production. This will make it difficult to compete with the already-established firms. Therefore, the oligopoly firms have a built-in defense against new competition.
Take the example of the cell phone industry in the United States. As of the fourth quarter of 2008, Verizon, AT&T, Sprint, and T-Mobile together controlled 89% of the U.S. cell phone market. The cell phone industry has increasing returns to scale: the cost of providing cellular access to 100,000 people is more than half the cost of providing cellular access to 200,000 people. Any new entrant into the cell phone market will either need to pay one of the larger companies for access to its already-existing network, or try to build a network from scratch. Both options result in higher costs, higher prices, and difficulty in competing with the major networks.
Cell Phone Tower: Cell phone companies have increasing returns to scale, which leads to a market dominated by only a few firms.
Product Differentiation
Oligopolies can form when product differentiation causes decreased competition within an industry.
learning objectives
• Explain the relationship between product differentiation and the existence of an oligopoly
Product differentiation (or simply differentiation) is the process of distinguishing a product or service from others, to make it more attractive to a particular target market. This involves differentiating it from competitors’ products as well as a firm’s own products. In economics, successful product differentiation is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes.
Differentiation is due to buyers perceiving a difference; hence, causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The major sources of product differentiation are as follows:
• Differences in quality which are usually accompanied by differences in price
• Differences in functional features or design
• Ignorance on the part of buyers regarding the essential characteristics and qualities of goods they are purchasing
• Sales promotion activities of sellers and, in particular, advertising
• Differences in availability (e.g. timing and location).
The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition: As the product becomes more differentiated, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move a product from competing based primarily on price to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).
Product Differentiation and Oligopolies
While some oligopoly industries make standardized products – tools, copper, and steep pipes, for example – others make differentiated products: cars, cigarettes, soda, and cell phone manufacturers. Product differentiation is not necessary for the existence of an oligopoly, but if a firm can successfully engage in product differentiation it can more easily gain market power and dominate at least part of the industry.
For example, the soft drink industry in the US is an oligopoly dominated by the Coca-Cola Company, the Dr. Pepper Snapple Group, and PepsiCo. These companies are able to differentiate their products (e.g. by taste), and are therefore able to gain market power.
Advertising for Product Differentiation: Some companies are able to use marketing to achieve product differentiation, encouraging the formation of oligopolies.
Entry Barriers
One important source of oligopoly power are barriers to entry: obstacles that make it difficult to enter a given market.
learning objectives
• Explain the necessity of entry barriers for the existence of an oligopoly
One important source of oligopoly power is barriers to entry. Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry—such as government regulation and patents, or a large, established firm taking advantage of economies of scale—or those an individual faces in trying to gain entrance to a profession—such as education or licensing requirements. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.
The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants. For example, microprocessing companies face high research and development costs before possibly making a profit. This means that new firms cannot enter the market whenever existing firms are making a positive economic profit, as is the case in perfect competition. Pharmaceutical manufacturers are one type of company that generally rely on patents, which makes competition irrelevant for a period of time after development: competitors can’t legally begin manufacturing the product until the patent expires.
Additional sources of barriers to entry often result from government regulation favoring existing firms. For example, requirements for licenses and permits may raise the investment needed to enter a market, creating an effective barrier to entry.
In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. For example, there are now only a small number of manufacturers of civil passenger aircraft. Oligopolies have also formed in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate.
Oligopoly in Aircraft Manufacturing: Manufacturing commercial airplanes takes a very large initial investment in technology, equipment, and licensing. Consequently, the industry is dominated by two firms.
Price Leadership
Price leadership is a form of tacit collusion that oligopolies may use to achieve a monopoly-like market outcome.
learning objectives
• Define price leadership within the context of an oligopoly
Oligopoly
Oligopolies are defined by one firm’s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected. Unlike perfect competition and monopoly, uncertainty about how rival firms interact makes the specification of a single model of oligopoly impossible. Economists often simplify firm behavior into two strategies: firm can compete, in which case the market outcome will resemble that in perfect competition; or they can collude, in which case the market outcome will more closely resemble monopoly. When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.
Price Leadership
Firms can collude explicitly, as in the case of cartels, but this type of behavior is illegal in many parts of the world. An alternative to overt collusion is tacit collusion, in which firms have an unspoken understanding that limits their competition. One way in which firms achieve this is price leadership, in which one firm serves as an industry leader and sets prices, while other firms raise and lower their prices to match. For example, the steel, cars, and breakfast cereals industries have all been accused of engaging in tacit collusion..
Tacit collusion can be difficult to identify. The fact that a price change by one firm is follwed by similar price changes among other firms doesn’t necessarily mean that tacit collusion exists. After all, in a perfectly competitive industry, economists expect prices to move together because all firms face similar changes in demand and the cost of inputs.
For example, imagine that a town has three gas stations. Without any way to communicate, all three will lower their prices in an attempt to capture the entire market, stopping only when marginal cost equals marginal revenue. If the firms could cooperate, however, they would be better off if all set the price of gas at \$0.20 above marginal cost. Each would have slightly lower sales but would have much higher revenue. Although explicit communication about prices is illegal, the firms might tacitly agree that whenever one station raises its prices, the other two will follow suit. In this way, all three can receive the benefits of oligopoly. The gas station that first raises its prices, and that the other two follow, is called the price leader.
Price Leadership and Gas Prices: Although companies cannot legally communicate to set prices, some accuse certain industries of using price leadership to accomplish the same goal.
Key Points
• The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market.
• Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output.
• Monopolies and oligopolies often form when an industry has increasing returns to scale at relatively high output levels.
• Product differentiation is the process of distinguishing a product or service from others, to make it more attractive to a particular target market.
• The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition.
• Many oligopolies make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal, and soft drinks.
• Although product differentiation is not required for an oligopoly to form, if a firm can successfully differentiate its products it will gain market power and resist competition more easily.
• Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.
• The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants.
• In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization.
• Oligopolies are defined by one firm ‘s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected.
• When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.
• An alternative to overt collusion is tacit collusion, an unwritten, unspoken understanding through which firms agree to limit their competition.
• One strategy is to follow the price leadership of a particular firm, raising or lowering prices when the leader makes such a change. The price leader may be the largest firm in the industry, or it may be a firm that has been particularly good at assessing changes in demand or cost.
Key Terms
• oligopoly: An economic condition in which a small number of sellers exert control over the market of a commodity.
• returns to scale: A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).
• product differentiation: Perceived differences between the product of one firm and that of its rivals so that some customers value it more.
• research and development: The process of discovering and creating new knowledge about scientific and technological topics in order to develop new products
• incumbent: A firm that is an established player in the market.
• patent: A declaration issued by a government agency declaring someone the inventor of a new invention and having the privilege of stopping others from making, using, or selling the claimed invention.
• Price leadership: The action taken by a leader in an oligopolistic industry to determine prices for the entire industry.
• collude: To act in concert with; to conspire.
• Cartel: A group of businesses or nations that collude explicitly to limit competition within an industry or market.
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Collusion and Competition
Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.
learning objectives
• Assess the considerations involved in the oligopolist’s decision about whether to compete or cooperate
Oligopoly is a market structure in which there are a few firms producing a product. When there are few firms in the market, they may collude to set a price or output level for the market in order to maximize industry profits. As a result, price will be higher than the market-clearing price, and output is likely to be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, allowing them to earn higher profits.
OPEC: The oil-producing countries of OPEC have at times cooperated to raise world oil prices in order to secure a steady income for themselves.
If oligopolists individually pursued their own self-interest, then they would produce a total quantity greater than the monopoly quantity, and charge a lower price than the monopoly price, thus earning a smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However, collusive oligopoly is inherently unstable, because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.
Several factors deter collusion. First, price-fixing is illegal in the United States, and antitrust laws exist to prevent collusion between firms. Second, coordination among firms is difficult, and becomes more so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to collude and then break the agreement, undercutting the profits of the firms still holding to the agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punish firms that may break the agreement.
In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor publishes its price ahead of other firms in the market, and the other firms then match the announced price. The leader will typically set the price to maximize its profits, which may not be the price that maximized other firms’ profits.
Game Theory Applications to Oligopoly
Game theory provides a framework for understanding how firms behave in an oligopoly.
learning objectives
• Explain how game theory applies to oligopolies
In an oligopoly, firms are interdependent; they are affected not only by their own decisions regarding how much to produce, but by the decisions of other firms in the market as well. Game theory offers a useful framework for thinking about how firms may act in the context of this interdependence. More specifically, game theory can be used to model situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.
For example, game theory can explain why oligopolies have trouble maintaining collusive arrangements to generate monopoly profits. While firms would be better off collectively if they cooperate, each individual firm has a strong incentive to cheat and undercut their competitors in order to increase market share. Because the incentive to defect is strong, firms may not even enter into a collusive agreement if they don’t perceive there to be a way to effectively punish defectors.
The prisoner’s dilemma is a specific type of game in game theory that illustrates why cooperation may be difficult to maintain for oligopolists even when it is mutually beneficial. In the game, two members of a criminal gang are arrested and imprisoned. The prisoners are separated and left to contemplate their options. If both prisoners confess, each will serve a two-year prison term. If one confesses, but the other denies the crime, the one that confessed will walk free, while the one that denied the crime would get a three-year sentence. If both deny the crime, they will both serve only a one year sentence. Betraying the partner by confessing is the dominant strategy; it is the better strategy for each player regardless of how the other plays. This is known as a Nash equilibrium. The result of the game is that both prisoners pursue individual logic and betray, when they would have collectively gotten a better outcome if they had both cooperated.
Prisoner’s Dilemma : In a prisoner’s dilemma game, the dominant strategy for each player is to betray the other, even though cooperation would have led to a better collective outcome.
The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy. If a player knew the strategies of the other players (and those strategies could not change), and could not benefit by changing his or her strategy, then that set of strategies represents a Nash equilibrium. If any player would benefit by changing his or her strategy, then that set of strategies is not a Nash equilibrium.
While game theory is important to understanding firm behavior in oligopolies, it is generally not needed to understand competitive or monopolized markets. In competitive markets, firms have such a small individual effect on the market, that taking other firms into account is simply not necessary. A monopolized market has only one firm, and thus strategic interactions do not occur.
The Prisoner’s Dilemma and Oligopoly
The prisoner’s dilemma shows why two individuals might not cooperate, even if it is collectively in their best interest to do so.
learning objectives
• Analyze the prisoner’s dilemma using the concepts of strategic dominance, Pareto optimality, and Nash equilibria
Sometimes firms fail to cooperate with each other, even when cooperation would bring about a better collective outcome. The prisoner’s dilemma is a canonical example of a game analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so.
In the game, two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of speaking to or exchanging messages with the other. The police offer each prisoner a bargain:
Prisoner’s Dilemma: Betrayal in the dominant strategy for both players, as it provides for a better individual outcome regardless of what the other player does. However, the resulting outcome is not Pareto-optimal. Both players would clearly have been better off if they had cooperated.
• If Prisoner A and Prisoner B both confess to the crime, each of them will serve two years in prison.
• If A confesses but B denies the crime, A will be set free, while B will serve three years in prison (and vice versa).
• If both A and B deny the crime, both of them will only serve one year in prison.
For both players, the choice to betray the partner by confessing has strategic dominance in this situation; it is the better strategy for each player regardless of what the other player does. This set of strategies is thus a Nash equilibrium in the game–no player would be better off by changing his or her strategy. As a result, all purely self-interested prisoners would betray each other, resulting in a two year prison sentence for both. This outcome is not Pareto optimal; it is clearly possible to improve the outcomes for both players through cooperation. If both players had denied the crime, they would each be serving only one year in prison.
Similarly to the prisoner’s dilemma scenario, cooperation is difficult to maintain in an oligopoly because cooperation is not in the best interest of the individual players. However, the collective outcome would be improved if firms cooperated, and were thus able to maintain low production, high prices, and monopoly profits.
One traditional example of game theory and the prisoner’s dilemma in practice involves soft drinks. Coca-Cola and Pepsi compete in an oligopoly, and thus are highly competitive against one another (as they have limited other competitive threats). Considering the similarity of their products in the soft drink industry (i.e. varying types of soda), any price deviation on part of one competitor is seen as an act of non-conformity or betrayal of an established status quo.
In such a scenario, there are a number of plausible reactions and outcomes. If Coca-Cola reduces their prices, Pepsi may follow to ensure they do not lose market share. In this situation, defection results in a lose-lose. Which is to say that, due to the initial price reduction by Coca-Cola (betrayal of status quo), both companies likely see reduced profit margins. On the other hand, Pepsi could uphold the price point despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola but maintaining the established price point. Prisoner dilemma scenarios are difficult strategic choices, as any deviation from established competitive practice may result in less profits and/or market share.
Duopoly Example
The Cournot model, in which firms compete on output, and the Bertrand model, in which firms compete on price, describe duopoly dynamics.
learning objectives
• Discuss the characteristics of a duopoly
A true duopoly is a specific type of oligopoly where only two producers exist in a market. There are two principle duopoly models: Cournot duopoly and Bertrand duopoly.
Cournot Duopoly
Cournot duopoly is an economic model that describes an industry structure in which firms compete on output levels. The model makes the following assumptions:
• There are two firms, which produce a homogeneous product;
• The number of firms is fixed;
• Firms do not cooperate (there is no collusion);
• Firms have market power, and each firm’s output decision affects the good’s price;
• Firms are economically rational and act strategically, seeking to maximize profit given their competitor’s decisions; and
• Firms compete on quantity, and choose quantity simultaneously.
The Cournot model focuses on the production output decision of a single firm. The firm determines its rival’s output level, evaluates the residual market demand, and then changes its own output level to maximize profits. It is assumed that the firm’s output decision will not affect the output decision of its competitor.
For example, suppose that there are two firms in the market for toasters with a given demand function. Firm A will determine the output of Firm B, hold it constant, and then determine the remainder of the market demand for toasters. Firm A will then determine its profit-maximizing output for that residual demand as if it were the entire market, and produce accordingly. Firm B will be conducting similar calculations with respect to Firm A at the same time.
Bertrand Duopoly
The Bertrand model describes interactions among firms that compete on price. Firms set profit-maximizing prices in response to what they expect a competitor to charge. The model rests on the following assumptions:
• There are two firms producing homogeneous products;
• Firms do not cooperate;
• Firms compete by setting prices simultaneously; and
• Consumers buy everything from a firm with a lower price. If all firms charge the same price, consumers randomly select among them.
In the Bertrand model, Firm A’s optimum price depends on where it believes Firm B will set its price. Pricing just below the other firm will obtain full market demand, though this choice is not optimal if the other firm is pricing below marginal cost, as this would result in negative profits. If Firm B is setting the price below marginal cost, Firm A will set the price at marginal cost. If Firm B is setting the price above marginal cost but below monopoly price, then Firm A will set the price just below that of Firm B. If Firm B sets the price above monopoly price, Firm A will set the price at monopoly level.
Bertrand Duopoly: The diagram shows the reaction function of a firm competing on price. When P2 (the price set by Firm 2) is less than marginal cost, Firm 1 prices at marginal cost (P1=MC). When Firm 2 prices above MC but below monopoly prices, Firm 1 prices just below Firm 2. When Firm 2 prices above monopoly price (PM), Firm 1 prices at monopoly level (P1=PM).
Imagine if both firms set equal prices above marginal cost. Each firm would get half the market at a higher than marginal cost price. However, by lowering prices just slightly, a firm could gain the whole market. As a result, both firms are tempted to lower prices as much as they can. However, it would be irrational to price below marginal cost, because the firm would make a loss. Therefore, both firms will lower prices until they reach the marginal cost limit. According to this model, a duopoly will result in an outcome exactly equivalent to what prevails under perfect competition. The result of the firms’ strategies is a Nash equilibrium –a pair or strategies where neither firm can increase profits by unilaterally changing the price.
Colluding to charge the monopoly price and supplying one half of the market each is the best that the firms could do in this scenario. However, not colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model.
The accuracy of the Cournot or Bertrand model will vary from industry to industry. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. If output and capacity are difficult to adjust, then Cournot is generally a better model.
Cartel Example
A cartel is a formal collusive arrangement among firms with the goal of increasing profits.
learning objectives
• Assess the role of competition and collusion in the formation of cartels
A cartel is an agreement among competing firms to collude in order to attain higher profits. Cartels usually occur in an oligopolistic industry, where the number of sellers is small and the products being traded are homogeneous. Cartel members may agree on such matters are price fixing, total industry output, market share, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits.
Game theory suggests that cartels are inherently unstable, because the behavior of cartel members represents a prisoner’s dilemma. Each member of a cartel would be able to make a higher profit, at least in the short-run, by breaking the agreement (producing a greater quantity or selling at a lower price) than it would make by abiding by it. However, if the cartel collapses because of defections, the firms would revert to competing, profits would drop, and all would be worse off.
Whether members of a cartel choose to cheat on the agreement depends on whether the short-term returns to cheating outweigh the long-term losses from the possible breakdown of the cartel. It also partly depends on how difficult it is for firms to monitor whether the agreement is being adhered to by other firms. If monitoring is difficult, a member is likely to get away with cheating for longer; members would then be more likely to cheat, and the cartel will be more unstable.
Perhaps the most globally recognizable and effective cartel is OPEC, the Organization of Petroleum Exporting Countries. In 1973 members of OPEC reduced their production of oil. Because crude oil from the Middle East was known to have few substitutes, OPEC member’s profits skyrocketed. From 1973 to 1979, the price of oil increased by \$70 per barrel, an unprecedented number at the time. In the mid 1980s, however, OPEC started to weaken. Discovery of new oil fields in Alaska and Canada introduced new alternatives to Middle Eastern oil, causing OPEC’s prices and profits to fall. Around the same time OPEC members also started cheating to try to increase individual profits.
OPEC: In the 1970s, OPEC members successfully colluded to reduce the global production of oil, leading to higher profits for member countries.
Key Points
• Firms in an oligopoly may collude to set a price or output level for a market in order to maximize industry profits. At an extreme, the colluding firms can act as a monopoly.
• Oligopolists pursuing their individual self-interest would produce a greater quantity than a monopolist, and charge a lower price.
• Collusive arrangements are generally illegal. Moreover, it is difficult for firms to coordinate actions, and there is a threat that firms may defect and undermine the others in the arrangement.
• Price leadership, which occurs when a dominant competitor sets the industry price and others follow suit, is an informal type of collusion which is generally legal.
• In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.
• The prisoner’s dilemma is a type of game that illustrates why cooperation is difficult to maintain for oligopolists even when it is mutually beneficial. In this game, the dominant strategy of each actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome.
• The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy.
• Game theory is generally not needed to understand competitive or monopolized markets.
• In the game, two criminals are arrested and imprisoned. Each criminal must decide whether he will cooperate with or betray his partner. The criminals cannot communicate to coordinate their actions.
• Betrayal is the dominant strategy for both players in the game. Betrayal leads to best individual outcome regardless of what the other person does.
• Both players choosing betrayal is the Nash equilibrium of the game. However, this outcome is not Pareto-optimal. Both players would have clearly been better off if they had cooperated.
• Cooperation by firms in oligopolies is difficult to achieve because defection is in the best interest of each individual firm.
• The Cournot model focuses on the production output decision of a single firm. A firm determines its competitor’s output level and the residual market demand. It then determines its profit -maximizing output for that residual demand as if it were the entire market, and produces accordingly.
• In the Bertrand model, firms set profit-maximizing prices in response to what they expect the competitor to charge. The model predicts that both firms will lower prices until they reach the marginal cost limit, arriving at an outcome equivalent to what prevails under perfect competition.
• The accuracy of the Cournot or Bertrand model will vary from industry to industry, depending on how easy it is to adjust output levels in the industry.
• Cartel members cooperate to set industry price and output.
• Game theory indicates that cartels are inherently unstable. Each individual member has an incentive to cheat in order to make higher profits in the short run.
• Cheating may lead to the collapse of a cartel. With the collapse, firms would revert to competing, which would lead to decreased profits.
• OPEC, the Organization of Petroleum Exporting Countries, provides an example of a historically effective cartel.
Key Terms
• Price leadership: Occurs when one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.
• collusion: A secret agreement for an illegal purpose; conspiracy.
• price fixing: An agreement between sellers to sell a product only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply.
• Prisoner’s dilemma: A game that shows why two individuals might not cooperate, even if it appears that it is in their best interests to do so.
• game theory: A branch of applied mathematics that studies strategic situations in which individuals or organisations choose various actions in an attempt to maximize their returns.
• Nash equilibrium: The set of players’ strategies for which no player can benefit by changing his or her strategy, assuming that the other players keep theirs unchanged.
• Pareto optimal: Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.
• Strategic dominance: Occurs when one strategy is better than another strategy for one player, no matter how that player’s opponents may play.
• Cournot duopoly: An economic model describing an industry in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time.
• Bertrand duopoly: A model that describes interactions among firms competing on price.
• Cartel: A group of businesses or nations that collude to limit competition within an industry or market.
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Marginal Product of Labor (Physical)
The marginal product of labor is the change in output that results from employing an added unit of labor.
learning objectives
• Define the marginal product of labor
In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. This is not always equivalent to the output directly produced by that added unit of labor; for example, employing an additional cook at a restaurant may make the other cooks more efficient by allowing more specialization of tasks, creating a marginal product that is greater than that produced directly by the new employee. Conversely, hiring an additional worker onto an already crowded factory floor may make the other employees less productive, leading to a marginal product that is lower than the work done by the additional employee.
When production is discrete, we can define the marginal product of labor as ΔY/ΔL where Y is output. If a factory that is initially producing 100 widgets hires another employee and is then able to produce 106 widgets, the MPL is simply six. When production is continuous, the MPL is the first derivative of the production function in terms of L. Graphically, the MPL is the slope of the production function.
gives another example of marginal product of labor. The second column shows total production with different quantities of labor, while the third column shows the increase (or decrease) as labor is added to the production process.
Marginal Product of Labor: This table shows hypothetical returns and marginal product of labor. Note that in reality this firm would never hire more than seven employees, since a negative marginal product is bad for the firm regardless of the wage rate.
The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing. The law states that “as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline.” The law of diminishing marginal returns applies regardless of whether the production function exhibits increasing, decreasing or constant returns to scale. The key factor is that the variable input is being changed while all other factors of production are being held constant. Under such circumstances diminishing marginal returns are inevitable at some level of production.
Marginal Product of Labor (Revenue)
The marginal revenue product of labor is the change in revenue that results from employing an additional unit of labor.
learning objectives
• Define the marginal product of labor under the marginal revenue productivity theory of wages
The marginal revenue product of labor (MRPL) is the change in revenue that results from employing an additional unit of labor, holding all other inputs constant. The marginal revenue product of a worker is equal to the product of the marginal product of labor (MPL) and the marginal revenue (MR) of output, given by MR×MP: = MRPL. This can be used to determine the optimal number of workers to employ at an exogenously determined market wage rate. Theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate, because it is not efficient for a firm to pay its workers more than it will earn in revenues from their labor.
For example, if a firm can sell t-shirts for $10 each and the wage rate is$20/hour, the firm will continue to hire workers until the marginal product of an additional hour of work is two t-shirts. If the MPL is three t-shirts the first will hire more workers until the MPL reaches two; if the MPL is one t-shirt then the firm will remove workers until the MPL reaches two.
Let TR=Total Revenue; L=Labor; Q=Quantity. Mathematically:
• $\mathrm{MRPL= \frac{∆TR}{∆L}}$
• $\mathrm{MR = \frac{TR}{∆Q}}$
• $\mathrm{MPL =\frac{ ∆Q}{∆L}}$
• $\mathrm{MR \times MPL = (\frac{∆TR}{∆Q}) \times (\frac{∆Q}{∆L}) = \frac{∆TR}{∆L}}$
Note that the change in output is not limited to that directly attributable to the additional worker. Assuming that the firm is operating with diminishing marginal returns then the addition of an extra worker reduces the average productivity of every other worker (and every other worker affects the marginal productivity of the additional worker) – in other words, everybody is getting in each other’s way.
Because the MRPL is equal to the marginal product of labor times the price of output, any variable that affects either MPL or price will affect the MRPL. For example, changes in technology or the quantity of other inputs will change the marginal product of labor, and changes in the product demand or changes in the price of complements or substitutes will affect the price of output. These will all cause shifts in the MRPL.
Deriving the Labor Demand Curve
Firms will demand labor until the marginal revenue product of labor is equal to the wage rate.
learning objectives
• Explain how a company uses marginal revenue product in hiring decisions
Firms demand labor and an input to production. The cost of labor to a firm is called the wage rate. This can be thought of as the firm’s marginal cost. The additional revenue generated by hiring one more unit of labor is the marginal revenue product of labor (MRPL). This can be thought of as the marginal benefit.
The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor (MPL) – the amount of additional output one additional worker can generate – by the price of output. If an employee of a customer support call center can take eight calls an hour (the MPL) and each call earns the company $3, then the MRPL is$24.
We can use the MRPL curve to determine the quantity of labor a company will hire. Suppose workers are available at an hourly rate of $10. The amount a factor adds to a firm’s total cost per period is the marginal cost of that factor, so in this case the marginal cost of labor is$10. Firms maximize profit when marginal costs equal marginal revenues, and in the labor market this means that firms will hire more employees until the wage rate (marginal cost of labor) equals the MRPL. At a price of $10, the company will hire workers until the last worker hired gives a marginal revenue product of$10.
Marginal Product of Labor: The MPL falls as the amount of labor employed increases. The optimum demand for labor falls where the real wage rate (w/P) is equal to the MPL.
Thus, the downward-sloping portion of the marginal revenue product curve shows the number of employees a company will hire at each price (wage), so we can interpret this part of the curve as the firm’s demand for labor. As with other demand curves, the market demand curve for labor is the sum of all firm’s individual demand curves.
Shifting the Demand for Labor
There are three main reasons why the demand curve for labor may shift:
1. Changes to the marginal productivity of labor: Technology, for instance, may increase the marginal productivity of labor, shifting the demand curve to the right. For example, computer technology has increased the productivity (marginal product) of many types of workers. This has led to an increase in the marginal revenue product of labor for these jobs, shifting firms’ demand for labor to the right. This both increases the number of employed workers and increases the wage rate.
2. The prices of other factors of production: The change in the relative price of labor will increase or decrease demand for labor. For example, is capital becomes more expensive relative to labor, the demand for labor will increase as firms seek to substitute labor for capital.
3. The price of the firm’s output: Since the price of the output is a component of MRPL, changes will shift the demand curve for labor. If the price that a firm can charge for its output increases, for example, the MRPL will increase. This is reflected in an outward shift of the demand for labor.
Key Points
• The marginal product of labor is not always equivalent to the output directly produced by that added unit of labor.
• When production is discrete, we can define the marginal product of labor (MPL) as ΔY/ΔL.
• When production is continuous, the MPL is the first derivative of the production function in terms of L.
• Graphically, the MPL is the slope of the production function.
• The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing.
• The marginal revenue product of a worker is equal to the product of the marginal product of labor (MP:) and the marginal revenue (MR) of output.
• The marginal revenue productivity theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate.
• The change in output from hiring one more employee is not limited to that directly attributable to the additional worker.
• The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor by the price of output.
• Firms will demand labor until the MRPL equals the wage rate.
• The demand curve for labor can be shifted by shifted by changes in the productivity of labor, the relative price of labor, or the price of the output.
• It will also change as a result of a change in technology, a change in the price of the good being produced, or a change in the number of firms hiring the labor.
Key Terms
• returns to scale: A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).
• marginal product: The extra output that can be produced by using one more unit of the input.
• diminishing marginal returns: The decrease in the per-unit output of a production process as the amount of a single factor of production is increased.
• marginal revenue product: The change in total revenue earned by a firm that results from employing one more unit of labor.
• factor of production: A resource employed to produce goods and services, such as labor, land, and capital.
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Conditions of Equilibrium
Equilibrium in the labor market requires that the marginal revenue product of labor is equal to the wage rate, and that $\mathrm{\frac{MPL}{PL}=\frac{MPK}{PK}}$.
learning objectives
• Employ the marginal decision rule to determine the equilibrium cost of labor
The labor market differs somewhat from the market for goods and services because labor demand is a derived demand; labor is not desired for its own sake but rather because it aids in producing output. Firms determine their demand for labor through a lens of profit maximization, ultimately seeking to produce the optimum level of output and the lowest possible cost.
Labor Market Equilibrium
In order to find the equilibrium quantity and price of labor, economists generally make several assumptions:
• The marginal product of labor (MPL) is decreasing;
• Firms are price-takers in the goods market (cannot affect the price of output) as well as in the labor market (cannot affect the wage rate);
• The supply of labor is elastic and increases with the wage rate (upward sloping supply); and
• Firms are profit-maximizers.
The marginal revenue product of labor (MRPL) is equal to the MPL multiplied by the price of output. The MRPL represents the additional revenue that a firm can expect to gain from employing one additional unit of labor – it is the marginal benefit to the firm from labor. Under the above assumptions, the MRPL is decreasing as the quantity of labor increases, and firms can increase profit by hiring more labor if the MRPL is greater than the marginal cost of that additional unit of labor – the wage rate. Thus, firms will hire more labor when the MRPL is greater than the wage rate, and stop hiring as soon as the two values are equal. The point at which the MRPL equals the prevailing wage rate is the labor market equilibrium.
Optimal Demand for Labor: The optimal demand for labor is located where the marginal product equals the real wage rate. The curved line represents the falling marginal product of labor, the y-axis is the marginal product/wage rate, and the x-axis is the quantity of labor.
Optimizing Capital and Labor
In the long run, firms maximize profit by choosing the optimal combination of labor and capital to produce a given amount of output. It’s possible that an automobile company could manufacture 1,000 cars using only expensive, technologically advanced robots and machinery (capital) that do not require any human participation. It’s also possible that the company could produce the same number of vehicles using only employee work (labor), without any assistance from machines or technology. For most industries, however, relying solely on capital or solely on labor is more expensive than using some combination of the two.
Factory Worker: Most firms need a combination of both labor and capital in order to produce their product.
Firms use the marginal decision rule in order to decide what combination of labor, capital, and other factors of production to use in the creation of output. The marginal decision rule says that a firm will shift spending among factors of production as long as the marginal benefit of such a shift exceeds the marginal cost. Imagine that a firm must decide whether to spend an additional dollar on labor. To determine the marginal benefit of that dollar, we divide the marginal product of labor (MPL) by it’s price (the wage rate, PL): MPL/PL. If capital and labor are the only factors of production, then spending an additional $1 on labor while holding the total cost constant means taking$1 out of capital. The cost of that action will be the output lost from cutting back on capital, which is the ratio of the marginal product of capital (MPK) to the price of capital (the rental rate, PK). Thus, the cost of cutting back on capital is MPK/PK.
If the marginal benefit of additional labor, MPL/PL, exceeds the marginal cost, MPK/PK, then the firm will be better off by spending more on labor and less on capital. On the other hand, if MPK/PK is greater than MPL/PL, the firm will be better off spending more on capital and less on labor. The equilibrium – the point at which the firm is producing the maximum amount of output at a given cost – occurs where MPL/PL=MPK/PK.
The Wage Rate
The wage rate is determined by the intersection of supply of and demand for labor.
learning objectives
• Describe the factors that determine the wage rate
When labor is an input to production, firms hire workers. Firms are demand labor and workers provide it at a price called the wage rate. Colloquially, “wages” refer to just the dollar amount paid to a worker, but in economics, it refers to total compensation (i.e. it includes benefits).
The marginal benefit of hiring an additional unit of labor is called the marginal product of labor: it is the additional revenue generated from the last unit of labor. In theory, as with other inputs to production, firms will hire workers until the wage rate (marginal cost) equals the marginal revenue product of labor (marginal benefit).
Changes in Supply and Demand
In competitive markets, the demand curve for labor is the same as the marginal revenue curve. Thus, shifts in the demand for labor are a function of changes in the marginal product of labor. This can occur for a number of reasons. First of all, you can imagine that a new product or company is created that represents new demand for labor of a certain type. There are also three main factors that would shift the labor demand curve:
1. Technology which affects the output of a unit of labor.
2. Changes in the price of the output which affect the value of the unit of labor.
3. Changes in the price of labor relative to other factors of production.
In the long run, the supply of labor is a function of the population. A decrease in the supply of labor will typically cause an increase in the wage rate. The fact that a reduction in supply tends to strengthen wages explains why unions and other professional associations have often sought to limit the number of workers in their particular industry. Physicians, for example, have a financial incentive to enforce rigorous training, licensing, and certification requirements in order to limit the number of practitioners and keep the labor supply low.
Wage Rate in the Long Run: In the long run the supply of labor is fixed and demand is downward-sloping. The wage rate is determined by their intersection.
Compensation Differentials
Some differences in wage rates across places, occupations, and demographic groups can be explained by compensation differentials.
learning objectives
• Describe nonmonetary factors that affect wage rates
According to the basic theory of the labor market, there ought to be one equilibrium wage rate that applies to all workers across industries and countries. Of course this is not the case; doctors typically make more per hour than retail clerks, and workers in the United States typically earn a higher wage than workers in India. These wage differences are called compensation differentials and can be explained by many factors, such as differences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves.
Education Differentials
One common source of differences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher. Additionally, the differential pay for more education tends to compensate workers for the time, effort, and foregone wages from obtaining the necessary training. If all jobs paid the same rate, for example, fewer people would go through the expense and effort of law school. The compensation differential ensures that individuals are willing to invest in their own human capital.
Education Differentials: Workers seek increased compensation by attaining higher levels of education
Geographic Compensation Differentials
If a certain part of a country is a particularly attractive area to live in and if labor mobility is perfect, then more and more workers will move to that area, which in turn will increase the supply of labor and depress wages. If the attractiveness of that area compared to other areas does not change, the wage rate will be set at such a rate that workers will be indifferent between living in areas that are more attractive but with a lower wage and living in areas which are more attractive with a higher wage. In this way, a sustained equilibrium with different wage rates across different areas can occur.
Discrimination and Compensation Differentials
In the United States, minorities and women make lower wages on average than Caucasian men. Some of this is due to historical trends affecting these groups that result in less human capital or a concentration in certain lower-paying occupations. Another source of differing wage rates, however, is discrimination. Several studies have shown that, in the United States, several minority groups (including black men and women, Hispanic men and women, and white women) suffer from decreased wage earning for the same job with the same performance levels and responsibilities as white males.
Compensating Differential
Not to be confused with a compensation differential, a compensating differential is a term used in labor economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. It is defined as the additional amount of income that a given worker must be offered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. One can also speak of the compensating differential for an especially desirable job, or one that provides special benefits, but in this case the differential would be negative: that is, a given worker would be willing to accept a lower wage for an especially desirable job, relative to other jobs.
Hazard Differential: Hazard pay is a type of compensating differential. Occupations that are dangerous, such as police work, will typically have higher pay to compensate for the risk associated with that job.
Performance and Pay
Theoretically there is a direct connection between job performance and pay, but in reality other factors often distort this relationship.
learning objectives
• Identify the relationship between performance and wages
According to economic theory, workers’ wages are equal to the marginal revenue product of their labor. If one employee is very productive he or she will have a high marginal revenue product: one additional hour of their work will produce a significant increase in output. It follows that more productive employees should have higher wages than less productive employees. Imagine if this were not true: a firm decides to pay a highly productive worker less than the marginal revenue product of his labor. Any other firm could make a profit by offering a higher salary to attract the productive employee to their company, and the worker’s wage would rise. Theoretically, therefore, there is a direct relationship between job performance and pay.
We know that this is not always the case in reality. Wages are determined not only by one’s productivity, but also by seniority, networking, ambition, and luck. It is very rare for an entry-level worker to make the same wage as an experienced member of the same profession regardless of their relative levels of productivity because the older worker has had time to receive pay raises and promotions for which the younger employee is simply not eligible. Discrimination is sometimes responsible for members of minority racial or gender groups receiving wages that are less than wages for the majority group even when productivity levels are the same. Finally, outside forces, such as unions or government regulations, can distort pay rates.
Wages and Productivity in the U.S.: On a macroeconomic level, this graph shows the disconnect, beginning around 1975, between the productivity of labor and the wage rate in the U.S. If the economic theory were correct in the real world, wages and productivity would increase together.
Linking Performance and Pay
Some of the disconnect between performance and pay can be addressed with alternate pay schemes. While a salary or hourly pay does not directly take into account the quality of work, performance-related pay compensates workers with higher levels of productivity directly. One example is commission-based pay. In this type of pay scheme, workers receive some percentage of the profit that they generate for their company. This may be paid on top of a baseline salary or may be the only form of compensation. This type of system is very common among car salespeople and insurance brokers.
Another alternative is piece-work, in which employees are paid a fixed rate for every unit produced or action performed, regardless of the time it takes. This is common in settings where it is easy to measure the output of piece work, such as when a garment worker is paid per each piece of cloth sewn or a telemarketer is paid for every call placed.
Marginal Revenue Productivity and Wages
In a perfectly competitive market, the wage rate is equal to the marginal revenue product of labor.
learning objectives
• Explain how wages are determines by marginal revenue productivity
Just as in any market, the price of labor, the wage rate, is determined by the intersection of supply and demand. When the supply of labor increases the equilibrium price falls, and when the demand for labor increases the equilibrium price rises. In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for labor.
To determine demand in the labor market we must find the marginal revenue product of labor (MRPL), which is based on the marginal productivity of labor (MPL) and the price of output. Conceptually, the MRPL represents the additional revenue that the firm can generate by adding one additional unit of labor (recall that MPL is the additional output from the additional unit of labor). Thus, MRPL is simply the product of MPL and the price of the output.
The MPL is generally decreasing: adding a 100th unit of labor will not increase output as much as adding a 99th. Since competitive industries are price takers and cannot change the price of output by changing their level of production, the MRPL curve will have the same downward slope as the MPL curve.
From the perspective of the firm, the MRPL is the marginal benefit to the firm of hiring an additional unit of labor. We know that a profit-maximizing firm will increase its factors of production until their marginal benefit is equal to the marginal cost. Therefore, firms will continue to add labor (hire workers) until the MRPL equals the wage rate. Thus, workers earn a wage equal to the marginal revenue product of their labor. For example, in a perfectly competitive market, an employee who earns $20/hour has a marginal productivity that is worth exactly$20.
Marginal Product and Wages: The graph shows that a factor of production – in our case, labor – has a fixed supply in the long run, so the wage rate is determined by the factor demand curve – in our case, the marginal revenue product of labor. The intersection of vertical supply and the downward sloping demand gives the wage rate.
Changes in Equilibrium for Shifts in Market Supply and Market Demand
A shift in the supply or demand of labor will cause a change in the market equilibrium.
learning objectives
• Discuss the factors that influence the shape and position of the labor supply curve
As in all competitive markets, the equilibrium price and quantity of labor is determined by supply and demand.
Labor Supply
Labour supply curves are derived from the ‘labor-leisure’ trade-off. More hours worked earn higher incomes but necessitate a cut in the amount of other things workers enjoy such as going to movies, hanging out with friends, or sleeping. The opportunity cost of working is leisure time and vis versa. Considering this tradeoff, workers collectively offer a set of labor to the market which economists call the supply of labor.
To see how changes in wages affect the supply of labor, suppose wages rise. This increases the cost of leisure and causes the supply of labor to rise – this is the substitution effect, which states that as the relative price of one good increases, consumption of that good will decrease. However, there is also an income effect – an increased wage means higher income, and since leisure is a normal good, the quantity of leisure demanded will go up. In general, at low wage levels the substitution effect dominates the income effect and higher wages cause an increase in the supply of labor. At high incomes, however, the negative income effect could offset the positive substitution effect and higher wage levels could actually cause labor to decrease. A worker making $800/hour who receives a raise to$1200/hour may not have much use for the extra money and may choose to work less while maintaining the same standard of living, for example. This creates a supply curve that bends backwards, initially increasing with the wage rate but later decreasing.
Backward Bending Supply: While normally hours of labor supplied will increase with the wage rate, the income effect may produce the opposite effect at high wage levels.
People supply labor in order to increase their utility —just as they demand goods and services in order to increase their utility. The supply curve for labor will shift in response to changes in the same factors that shift demand for goods and services. These include changes in preferences, changes in income, changes in population, and changes in expectations. A change in preferences that causes people to prefer more leisure, for example, will shift the supply curve to the left, creating a lower level of employment and a higher wage rate.
Labor Demand
An increase in the demand for labor will increase both the level of employment and the wage rate. We have already seen that the demand for labor is based on the marginal product of labor and the price of output. Thus, any factor that affects productivity or output prices will also shift labor demand. Some of these factors include:
• Available technology (marginal productivity of labor)
• The skills or education of the workforce (marginal productivity of labor)
• Level of physical capital (marginal productivity of labor)
• Price of physical capital (price of output)
• Price of substitute or complement goods (price of output)
• Consumer preferences (price of output)
All of the above may cause the demand for labor to shift and change the equilibrium quantity and price of labor.
Labor Union Impacts on Equilibrium
Unions are organizations of workers that seek to improve working conditions and raise the equilibrium wage rate.
learning objectives
• Examine the role of unions and collective bargaining in labor-firm relations
A labor union is an organization of workers who have banded together to achieve common goals. The primary activity of the union is to bargain with the employer on behalf of union members and negotiate labor contracts. The most common purpose of associations or unions is maintaining or improving the conditions of employment, which may include the negotiation of wages, work rules, complaint procedures, promotions, benefits, workplace safety, and policies.
In order to achieve these goals unions engage in collective bargaining: the process of negotiation between a company’s management and a labor union. When collective bargaining fails, union members may go on strike, refusing to work until a firm addresses the workers’ grievances.
Union Impacts on Equilibrium
Fundamentally, unions seek higher wages for its member workers (though, here “wages” encompases all types of compensation, not just cash paid to the workers by the employer).
The effect of unions on the labor market equilibrium can be analyzed like any other price increase. If employers (those who demand labor) have an inelastic demand for labor, the increase in wages (the price of labor) will not translate into a drop in employment (quantity of labor supplied). If, however, their demand is elastic, employers will simply respond to union demands for higher wages by hiring fewer workers.
However, the reality of unions is more complex. As an organized body, unions are also active in the political realm. They can lobby for legislation that will affect the market not only for labor, but also for the goods they produce. For example, unions may advocate for trade restrictions to protect the markets in which they work from foreign competition. By preventing domestic firms from having to compete with unrestricted foreign firms, they can ensure that consumers do not have lower cost alternatives which would drive employers who pay a higher union wage out of business.
Union Members Strike: One tool that unions may use to raise wages is to go on strike.
Key Points
• Firms will hire more labor when the marginal revenue product of labor is greater than the wage rate, and stop hiring as soon as the two values are equal.
• The point at which the MRPL equals the prevailing wage rate is the labor market equilibrium.
• The marginal decision rule says that a firm will shift spending among factors of production as long as the marginal benefit of such a shift exceeds the marginal cost.
• If the marginal benefit of additional labor, MPL/PL, exceeds the marginal cost, MPK/PK, then the firm will be better off by spending more on labor and less on capital.
• According to the marginal decision rule, equilibrium in the labor market must occur where MPL/PL=MPK/PK.
• An increase in demand or a reduction in supply will raise wages; an increase in supply or a reduction in demand will lower them.
• The demand curve depends on the marginal product of labor and the price of the good labor produces. If the demand curve shifts to the right, either because productivity or the price of output has increased, wages will be pushed up.
• In the long run the supply of labor is simply a function of the population size, but in the short run it depends on variables such as worker preferences, the skills and training a job requires, and wages available in alternative occupations.
• Although basic economic theory suggests that there ought to be one prevailing wage rate for all labor, this is not the case.
• Wage differences are called compensation differentials and can be explained by many factors, such as differences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves.
• One common source of differences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher.
• If a certain area is a desirable place to live, the supply of labor will be higher than in other areas and wages will be lower. This is a type of geographical differential.
• Discrimination against gender or racial groups can cause compensation differentials.
• A compensating differential is the additional amount of income that a given worker must be offered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform.
• According to economic theory, workers’ wages are equal to the marginal revenue product of their labor. If one employee is very productive he or she will have a high marginal revenue product.
• In reality, wages are determined not only by one’s productivity, but also by seniority, networking, ambition, and luck.
• Some of the disconnect between performance and pay can be addressed with alternate pay schemes.
• In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for labor.
• The marginal product of labor (MPL) is the increase in output that a firm experiences from adding one additional unit of labor.
• The marginal benefit to the firm of hiring an additional unit of labor is called the marginal revenue product of labor (MRPL). It is calculated by multiplying MPL by the price of the output.
• The MRPL represents the firm’s demand curve for labor, which means that the firm will continue to hire more labor until the MRPL is equal to the wage rate.
• The opportunity cost of leisure is the wages lost while not working; as wages rise, the cost of leisure increases.
• The substitution effect means that when wages rise, people are likely to substitute more labor for less leisure.
• However, the income effect means that as people become wealthier, their demand for normal goods such as leisure increases.
• Typically the substitution effect dominates the supply of labor at normal wage rates, but the income effect may come to dominate at higher wage rates. This creates a backward bending labor supply curve.
• The supply curve for labor will shift in response to changes in preferences, changes in income, changes in population, and changes in expectations.
• The demand curve for labor will shift in response to changes in human capital, changes in technology, changes in the price of complements or substitutes for output, and changes in consumer preferences.
• Unions ‘ primary work involves negotiating wages, work rules, complaint procedures, promotions, benefits, workplace safety and policies with company management.
• If the labor market is a competitive one in which wages are determined by demand and supply, increasing the wage requires either increasing the demand for labor or reducing the supply.
• Increasing demand for labor requires increasing the marginal product of labor or raising the price of the good produced by labor.
• Unions can restrict the supply of labor in two ways: slowing the growth of the labor force and promoting policies that make it difficult for workers to enter a particular craft.
Key Terms
• marginal product: The extra output that can be produced by using one more unit of the input.
• marginal revenue product: The change in total revenue earned by a firm that results from employing one more unit of labor.
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
• Union: an organization of workers who have banded together to achieve common goals
• differential: a qualitative or quantitative difference between similar or comparable things
• discrimination: Distinct treatment of an individual or group to their disadvantage; treatment or consideration based on class or category rather than individual merit; partiality; prejudice; bigotry.
• commission: A fee charged by an agent or broker for carrying out a transaction
• piece work: Work that a worker is paid for according to the number of units produced, rather than the number of hours worked.
• marginal benefit: The extra benefit received from a small increase in the consumption of a good or service. It is calculated as the increase in total benefit divided by the increase in consumption.
• marginal revenue product: The change in total revenue earned by a firm that results from employing one more unit of labor.
• normal good: A good for which demand increases when income increases and falls when income decreases but price remains constant.
• Opportunity cost: The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
• collective bargaining: A method of negotiation in which employees negotiate as a group with their employers.
• strike: A work stoppage (or otherwise concerted stoppage of an activity) as a form of protest.
• minimum wage: The lowest rate at which an employer can legally pay an employee; usually expressed as pay per hour.
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• Factor compensation. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Fa...mpensation.jpg. License: CC BY-SA: Attribution-ShareAlike
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• normal good. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/normal_good. License: CC BY-SA: Attribution-ShareAlike
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• Labor supply. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Labour_supply. License: CC BY-SA: Attribution-ShareAlike
• Opportunity cost. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/Opportunity+cost. License: CC BY-SA: Attribution-ShareAlike
• Fator. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Fator.jpg. License: CC BY-SA: Attribution-ShareAlike
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• Factor compensation. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Fa...mpensation.jpg. License: CC BY-SA: Attribution-ShareAlike
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• Factor compensation. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Fa...mpensation.jpg. License: CC BY-SA: Attribution-ShareAlike
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• collective bargaining. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/collective_bargaining. License: CC BY-SA: Attribution-ShareAlike
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• strike. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/strike. License: CC BY-SA: Attribution-ShareAlike
• minimum wage. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/minimum_wage. License: CC BY-SA: Attribution-ShareAlike
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• US productivity and real wages. Provided by: Wikimedia. Located at: commons.wikimedia.org/wiki/Fi...real_wages.jpg. License: Public Domain: No Known Copyright
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How Income is Allocated
Recent growth in overall income inequality has been driven mostly by increasing inequality in wages and salaries.
learning objectives
• Discuss factors that contribute to income inequality
Recent growth in overall income inequality has been driven mostly by increasing inequality in wages and salaries. Globalization has contributed to some portion of rising inequality as jobs have moved to lower wage geographies, placing downward pressure on wages of higher cost of living countries. However, economists view the impact of technological progress to outweigh the effect of globalization, as technology has effectively been substituted for more expensive wage labor. Policy reforms and regressive taxation have promoted disparity but are relatively minor contributors to existing inequality. Discrimination and favoritism in the workplace has continued to limit advancement of minority groups and women, but evidence reveals that wage related impacts to marginalized groups diminish with the increase in educational attainment.
Common factors thought to impact domestic economic inequality include:
• Labor market outcomes
• Globalization
• Technological changes
• Policy reforms
• More regressive taxation
• Discrimination
Globally, income inequality has increased over the last few decades. In the U.S., recent studies have stated that the wealthiest 400 Americans control nearly 50% of domestic wealth. Given that economic theory points to a decline in income inequality over time, the recent increase has led many researchers to conclude that we may be starting a new inequality cycle.
Kuznets curve: The Kuznets curve depicts the relationship between inequality and income; after hitting a market peak, inequality will decrease as income increases. Recent economic trends have caused researchers to believe that the economy may have started on a new Kuznet’s curve given the heightening economic inequality.
Role of Government
The market for labor is not completely transparent, competition is imperfect, information unevenly distributed, opportunities to acquire education and skills unequal, and since many such imperfect conditions exist in virtually every market, there is in fact little presumption that markets are in general efficient. This means that there is an enormous potential role for government to correct these market failures.
Governments have a number of tools with which they can affect income distribution. One way in which governments attempt to decrease income inequality is through progressive taxation. Wealthier people pay proportionally more of their income in taxes, which are then used to pay for services for the poor. Government can also place regulations of hiring and firing practices to address issues such as discrimination.
Current Topics in Income Distribution
Income inequality in the United States has grown significantly since the early 1970s.
learning objectives
• Describe trends in income inequality in the U.S.
While income inequality has risen among most developed countries, and especially English-speaking ones, it is highest in the United States. Income inequality in the United States has grown significantly since the early 1970s and has been the subject of study of many scholars and institutions.
Most of the income growth has been between the middle class and top earners, with the disparity becoming more extreme the further one goes up in the income distribution. A 2011 study by the Congressional Budget Office (CBO) found that the top earning 1% of households increased their income by about 275% after federal taxes and income transfers over a period between 1979 and 2007, compared to a gain of just under 40% for the 60% in the middle of America’s income distribution. Scholars and others differ as to the causes, solutions, and the significance of the trend, which in 2011 helped ignite the “Occupy” protest movement. As a result, inequality has been described both as irrelevant in the face of economic opportunity (or social mobility) in America, and as a cause of the decline in that opportunity.
Yale professor and economist Robert J. Shiller, who was among three Americans who won the Nobel prize for economics in 2013, believes that rising economic inequality in the United States and other countries is “the most important problem that we are facing now today.”
Brief History of Income Disparity in America
The first era of inequality lasted roughly from the post-civil war era (“the Gilded Age”) to sometime around 1937. But from about 1937 to 1947, a period that has been dubbed the “Great Compression,” income inequality in America fell dramatically. Highly progressive New Deal taxation, the strengthening of unions, and regulation of the National War Labor Board during World War II raised the income of the poor and working class and lowered that of top earners. This “middle class society” characterized by a relatively low level of inequality remained fairly steady for about three decades ending in early 1970s. The return to high inequality or what has been referred as the “Great Divergence,” began in the 1970s. It was caused mainly due to the widening gap between middle and top earners.
Recent History: Inequality on the Rise
The income growth of the average American family closely matched that of economic productivity until some time in the 1970s. However, while income began to stagnate, productivity continued to climb.
U.S. Income over time: Though productivity gains were primarily the basis for the increase in U.S. income, in more recent times, productivity increases have not been captured in income increases for the majority of U.S. families as noted in the graph.
In 2013, the Economic Policy Institute noted that even though corporate profits are at historic highs, the wage and benefit growth of the vast majority has stagnated. The fruits of overall growth have accrued disproportionately to the top 1%. According to PolitiFact and others, 400 Americans now own more than 50% of the net wealth of the United States.
Key Points
• There is a potential role for government to correct the market failures that have propelled the rise in income inequality.
• Common factors thought to impact domestic economic inequality include labor market outcomes, globalization, technological changes, policy reforms, more regressive taxation, and discrimination.
• Some government tools for affecting income distribution are policies, hiring regulations, and progressive taxation.
• While inequality has risen among most developed countries, and especially English-speaking ones, it is highest in the United States.
• The fruits of overall growth have accrued disproportionately to the top 1%.
• According to PolitiFact and others, 400 Americans now own more than 50% of the net wealth of the United States.
Key Terms
• regressive: Whose rate decreases as the amount increases.
• progressive: Gradually advancing in extent; increasing.
• globalization: The process of international integration arising from the interchange of world views, products, ideas, and other aspects of culture.
• inequality: An unfair, not equal, state.
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Other Factors of Production
There are three factors of production that are required to produce economic output: land, labor, and capital.
learning objectives
• Discuss the role of capital and resources in production
Factors of production are the inputs to the production process. Finished goods are the output. Input determines the quantity of output; in other words, output depends upon input. Input is the starting point and output is the end point of a production process and such input-output relationship is called a production function. There are three basic, otherwise known as classical, factors of production:
• Land: which includes the site where goods are produced as well as all the minerals below and above the site;
• Labor: which includes all human effort used in production as well as the necessary technical and marketing expertise; and
• Capital: which are the human-made goods used in the production of other goods, such as machinery and buildings.
Land is sometime included with capital in certain situations, such as in service industries where land has little importance. All three of these are required in combination at a time to produce a commodity. In economics, production means creation or an addition of utility. Factors of production (or productive ‘inputs’ or ‘resources’) are any commodities or services used to produce goods or services.
Further Defining Capital
In accounting and other disciplines, the phrase “capital” can also refer to cash that have been invested in a business. The classical economists also employed the word “capital” in reference to money. Money, however, was not considered to be a factor of production in the sense of capital stock since it is not used to directly produce any good. The return to loaned money or to loaned stock was styled as interest while the return to the actual proprietor of capital stock (tools, etc.) is classified as profit.
It is important to note that the final output is the result of the combination of all of the inputs. Things like technological advancement and worker productivity are intricately tied to the productivity of the inputs; it is not enough to simply have the factors of production in one place without the knowledge and ability to convert them into the correct outputs.
The Importance of Factor Prices
The prices of different factors of production can help determine which products a country will produce.
learning objectives
• Explain how changes in resource prices affect production
Comparative advantage is the ability of one country or region to produce a particular good or service at a lower opportunity cost than another. This idea suggests that in the long-run, entities will specialize in what costs them less to produce. These entities will then trade the goods they produce for the items that it would be expensive for them to produce. As a result, the prices of different factors of production can help dictate which products a country will choose to produce.
Trade: Trade and comparative advantage are why factor prices are so important in determining what a country produces. Trade allows a country to produce only what is comparatively cheaper for them to manufacture because they can get everything else they need through trade.
This idea was expanded upon in the Heckscher-Ohlin Model (H-O model), which was designed to be used to predict patterns of international commerce. This model is premised on several assumptions. These assumptions are:
• All countries have identical production technology;
• Production output is assumed to exhibit constant returns to scale;
• The technologies used to produce the two commodities differ;
• Factor mobility within countries;
• Factor immobility between countries;
• Commodity prices are the same everywhere; and
• Perfect internal competition.
If these assumptions are held to be true, the HO-model suggests that the exports of a capital-abundant country will be from capital-intensive industries, and labor-abundant countries will import such goods, exporting labor intensive goods in return.
For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor. If capital and land are abundant, their prices will be low. As capital and land the main factors used in the production of grain, the price of grain will also be low, and thus attractive for both local consumption and export. Labor intensive goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.
Shifts in Factor Prices
Assuming the cost of relative goods remain constant, if one factor of production becomes more or less expensive, it can cause a significant shift of what is produced in that country.
If one factor of production becomes more plentiful, and therefore cheaper, it will cause production of the good that relies on that factor to increase. In response to that increase, the country will produce fewer goods that rely on other factors.
For example, imagine a country has a population boom from immigration. Its supply of labor will increase. As a result, the price of labor decreases. This country produces one good that is labor intensive, clothes, and one that is capital intensive, cars. When the cost of labor decreases, the country will produce more clothes and less cars. This is not necessarily a one-to-one relationship where the production of one more shirt means one less car is produced; the only thing that can be predicted is an overall shift in production levels.
It is important to note that the shifts in factor prices described above are based entirely on the assumptions found in the H-O Model. It is rare that a real market would meet all of those standards, so the results in the real world might vary from what this section describes.
Marginal Productivity and Resource Demand
Firms will demand more of a resource if the marginal product of the resource is greater than the marginal cost.
learning objectives
• Explain the relationship between marginal productivity and resource demand
The marginal product of a given resource is the additional revenue generated by employing one more unit of the resource. In the case of labor, for example, the marginal product of labor is the additional value generated for the company by hiring one additional worker. A firm will continue to employ more of the resource until the marginal revenue equals the marginal cost to the firm. The same concept applies to all resources that can be used in production, whether its labor or wood or land.
Since firms will seek to use additional resources if the net marginal product is positive, they can affect the demand for the resources. For many resources, the increased demand has the same effects as if it were any other input: an increase in demand will lead to an increase in price.
Oil Rig: Oil is a natural resource that is traded in markets. When firms have positive net marginal productivity from using more oil, demand for oil will rise.
Some resources, though, are public goods and therefore are not regulated by normal market forces. Take, for example, a body of water that multiple firms all use. If each firm has a positive marginal productivity of using more water in their manufacturing process, they will use more water since it’s free (there is no, or limited, marginal cost). If each firm individually chooses to use more water, the lake will eventually be damaged. This is known as the tragedy of the commons.
Governments have an incentive to attempt to correct such market failures. There are often regulations on the use of public goods to prevent the tragedy of the common, and there may be regulations on private goods as well (e.g. companies are required to get permits to mine on land they own).
Marginal Productivity and Income Distribution
Demand for the type of workers that can provide positive marginal productivity over marginal cost will see an increase in their wages.
learning objectives
• Explain how the marginal productivity of different factors can affect income distribution
Firms will hire workers if the marginal productivity of the worker is greater than the marginal cost. That is, firms will hire someone if the employee can produce more value for the firm than s/he costs in wages or salary.
Not all labor, however, is equal in the firm’s eyes. The two broad categorizations of laborers is skilled (e.g. doctor) and unskilled (e.g. an assembly line worker). Firms will hire the type of workers that they need.
Scientists are Skilled Workers: Scientists are skilled workers. Firms, such as pharmaceutical companies, will hire more scientists if the marginal productivity is greater than the marginal cost. This will drive up demand for scientists, and therefore their wages.
Suppose there are many firms with positive net marginal productivity of skilled labor. They will each seek to hire more skilled workers, driving up demand for skilled workers. This will increase the wages of skilled workers, but not of unskilled workers. Skilled workers will be gain proportionally more wealth than unskilled workers. Taken in aggregate, the marginal productivity of one type of worker influences the income that they earn in comparison to other types of workers.
On a national scale, this can have massive implications. If a country has a number of workers with high marginal productivity proportional to marginal cost, firms will want to hire those workers. Those workers will see gains to their income, affecting overall income distribution.
It is important to remember, however, that countries will specialize in goods in which they have a comparative advantage. If a country has an absolutely advantage in both skilled and unskilled workers, but a comparative advantage in unskilled workers, the country will specialize in the good that is intensive in the use of unskilled labor. The increased returns will go to unskilled workers (they will see their wages increase), even though the country also has an absolute advantage in skilled labor.
Capital Market
A capital market is a financial exchange for the buying and selling of long-term debt and equity-backed securities.
learning objectives
• Define the capital market
A capital market is a financial exchange for the buying and selling of long-term debt and equity-backed securities. The purpose of these markets is to channel the funds of savers to entities that would put that capital to long-term productive use (i.e. borrowers).
NYSE: This is the floor of the New York Stock Exchange. The NYSE is one of the largest capital markets in the world.
Primary vs. Secondary Markets
A key division within the capital markets is between the primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors. The main entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies). Governments tend to issue only bonds, whereas companies often issue either equity or bonds. The main entities purchasing the bonds or stocks include pension funds, hedge funds, sovereign wealth funds, and, less commonly, individuals and investment banks trading on their own behalf.
In the secondary markets, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary markets increases the willingness of investors in primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises.
Money Market vs. Capital Market
Money markets and capital markets are closely related, but are different types of financial markets. The money markets are used for the raising of short term finance, sometimes for loans that are expected to be paid back as early as overnight. Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity.
Capital markets are used for the raising of long term finance, such as the purchase of shares, or for loans that are not expected to be fully paid back for at least a year. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long term.
Regular Bank Lending is Not a Capital Market Transaction
Regular bank lending is not usually classed as a capital market transaction, even when loans are extended for a period longer than a year. A key difference is that with a regular bank loan, the lending doesn’t take the form of resalable security like a share or bond that can be traded on the markets. A second difference is that lending from banks and similar institutions is more heavily regulated than capital market lending. A third difference is that bank depositors and shareholders tend to be more risk averse than capital market investors.
Natural Resource Market
Commodity markets are exchanges that trade in primary rather than manufactured products.
learning objectives
• Define the natural resource market
Natural resources are a fundamental part of the production process, as these goods make up the basis of any manufactured product. Most natural resources that are used can be acquired through the open market or through private deals. Below are some methods of acquiring different natural resources for production.
Public Goods
Some natural resources that are components of the production process are not sold, but are public goods. Public goods, like air and riverways, are non-excludable and non-rivalrous. This means that anyone can use these goods without paying a fee, and if one person uses the good it does not limit the ability of another to use the good.
As time has progressed, people have learned that some means of use of public goods in production processes can degrade certain natural resources. For example, pollution is a result of production processes that can foul the public goods of air and waterways. To combat this, governments have begun to impose ecotaxes on producers that use processes that pollute or otherwise dilute public goods. While not a market, these taxes are essentially a fee charged to producers for using public natural resources and can make the production process more expensive.
Commodity Markets
Commodity markets are exchanges that trade in primary rather than manufactured products. Not all commodities are natural resources, and not all natural resources are commodities, but commodity markets remain an important source for many resources. There are two types of commodities:
Chicago Mercantile Exchange: The Chicago Mercantile Exchange, shown above, is one of the world’s largest commodity markets.
• Soft commodities are agricultural products such as wheat, coffee, cocoa and sugar;
• Hard commodities are mined, such as gold, rubber and oil.
Commodity markets are heavily regulated. In the United States, the principal regulator of commodity and futures markets is the Commodity Futures Trading Commission (CFTC). The National Futures Association (NFA) formed in 1976 and is the futures industry’s self-regulatory organization. The NFA’s first regulatory operations began in 1982 and fall under the Commodity Exchange Act of the Commodity Futures Trading Commission Act.
In Europe, commodity markets are regulated by the European Securities and Markets Authority (Esma), based in Paris and formed in 2011. Esma sets position limits on commodity derivatives.
Closed Purchases
Not all natural resources can be acquired on commodity markets. Some must be acquired through direct purchases without the use of an intermediary clearing house. One example is for land. Land is one of the three factors of production, can be used to mine other natural resources and is absolutely necessary if a person wants to have a “brick and mortar” location where they can sell their goods. Land cannot be acquired through a commodity market, but must be obtained through an agreement with someone who owns the land. A person can either purchase the land outright or become a tenant of the person who owns the property.
The challenge of this process is that for these closed deals, the producer has to find the resource that they need, determine who owns it, and then negotiate with that person to obtain the resource. These costs can make these natural resources more expensive.
Key Points
• Land includes the site where goods are produced as well as all the minerals below and above the site.
• Labor includes all human effort used in production as well as the necessary technical and marketing expertise.
• Capital are the human-made goods used in the production of other goods, such as machinery and buildings. It does not include cash.
• The exports of a capital -abundant country will be from capital-intensive industries, and relatively labor -abundant countries will import such goods, exporting labor intensive goods in return.
• In the long-run, entities will specialize in what costs them comparatively less to produce.
• If one factor of production becomes more plentiful, and therefore cheaper, it will cause production of the good that relies on that factor to increase.
• When firms have positive net marginal products of resources, the demand for the resource will increase.
• Some resources are subject to the typical market constraints of supply and demand.
• Some resources are public goods, which means that they could be depleted if firms that have positive net marginal products from the resource are not regulated.
• Firms hire workers when they have higher marginal productivity than marginal cost.
• Workers are often categorized as either skilled or unskilled workers. Firms only hire the type of workers they need.
• If, on aggregate, there is a higher demand for skilled workers than unskilled workers, skilled workers will gain proportionally more income as their wages rise.
• In primary markets, new stock or bond issues are sold to investors, often via a mechanism known as underwriting. In the secondary markets, existing securities are sold and bought among investors or traders.
• The money markets are used for the raising of short term finance, sometimes for loans that are expected to be paid back as early as overnight. Capital markets are used for the raising of long term finance.
• Regular bank lending is not usually classed as a capital market transaction, even when loans are extended for a period longer than a year.
• There are two types of commodities. Hard commodities are mined and soft commodities are agricultural products.
• There are approximately 50 commodity markets worldwide. In general, these markets deal in purely financial transactions instead of outright purchases of goods. These financial transactions are known as financial derivatives.
• In the United States, the principal regulator of commodity and futures markets is the Commodity Futures Trading Commission (CFTC). The National Futures Association (NFA) formed in 1976 and is the futures industry’s self-regulatory organization.
Key terms
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
• comparative advantage: The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.
• marginal productivity: The extra output that can be produced by using one more unit of the input
• capital market: The market for long-term securities, including the stock market and the bond market.
• commodity: Raw materials, agricultural and other primary products as objects of large-scale trading in specialized exchanges.
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• Factors of production. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Factors...on%23Classical. License: CC BY-SA: Attribution-ShareAlike
• capital. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/capital. License: CC BY-SA: Attribution-ShareAlike
• Rybczynski theorem. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Rybczynski_theorem. License: CC BY-SA: Attribution-ShareAlike
• Heckscher-Ohlin model. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Hecksch...3Ohlin_theorem. License: CC BY-SA: Attribution-ShareAlike
• Comparative advantage. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Comparative_advantage. License: CC BY-SA: Attribution-ShareAlike
• Boundless. Provided by: Boundless Learning. Located at: www.boundless.com//business/d...tive-advantage. License: CC BY-SA: Attribution-ShareAlike
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Capital and Technology
Firms add capital to the point where the value of marginal product of capital is equal to the rental rate of capital.
learning objectives
• Analyze how firms determine the amount of capital to use in production.
Capital is a factor of production, along with labor and land. It consists of the infrastructure and equipment used to produce goods and services. Capital can include factory buildings, vehicles, plant machinery, and tools used in the production process. Firms may buy, rent, or lease infrastructure and tools in the capital market, but even if the firm owns these factors of production, the opportunity cost of using this capital is the foregone rent that the firm could receive if it rented the capital to somebody else rather than using it for production. Because of this, we say that the price of capital is the rental rate.
A firm decides how much of each factor input to use and how much output to produce based on the market prices for outputs and inputs, as well as exogenous technological determinants represented by the production function. The production function describes the relationship between the quantity of inputs used in production and the quantity of output. It can be used to derive the marginal product for capital, which is the increase in the amount of output from an additional unit of capital. The value of marginal product (VMP) of capital is the marginal product of capital multiplied by price. The downward-sloping demand curve for capital, which is equal to the VMP of capital, reflects the fact that the production process exhibits diminishing marginal product. A firm will continue to add capital up to the point where the rental rate is equal to the value of marginal product of capital, which is the point of equilibrium.
Firm Demand for Capital: Firms will increase the quantity of capital hired to the point where the value of marginal product of capital is equal to the rental rate of capital.
Total Factor Productivity
Total factor productivity, which captures how efficiently inputs are utilized, is a key indicator of competitiveness.
learning objectives
• Discuss the importance of Total Factor Productivity in comparing firms, industries, and countries.
Total factor productivity measures the residual growth in total output of a firm, industry, or national economy that cannot be explained by the accumulation of traditional inputs such as labor and capital. Increases in total factor productivity reflect a more efficient use of inputs, and total factor productivity is often taken as a measure of long-term technological change or dynamism brought about by such factors as technical innovation.
Total Factor Productivity: Total output is not only a function of labor and capital, but also of total factor productivity, a measure of efficiency.
Total factor productivity cannot be measured directly. Instead, it is a residual which accounts for effects on total output not caused by inputs. In the Cobb-Douglas production function, total factor productivity is captured by the variable A:
\[Y=AK^αL^β\]
In the equation above, Y represents total output, K represents capital input, L represents labor input, and alpha and beta are the two inputs’ respective shares of output. An increase in K or L will lead to an increase in output. However, due to to the law of diminishing returns, the increased use of inputs will fail to yield increased output in the long run. The quantity of inputs used thus does not completely determine the amount of output produced. How effectively the factors of production are used is also important. Total factor productivity is less tangible than capital and labor inputs, and it can account for a range of factors, from technology, to human capital, to organizational innovation.
Total factor productivity can be used to measure competitiveness. The higher a country’s total factor productivity, the more competitive it is likely to be (subject to constraints such as resources). It is also generally viewed as one of the main vehicles for driving economic growth.
When a country is able to increase its total factor productivity, it can yield higher output with the same resources, and therefore drive economic growth.
Changes in Technology Over Time
Technological improvement improves the efficiency of production, which increases supply and lowers prices.
learning objectives
• Summarize how changes in technology affect a firm’s decision to produce.
Factors of production typically include land, labor, capital, and natural resources. These inputs are used directly to produce a good or service. Technology, on the other hand, is used to put these factors of production to work. A firm doesn’t purchase additional units of technology to feed into the production process in the same way that a firm might hire more labor in order to increase output. Instead, the technology available in a particular industry or economy allows firms to use labor and capital more or less efficiently. It is important to note that advances in technology are a result of innovation, innovative practices such as process changes are also worth mentioning in this context. Innovation is the driving economic force behind these leaps in efficiency.
Technological change is a term used to describe any change in the set of feasible production possibilities. A change in technology alters the combinations of inputs or the types of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed. If the cost of production is lower, the profits available at a given price will increase, and producers will produce more. With more produced at every price, the supply curve will shift to the right, meaning an increase in supply and a decrease in prices. For the economy as a whole, an improvement in technology shifts the production possibilities frontier outward.
Production Possibility Frontier (PPF): An increase in technology that allows for greater output based upon the same inputs can be described as an outward shift of the PPF, as demonstrated in this figure.
The invention and popularization of the assembly line is an example of process change, which is worth mentioning in context with technological change. Innovative practices to how we do this is an example of the way in which output can be increased with the same input, and is often discussed in conjunction with technological innovation. During the industrial revolution, many products that had previously been created by hand by a single person or a team of craftsmen began to be manufactured instead in factories in which each worker performed one simple operation. This meant that companies could produce much more output using the same amount of raw materials, capital, and labor. Supply of these goods increased, and the production possibilities curve for the entire economy shifted outwards.
Technological change in the computer industry has resulting in a shift of the computer supply curve. Due to advances in technology, computers can now be manufactured more cheaply, even though they continue to grow smaller, faster, and more powerful. Producers respond to the cheaper production process by increasing output, shifting the supply curve outwards. Thus, the number of computers produced increases and the price of computers falls.
Key Points
• Capital is the infrastructure and equipment used to produce goods and services.
• The production function describes the relationship between the quantity of inputs used in production and the quantity of output. It can be used to derive the marginal product for capital.
• The value of marginal product (VMP) of capital is the marginal product of capital multiplied by its price. The firm ‘s demand curve for capital is derived from the VMP of capital.
• Total factor productivity measures the residual growth in total output of a firm, industry, or national economy that cannot be explained by the accumulation of traditional inputs such as labor and capital.
• Total factor productivity cannot be measured directly. Instead, it is a residual which accounts for effects on total output not caused by inputs.
• Total factor productivity is considered one of the key indicators of competitiveness. It is also accepted by economics as the main contributing factor to economic growth.
• The technology available in a particular industry or economy allows firms to use labor and capital more or less efficiently.
• A change in technology alters the combination of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed.
• If the cost of production is lower, the profits available at a given price will increase, and producers will produce more.
• While we usually think of technology as enhancing production, declines in production due to problems in technology are also possible.
Key Terms
• Production function: Relates physical output of a production process to physical inputs or factors of production.
• Value of marginal product of capital: The marginal product of capital multiplied by its price.
• Total factor productivity: A variable which accounts for effects in total output not caused by traditionally measured inputs of labor and capital.
• input: Something fed into a process with the intention of it shaping or affecting the outputs of that process.
• assembly line: A system of workers and machinery in which a product is assembled in a series of consecutive operations; typically the product is attached to a continuously moving belt
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Asymmetric Information: Adverse Selection and Moral Hazard
Asymmetric information, different information between two parties, leads to the following – adverse selection, moral hazards, and market failure.
learning objectives
• Examine the concept of adverse selection in the context of imperfect information
Asymmetric Information
Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power. For example, when you are trying to negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not know the minimum you will be willing to accept.
Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead to market failure.
Adverse Selection
Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of goods or services in a market to shift. This results in “bad” products or services being selected. For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers. The individual price would generate a low profit for the bank.
Moral Hazards and Market Failure
In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk. A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk. For example, moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision making will occur.
Moral Hazard: An insured driver getting into a car accident is an example of a moral hazard. The driver will take risks because the cost is not directly felt due to a transaction. The insurance company pays for the accident and not the driver.
Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure. A market failure is any scenario where an individual or firm’s pursuit of pure self interest leads to inefficient results.
Principle-Agent Problem
The principle-agent problem (agency dilemma) exists when conflicts of interest arise between a principal and an agent in a business setting.
learning objectives
• Explain the Principal-Agent Problem
Principal-Agent Problem
In economics, the principal-agent problem (also known as an agency dilemma) exists when conflicts of interest arise between a principal and an agent in a business setting. Conflicts usually exist when contracts are written due to uncertainty and risk taken on by both parties. The principal hires the agent to perform specific to duties that represent its best interest. The work that is performed can be costly to the agent and not in the principal’s best interest. In short, the work done by the agent doesn’t actually reflect the best interests of the principal. Examples of relationships that can experience the principal-agent problem include:
Principle agent problem: The diagram shows the basic idea of the principle agent problem. P is the principle and A is the agent. It clearly illustrates the working relationship between the principle and the agent while highlighting the presence of business partnership as well as self-interest.
• Management (agent) and shareholders (principal)
• Politicians (agent) and voters (principal)
The conflict of interest potentially arises in almost any context where one party is being paid by another to do something, whether it is in formal employment or a negotiated deal. The two parties have different interests and asymmetric information. The deviation of the agent from the principals interest is referred to as “agency costs.”
Contract Design
In order to minimize and control economic conflict, principals and agents design and agree on a contract. It serves as a guide and agreement to safeguard the best interests of both parties. The linear model is used to determine incentive compensation in a contract: \(w=a+b(e+x+gy)\).
In the linear model w is the wage, a is a constant, e is the unobserved effort, x is the unobserved exogenous effects on outcomes, and y is the observed exogenous effects; while g and a represent the weight given to y, and the base salary.
A business contract creates a straightforward connection between agent performance and profitability. This connection sets the standard for judging the performance of the agent.
Performance Evaluation
In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties. There are two forms of performance evaluation:
• objective performance evaluation – takes into account how fast a task can be completed. The evaluation compares the performance of an agent by comparing the work completed by peers within the industry.
• subjective performance evaluation – involves the principal directly evaluating the performance of the agent. In this case, the evaluation is based on opinions instead of observations or reasoning..
Incentive Structures
Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.
Principals offer various incentive structures, which are rewards or motivating factors that drive the agent to work in the best interest of the principal and complete tasks efficiently. Incentive structures include price rates/commissions, profit sharing, and efficiency wages.
It is usually in best interest of both parties to work together. For the principal, agent inefficiency results in sub-optimal results and low welfare. For the agent, efficiency is important in order to receive payment for work completed.
Public Choice: Median Voters and Inefficient Voting Outcomes
Public choice may not lead to an economically efficient outcomes due to who votes, why they vote, and in what system they vote.
learning objectives
• Use the Condorcet paradox to evaluate voting systems
A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum. The system enforces rules to ensure valid voting, accurate tabulation, and a final result. Common voting systems include majority rule, proportional representation, or plurality voting. The study of voting systems is called voting theory. Voting theory is a subfield of economics.
Public Choice Theory
No matter what voting system is used, the act of voting gives the public the ability to choose a candidate or influence a decision. Obviously, when voting takes place not everyone will agree with the outcome, but everyone has the ability to participate in the process. Public choice is described as “the use of economic tools to deal with traditional problems of political science.” In microeconomics, public choice analyses collective decision making and studies economic models of political processes including rent-seeking, elections, legislatures, and voting behavior.
Since not every voter participates in an election, not every voter will have full information, and not every voter will vote based on what s/he perceives as the best long-term outcome, voting outcomes may be inefficient. Elections do not necessarily reflect the best long-term outcome, what the active voters thought was best given their criteria at the time.
Condorcet Paradox
The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another. Conflicting majorities are made up of different groups of individuals. For example, the Condorcet paradox can be compared to the game rock/paper/scissors. For each candidate, there can be another that is preferred by some majority. The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates. Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, etc.
An example of a voting paradox can be seen in a simple voting scenario. There are three candidates including 1, 2, and 3. There are three voters with preferences. Each voter ranks the candidates from most to least favored. If the results are determined and 3 is the winner, it can be argued that another candidate should have won due to the number of preferred votes verse the first choice of each voter. In this case, the requirement of majority rule does not provide a clear winner. According to the Condorcet paradox additional methods would be needed to determine the winner since the voting process is complex and each voter provides preferences instead of only selecting one candidate.
Preferential voting ballot: The Condorcet paradox is used to evaluate voting systems. Voters rank candidates according to their own preferences. The Condorcet method states that a candidate wins by majority rule.
The Condorcet paradox means that there is not a clear winner and ambiguities must be resolved to determine the election results.
Behavioral Economics: Irrational Actions
Behavioral economics is the study of the effects of social, cognitive, and emotional facts on the financial decisions of individuals and institutions.
learning objectives
• Paraphrase the history and characteristics of behavioral economics
Behavioral economics is the study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions. It also studies the consequences for market prices, returns, and resource allocation. Behavioral economics focuses on the bounds of rationality of economic agents.
Characteristics
Behavioral economics has specific characteristics based on what is studied. Areas of focus include:
• Behavioral finance: the intent is to explain why market participants make systematic errors. Errors impact prices and returns which the create market inefficiencies. It also looks at how other participants take advantage of market inefficiencies.
• Financial models: some financial models used in money management incorporate behavioral financial parameters. Examples of areas studied include overreaction and irrational purchasing habits.
• Behavioral game theory: analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology. Studies interactive learning, social preferences, altruism, framing, and fairness.
There are many aspects in behavioral economics, and three of the most prevalent are:
• Heuristics: people make decisions based on approximate rules and not strict logic.
• Framing: using a collection of anecdotes and stereotypes that make up the mental and emotional filters that individuals rely on the understand and respond to events.
• Market inefficiencies: include the study non-rational decision making and incorrect pricing.
Behavioral economics focuses on the study of how and why individuals and institutions make economic decisions.
Decision making: This graph shows the three stages of rational decision making that was devised by Herbert Simon, a notable economist and scientist.
History
Behavioral economics was born out of the combination of economics and psychology. By 1979, economists used cognitive psychology to explain economic decision making, which included an editing stage and an evaluation stage. The editing stage simplified risky situations using heuristics of choice. The evaluation stage evaluated risky alternatives through the study of dependence, loss aversion, non-linear probability weighting, and sensitivity to gains and losses. Throughout its history, behavioral economics has studied the economic choices of individuals and institutions by analyzing psychology against economic research. The study of behavioral economics shows both the strengths and weaknesses in decision making tendencies and how the decisions impact economic choices.
Government Failure
Government failure occurs when possible interventions are not analyzed before action is taken regarding market inadequacies.
learning objectives
• Analyze situations in which the government has failed to act in an economically optimal way
Government Failure
Government failure, also known as non-market failure, is the public sector version of market failure. The market fails and government intervention causes a more inefficient allocation of goods and resources than would occur without the intervention. It occurs when the market inadequacies are not compared and analyzed against possible interventions before action is taken. Government failure can be described as providing “only limited help in prescribing therapies for government success.”
The Public Sector: This graph shows the layers of the government. The government is tied directly to the public sector. Government failure is an analogy made by the public sector when market failure occurs.
A government failure is not the failure of the government to enact a solution to a failure, but rather it is a systematic problem that prevents an efficient government solution to the problem. Government failures can occur in relation to both supply and demand within a market. Demand failures are the result of preference/revelation problems and the imbalance of voting and collective behavior. Supply failures are usually the result of principal-agent problems. In this case, the failure occurs in trying to get one party (agent) to work in the best interest of another party (principal).
Economic Crowding Out
There are specific scenarios that are directly associated with government failure. Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue which crowds out private sector investment due to higher interest rates. Government spending also crowds out private spending.
Government Regulation
When analyzing government failure, inefficient regulation contributes to market failure. The are three specific regulatory inefficiencies:
• Regulatory arbitrage occurs when a regulated institution takes advantage of the difference between its real risk and the regulatory position.
• Regulatory capture occurs when regulatory agencies co-opt whether its the members or the entire regulated industry. Mechanisms that allows regulatory capture include rent seeking and rational ignorance.
• Regulatory risk is a risk faced by private sector firms when there is a chance that regulatory changes will negatively affect their business.
Recent evidence has suggested that even when democracies are economically stable, transparency, media freedom, and a larger government all contribute to increased government corruption. Government corruption leads to both market and government failure.
Key Points
• Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information, also known as asymmetric information.
• Asymmetric information causes an imbalance of power.
• A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk.
• A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure.
• A business contract creates a straightforward connection between agent performance and profitability.
• In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties.
• Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.
• A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum.
• The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another.
• The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates.
• Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, ect.
• Behavioral economics studies the consequences for market prices, returns, and resource allocation. It focuses on the bounds of rationality of economic agents.
• Behavioral economics analyzes behavioral finance, financial models, and the behavioral game theory in order to gain insight into why certain economic decisions are made.
• Three prevalent themes in behavioral economics are heuristics, framing, and market inefficiencies, though there are many more.
• Throughout its history, behavioral economics has analyzed psychology and economic findings to determine how and why economic decisions are made. Areas of focus included fairness, justice, and utility.
• Government failure, also known as non- market failure, is the public sector version of market failure.
• Government failures can occur in relation to both supply and demand within a market.
• Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue.
• Inefficient government regulation contributes to market and government failure.
Key Terms
• moral hazard: A situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk.
• adverse selection: The process by which the price and quantity of goods or services in a given market is altered due to one party having information that the other party cannot have at reasonable cost.
• subjective: Formed, as in opinions, based upon a person’s feelings or intuition, not upon observation or reasoning; coming more from within the observer than from observations of the external environment.
• Objective: Agreed upon by all parties present (or nearly all); based on consensually observed facts.
• incentive: Something that motivates, rouses, or encourages.
• paradox: A counter-intuitive conclusion or outcome.
• public choice theory: The use of modern economic tools to study problems that traditionally are in the province of political science.
• voting system: A system used to determine the result of an election based on voters’ preferences.
• behavioral economics: Study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and resource allocation.
• heuristic: Relating to general strategies or methods for solving problems.
• expenditure: Act of expending or paying out.
• arbitrage: Taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance; the profit made between price differences.
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What Taxes Do
On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government.
learning objectives
• Explain the role of taxation with respect to consumer and firm behavior
Taxes are the primary source of revenue for most governments. They are simply defined as a charge or fee on income or commerce. Taxes are most readily understood from the perspective of income taxes or sales tax, although there are many other types of taxes levied on both individuals and firms.
Necessarily, taxes raise the price of purchasing the good or resource for firms and consumers. As a result, the quantity demanded and supplied reacts according to the supply and demand curves.
Tax Authority
In the United States, Congress has the power to tax as stated in The United States Constitution, Article 1, Section 8, Clause 1: “The Congress shall have the Power to lay and collect Taxes, Duties, Imposts, and Excises to pay the Debts and provide for the common Defense and general Welfare of the United States.” This power was reinforced in the Sixteenth Amendment to the Constitution: “The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”
It is important to note that Congress has delegated to the Internal Revenue Service (IRS) the responsibility of administering the tax laws, known as the Internal Revenue Code (the Code). Congress enacts these tax laws, and the IRS enforces them. Individual states also have the power to tax as do smaller government entities such as towns, cities, counties, and municipalities.
Purpose of Taxation
On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government including but not limited to public buildings, military, national parks, and public welfare in the form of transfer payments. Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks. However, governments also use taxes to establish income equity and modify consumption decisions.
Income and Outlays (IRS Publication 2105; Rev 3-2011): Tax revenue is used by the government to support services and activities available to all residents.
Sources of Tax Revenue: Income Taxation
Governments use different kinds of taxes and vary the tax rates. This is done to distribute the tax burden among individuals or classes of the population involved in taxable activities, such as business, or to redistribute resources between individuals or classes in the population. This type of taxation is referred to as progressive taxation because the tax liability increases in proportion to income.
Sources of Tax Revenue: Sales Taxes
Sales taxes are borne by the consumer when s/he purchases certain goods. It is an ad valorem tax: the charged value is based on the value of what is being sold. This is in contrast to an excise tax, where the charged value is based on the number of items being sold.
Sales tax is a form of regressive taxation; the liability is based on the percentage of income consumed, which is higher for low income earners. As a result, individuals earning a relatively lower income will pay a higher proportion of income in the form of sales tax, defining the regressive nature of the tax. Though a general revenue source, sales taxes are also used to modify behavior. For example taxes on cigarettes are meant to dissuade purchase due to the inherent health implications of smoking.
How Taxes Impact Efficiency: Deadweight Losses
In economics, deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal.
learning objectives
• Discuss how taxes create deadweight loss
Deadweight Loss
In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal (resource allocation where it is impossible to make any one individual better off without making at least one individual worse off). Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition (where supply and demand are equal) and include taxes or subsidies and binding price ceilings or floors (including minimum wages). Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.
Harberger’s Triangle, Taxes, and Deadweight Loss
Harberger’s triangle, generally attributed to Arnold Harberger, refers to the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market. This can happen through price floors, caps, taxes, tariffs, or quotas. In the case of a tax on the supplier of a good, the supply curve will shift inward in proportion to the tax and resulting in a non-market clearing level of supply. As a result, the price of the good increases and the quantity available decreases.
Taxation and Deadweight Loss: Taxation can be evaluated as a non-market cost. In this case imposition of taxes reduces supply, resulting in the creation of deadweight loss (triangle bounded by the demand curve and the vertical line representing the after-tax quantity supplied), similar to a binding constraint.
Harberger’s Triangle: Deadweight loss, represented by Harberger’s triangle, is the yellow triangle. It represents lost efficiency.
The area represented by the Harberger’s triangle results from the intersection of the supply and demand curves above market equilibrium resulting in a reduction in consumer surplus and producer surplus relative to their value before the imposition of the tax. The loss of the surplus, not recouped by tax revenues, is deadweight loss.
Some economists have argued that these triangles do not have a huge impact on the economy, whereas others maintain that they can seriously affect long term economic trends by pivoting the trend downwards, causing a magnification of losses in the long run.
Key Points
• Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks.
• Taxes are the primary source of revenue for most governments.
• Governments also use taxes to establish income equity and modify consumption decisions.
• Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition and include taxes.
• Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.
• Harberger’s triangle refers to the deadweight loss associated with government intervention in a perfect market.
Key Terms
• sales tax: A local or state tax imposed as a percentage of the selling price of goods or services payable by the customer. The tax is not recognized as the seller’s earnings; the seller only collects the tax and transmits the same to local or state authorities.
• progressive tax: A tax by which the rate increases as the taxable base amount increases.
• regressive tax: A tax imposed in such a manner that the rate decreases as the amount subject to taxation increases.
• income tax: A tax levied on earned and unearned income, net of allowed deductions.
• Pareto optimal: Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.
• deadweight loss: A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.
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How Taxes Work in the United States
Tax laws are passed by Congress and enforced by the Internal Revenue Service (IRS) at the federal level.
learning objectives
• Discuss the United States taxation process and the legislature involved
There are three levels of government in the United States: the federal government, state governments, and local governments. Each has its own authority to tax. For example, states can set their own sales and payroll taxes that apply only within the state. Similarly, local governments can impose a variety of taxes, such as property taxes. Since the taxation process varies on the state and local level, we will focus on the federal level.
IRS: The IRS is responsible for interpreting and enforcing tax legislation passed by Congress. The IRS taxes only realized returns, though financial reports must also include unrealized returns on the balance sheet.
Federal taxes are created by the US Congress, which passes laws mandating what is taxed and the amount of the tax. One of the most well-known taxes, the federal income tax, wasn’t created until the passage of the 16th amendment in 1913 explicitly gave the US Congress the authority to tax income. Congress then takes the tax revenue and apportions it through its power to create and manage the federal budget.
Congress is not the body, however, that actually collects taxes. That duty is charged to the Internal Revenue Service (IRS), a part of the Department of the Treasury. The IRS is responsible for ensuring that companies and individuals pay the taxes they are legally obligated to.
The IRS also has some power in determining exactly how the tax laws passed by Congress are interpreted and enforced. For example, Congress may say that depreciation will be an allowable expense “in accordance with regulations to be established by the IRS. ” This allows the IRS to articulate the conditions under which depreciation is considered an allowable expense. At the same time, the IRS must also interpret the laws passed by Congress to determine what the law was intended to mean for a given organization or individual.
As would be expected with any law or interpretation of a law by a government body, there are disputes. Disputes over tax rules are generally heard in the United States Tax Court before the tax is paid, or in a United States District Court or United States Court of Federal Claims after the tax is paid. Tax laws are treated like any other piece of legislation in that there is a judicial process for resolving disputes.
Key Points
• There are federal, state, and local taxes in the US.
• Congress passes federal tax laws that are then interpreted and enforced by the IRS.
• The US judicial system is employed to handle tax disputes by companies or individuals.
Key Terms
• Congress: The two legislative bodies of the United States: the House of Representatives, and the Senate.
• Internal Revenue Service: The United States government agency that collects taxes and enforces tax laws.
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Comparing Marginal and Average Tax Rates
Taxes can be evaluated based on an average impact or a marginal impact and can be categorized as progressive, regressive, or proportional.
learning objectives
• Calculate the average tax rate and marginal tax rate
Average and marginal tax rate
An average tax rate is the ratio of the total amount of taxes paid, T, to the total tax base, P, (taxable income or spending), expressed as a percentage. If a company pays different rates on the first $100,000 in earning than the next$100,000, it will sum up the total tax paid and divide it by $200,000 to calculate the average tax rate. T/P = average tax rate The marginal tax rate is sometimes defined as the tax rate that applies to the last (or next) unit of the tax base (taxable income or spending), it is in effect, the tax percentage on the highest dollar earned. For example, if a company pays 5% tax on its first$100,000 earned, and 10% on the next $100,000, the marginal tax rate of earning the$101,000th dollar is 10%.
Broadly, the marginal tax rate equals the change in taxes, divided by the change in tax base, expressed as a percentage.
$\dfrac{\text{change in T}}{\text{change in P}} = \text{marginal tax rate}$
Progressive tax
A progressive tax is a tax in which the tax rate increases as the taxable base amount increases. The term “progressive” describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate. The term can be applied to individual taxes or to a tax system as a whole; a year, multi-year, or lifetime. Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a lower ability-to-pay, as such taxes shift the incidence increasingly to those with a higher ability-to-pay. The opposite of a progressive tax is a regressive tax, where the relative tax rate or burden increases as an individual’s ability to pay it decreases.
Progressive taxation: Graph demonstrates a progressive tax distribution on income that becomes regressive for top earners.
Regressive tax
A regressive tax is a tax imposed in such a manner that the average tax rate decreases as the amount subject to taxation increases. “Regressive” describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, where the average tax rate exceeds the marginal tax rate. In terms of individual income and wealth, a regressive tax imposes a greater burden (relative to resources) on the poor than on the rich — there is an inverse relationship between the tax rate and the taxpayer’s ability to pay as measured by assets, consumption, or income.
Proportional tax
A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. “Proportional” describes a distribution effect on income or expenditure, referring to the way the rate remains consistent (does not progress from “low to high” or “high to low” as income or consumption changes), where the marginal tax rate is equal to the average tax rate.
Tax Incidence, Efficiency, and Fairness
Tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare.
learning objectives
• Identify who bears the tax burden in various scenarios
In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of economic welfare. Tax incidence is said to “fall” upon the group that ultimately bears the burden of, or ultimately has to pay, the tax. The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply.
Tax incidence does not consider the concept of tax efficiency or the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of a tax. For example, United States Social Security payroll taxes are paid half by the employee and half by the employer. However, some economists think that the worker is bearing almost the entire burden of the tax because the employer passes the tax on in the form of lower wages. The tax incidence is thus said to fall on the employee and due to the need for workers for a particular job, the tax burden also falls, in this case, on the worker.
Example of Tax Incidence
Imagine a $1 tax on every barrel of apples an apple farmer produces. If the product (apples) is price inelastic to the consumer (whereby if price rose, a small demand loss would be accounted for by the extra revenue), the farmer is able to pass the entire tax on to consumers of apples by raising the price by$1. In this example, consumers bear the entire burden of the tax; the tax incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices because the product is price elastic (if prices rose, more demand would be lost than extra revenue gained), the farmer has to bear the burden of the tax or face decreased revenues: the tax incidence falls on the farmer. If the apple farmer can raise prices by an amount less than $1, then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the farmer, this burden will typically flow back to owners of the relevant factors of production, including agricultural land and employee wages. Shared tax incidence: The imposition of a tax can result in a reduction to both consumer and producer surplus relative to the pre-tax scenario. Where the tax incidence falls depends (in the short run) on the price elasticity of demand and price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price (the group that has the most inelastic price-quantity curve). If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be borne disproportionately by the seller. Tax efficiency In the example provided, the tax burden falls disproportionately on the party exhibiting relatively more inelasticity in the situation. This characteristic results in a reduction of the ability of the party to participate in the market to the level of willingness that would have been present in the absence of the tax. The loss is conceptually defined as a loss of surplus and the loss of surplus is characterized as deadweight loss. Policy makers evaluate the surplus and deadweight loss in relation to the imposition of a tax in order to better evaluate the efficiency of a tax or the distortion that the imposed tax causes on the attainment of market equilibrium. Policymakers must consider the predicted tax incidence when creating them. If taxes fall on an unintended party, it may not achieve its intended objective and may not be fair. Tax Incidence and Elasticity Tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. learning objectives • Explain how elasticity influences the relative tax burden between suppliers and consumers (demand). Tax incidence refers to who ultimately pays the tax, the producer or consumer, and the resulting societal effect. Tax incidence is said to “fall” upon the group that ultimately bears the burden of, or ultimately has to pay, the tax. The key concept is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. Inelastic Supply, Elastic Demand If a producer is inelastic, he will produce the same quantity no matter what the price. If the consumer is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. Tax: Inelastic supply and elastic demand: In a scenario with inelastic supply and elastic demand, the tax burden falls disproportionately on suppliers. The imposition of the tax causes the market price to increase from P without tax to P with tax and the quantity demanded to fall from Q without tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the producer is inelastic, the price does not change much. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer. In this example, the tax is collected from the producer and the producer bears the tax burden. Comparable Elasticities In most markets, elasticities of supply and demand are fairly similar in the short-run, as a result the burden of an imposed tax is shared between the two groups albeit in varying proportions. Tax: Similar elasticity for supply and demand: When a tax is imposed in a scenario where demand and supply exhibit similar elasticities, the tax burden is shared. In general, the tax burden will be greater for the group exhibiting the greater relative inelasticity. Trading off Equity and Efficiency Taxes may be considered equitable if they are administered in accordance with the definition of either horizontal or vertical equity. learning objectives • Explain tax equity in relation to the progressive, proportional, and regressive nature of taxes. In public finance, horizontal equity conforms to the concept that people with a similar ability to pay taxes should pay the same or similar amounts. It is related to tax neutrality or the idea that the tax system should not discriminate between similar things or people, or unduly distort behavior. Vertical equity usually refers to the idea that people with a greater ability to pay taxes should pay more. Horizontal Equity, Vertical Equity, and Taxes Income taxes are a laddered progressive tax where income tax rates are set in income bands or ranges. Each tax rate corresponds to a particular income range; income above a tax range is subject to a higher tax rate that corresponds to a higher income range and income below a specific range is subject to a lower tax rate, similarly identified with a lower income range. Within any given income range, the tax rate is the same. The income range conforms with the idea that the individuals included within it are similar with respect to their ability to pay. The range can be identified as conforming to the concept of horizontal equity. Vertical equity follows from the laddering of income tax to progressively higher rates. The laddering of income taxes conforms to the underlying definition of vertical equity, as those who have a greater ability to pay tax, pay a higher proportion of their income. Proportional taxes, conform to horizontal equity. By definition proportional taxes are levied in proportion to income. However, income taxes are only proportional within specific income ranges. At the highest income tax rate, income taxes can become regressive, since high earners are only subject to a constant albeit highest rate on their income. For example, income from$500,000 and above will be subject to the same rate, making the overall tax burden as a proportion of income higher for the individuals on the starting point of the range.
Income tax: Income tax is a progressive tax that assumes a regressive nature at the highest tax rate.
Tax efficiency and tax equity
The purpose of a progressive tax system is to increase the tax burden to those most able to pay. However, some policy makers believe that progressive taxation is an overall inefficiency within the tax structure. These individuals and groups support a flat tax or proportional tax instead. Their argument for a tax modification is related to the view that increasing the tax rate in conjunction with income creates a disincentive to individuals to earn more and is, as a result, punitive to those that achieve income related success. The net result from this reasoning is that progressive taxation results in lower GDP than would have resulted in a proportional tax regime, also referred to as a loss of economic efficiency.
Key Points
• An average tax rate is the ratio of the total amount of taxes paid, T, to the total tax base, P, whereas the marginal tax rate equals the change in taxes, divided by the change in tax base.
• A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The average tax rate equals the marginal tax rate.
• A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. The average tax rate is higher than the marginal tax rate.
• A progressive tax is a tax in which the tax rate increases as the taxable base amount increases. The average tax rate is lower than the marginal tax rate.
• Tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply.
• Tax incidence falls mostly upon the group that responds least to price (the group that has the most inelastic price-quantity curve).
• If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be born disproportionately by the seller.
• If a producer (consumer) is inelastic, it will produce (demand) the same quantity no matter what the price.
• If the producer (consumer) is elastic, the producer (consumer) is very sensitive to price.
• The sensitivity between quantity and price will determine the proportion of tax incidence between producers and consumers of a good.
• Horizontal equity conforms to the concept that people with a similar ability to pay taxes should pay the same or similar amounts.
• Vertical equity usually refers to the idea that people with a greater ability to pay taxes should pay more.
• Income taxes are incorporate both horizontal and vertical equity via a progressive tax mechanism. Sales taxes are regressive and are considered inequitable.
Key Terms
• average tax rate: The ratio of the amount of taxes paid to the tax base (taxable income or spending).
• marginal tax rate: The tax rate that applies to the last unit of currency of the tax base (taxable income or spending), and is often applied to the change in one’s tax obligation as income rises.
• elastic: Sensitive to changes in price.
• tax: Money paid to the government other than for transaction-specific goods and services.
• inelastic: Not sensitive to changes in price.
• inelasticity: The insensitivity of changes in a quantity with respect to changes in another quantity.
• elasticity: The sensitivity of changes in a quantity with respect to changes in another quantity.
• progressive tax: A tax by which the rate increases as the taxable base amount increases.
• income tax: A tax levied on earned and unearned income, net of allowed deductions.
• equity: Justice, impartiality or fairness.
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Financing the US Government
Taxes are the primary source of government revenue.
learning objectives
• Identify the basis for taxation.
Financing of Government Expenditures
Taxation is the central part of modern public finance. The importance of taxation arises from the fact that it is by far the most significant source of government revenue and is therefore the primary means of financing government expenditures.
Taxation authority: In the United States the Internal Revenue Service is the regulatory authority empowered by Congress to collect taxes.
Due to the pervasive nature of taxation, taxes can be used as an instrument of attaining certain social objectives. For example, income taxes due to their progressive nature are used to equitably derive revenue by differentiating tax rates by income strata. The income derived in this manner is then used to transfer income to lower income groups, thereby, reducing inequalities related to income and wealth.
Taxation is also used as part of fiscal policy to stabilize the economy. Increasing taxes can reduce consumption and lead to economic slowing when the economy may be growing too quickly. Alternatively, decreasing taxes can be a mechanism to promote economic growth by increasing the funds available for consumption and investment spending. It is important to note that when the government spends more than the tax revenue it collects, the government is operating at a deficit and will have to borrow funds to finance operations until taxes can be increased to return the government spending to a balanced budget.
Types of Taxes
The US government imposes a number of different types of taxes in order to finance its operations. The following is a list of taxes in common use by governmental authorities:
• Excise tax: tax levied on production for sale, or sale, of a certain good.
• Sales tax: tax on business transactions, especially the sale of goods and services.
• Corporate income tax: tax on a company’s profits.
• Income tax: tax on an individual’s wages or salary.
• Capital gains tax: tax on increases in the value of owned assets.
Financing State and Local Government
Taxes are the primary source of revenue for state and local governments; income, property, and sales taxes are common examples of state and local taxes.
learning objectives
• Give an example of federal, state, and local taxes
Taxes are important to federal, state, and local governments. They are the primary source of revenue for the corresponding level of government and fund the activities of the governmental entity. For example, on a local level, taxes fund the provision of common services, such as police or fire department, and the maintenance of common areas, such as public parks. On a state level, taxes fund the school systems, including state universities. On a federal level, taxes are used to fund government activities such as the provision of welfare and transfer payments to redistribute income.
Pearl Hill State Park: State parks like Pearl Hill, located in Townsend, Massachusetts, rely on tax revenue for support and maintenance.
Example of a Federal, State, and Local Tax
Income taxes are taxes imposed on the net income of individuals and corporations by the federal, most state, and some local governments. State and local income tax rates vary widely by jurisdiction and many are graduated, or increase progressively as income levels increase. State taxes are generally treated as a deductible expense for federal tax computation.
Example of a State Tax
Sales taxes are imposed by most states on the retail sale price of many goods and some services. Sales tax rates also vary widely among jurisdictions, from 0% to 16%, and may vary within a jurisdiction based on the particular goods or services taxed. Sales tax is collected by the seller at the time of sale, or remitted as use tax by buyers of taxable items who did not pay sales tax.
Example of a Local Tax
Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. Property tax is generally imposed only on real estate, though some jurisdictions tax some forms of business property. Property tax rules and rates vary widely.
Key Points
• Taxes can be used to stabilize the economy.
• The implementation of taxes can promote social equity; for example the use of progressive income taxes.
• There are many types of taxes that can be legislated to derive revenue for government operations.
• State and local governments collect taxes from residents to support corresponding state and local government activities. Examples of these services include maintenance of public parks and provision of a police force.
• Property tax is an example of a local tax. It is imposed on the value of real estate.
• Sales tax may be imposed by both a state and local government. It is charged at the point of sale of the good or service.
• Income tax may be imposed by the federal, state, or local government. Tax rates vary by location, and often by income level.
Key Terms
• balanced budget: A (usually government) budget in which income and expenditure are equal over a set period of time.
• fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
• sales tax: A local or state tax imposed as a percentage of the selling price of goods or services payable by the customer. The tax is not recognized as the seller’s earnings; the seller only collects the tax and transmits the same to local or state authorities.
• property tax: An (usually) ad valorem tax charged on the basis of the fair market value of property.
• income tax: A tax levied on earned and unearned income, net of allowed deductions.
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Corporate and Payroll Taxes
Many countries impose taxes on a company’s earnings along with aspects of doing business. Two examples of these are corporate and payroll taxes.
learning objectives
• Give examples of corporate and payroll taxes
Corporate taxes
Many countries impose a corporate tax, also called corporation tax or company tax, on the income or capital of some types of legal entities. A similar tax may be imposed at state or lower levels. The taxes may also be referred to as income tax or capital tax. Most countries tax all corporations doing business in the country on income from that country. Many countries tax all income of corporations organized in the country. Company income subject to taxation is often determined much like taxable income for individuals. Generally, the tax is imposed on net profits. In some jurisdictions, rules for taxing companies may differ significantly from rules for taxing individuals.
Net taxable income for corporate tax is generally financial statement income. The rate of tax varies by jurisdiction; however, most companies provide or make public the effective tax rate on the income earned. The effective tax rate is the average corporate tax rate on the company’s income and this takes into consideration tax benefits included in a current tax year.
Corporations are also subject to a variety of other taxes including: property tax, payroll tax, excise tax, customs tax and value-added tax along with other common taxes, generally in the same manner as other taxpayers. These, however, are rarely referred to as “corporate taxes”.
Corporations are subject to multiple taxes: Corporations, such as CBS, whose headquarters are pictured above, are subject to multiple forms of tax, from corporate income tax to payroll taxes.
Other taxes: Payroll taxes
Payroll taxes are taxes that employers are required to pay when they pay salaries to their staff. Payroll taxes generally fall into two categories: deductions from an employee’s wages, and taxes paid by the employer based on the employee’s wages.
• Deductions from an employee’s wages are taxes that employers are required to withhold from employees’ wages, also known as withholding tax, pay-as-you-earn tax (PAYE), or pay-as-you-go tax (PAYG). These often cover advance payment of income tax, social security contributions, and various insurances, such as, unemployment and disability.
• Taxes paid by an employer based on the employee’s wages are taxes that are paid from the employer’s own funds. They are directly related to employing a worker. These can consist of fixed charges, or be proportionally linked to an employee’s pay. The charges paid by the employer usually cover the employer’s funding of the social security system, and other insurance programs.
In the United States, payroll taxes are assessed by the federal government, all fifty states, the District of Columbia, and numerous cities. These taxes are imposed on employers and employees and on various compensation bases and are collected and paid to the taxing jurisdiction by the employers. Most jurisdictions imposing payroll taxes require reporting quarterly and annually in most cases, and electronic reporting is generally required for all but small employers.
Key Points
• Two common taxes faced by companies are corporate tax and payroll tax.
• Corporate taxes are taxes a corporation must pay, and are analogous to personal taxes. Company income subject to taxation is often determined much like taxable income for individuals.
• Payroll taxes generally fall into two categories: deductions from an employee’s wages and taxes paid by the employer based on the employee’s wages.
Key Terms
• corporate tax: A tax levied on a corporation, especially on its profits; corporation tax
• payroll tax: A tax levied when an employer pays its employees.
• Social Security: A system whereby the state either through general or specific taxation provides various benefits to help ensure the wellbeing of its citizens.
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Defining and Measuring Poverty
Poverty is framed from a material possessions perspective, and is defined as lacking a certain amount to fulfill basic standards of living.
learning objectives
• Describe poverty and the poverty line
Poverty is framed from a material or capital possessions perspective, and is loosely defined as lacking a certain amount to fulfill basic standards of living. Absolute poverty is poverty to the extent of which an individual is deprived of the ability to fulfill basic human needs (i.e. water, shelter, food, education, etc.). The United Nations defines poverty as the inability to obtain choices and opportunities. The existence of poverty is one of the greatest challenges faced by the modern world, both in developing and developed nations. Addressing poverty is best approached through the science of understanding monetary exchanges and the creation of wealth, and thus it is useful to employ an economic perspective when discussing and providing solutions to global poverty.
Percentage of People Living on Less than \$1/Day: This map underlines the overall percentage of people in specific countries living on less than one dollar (USD) per day. The important takeaway is the wide range of countries suffering from varying levels of poverty.
The Poverty Line
When conceptually approaching the idea of a poverty line, it is useful to frame it within the context of generating an amount of income that is appropriate to ensure a reasonable standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities. The United States, for example, has most recently (2012) set the poverty line at \$23,050 (annually) with a total of 16% of the population falling under this level (according to the U.S. Census Bureau). Internationally, the World Bank defines extreme poverty as living on less than \$1 per day (adjusted for purchasing power).
In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrates the value in technological and economic progress. The industrial revolution, the modernization (and thus increased efficiency) of agriculture, mass production in factories, technological innovation and a wide range of factors that have driven production and economies upwards have contributed to an increased standard of living. Economically, while the distribution of wealth heavily has tended to benefit the wealthy, there has been great value derived in technological progress in regards to minimizing poverty.
Measuring Poverty
Varying approaches have been developed to measure poverty levels, with a particular focus on creating standardized tools to capture a global context. Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard that is consistent over time and geographic location. An example of absolute poverty is the number of people without access to clean drinking water, or the number of people eating less food than the body requires for survival. Absolute poverty levels, as discussed above, essentially underline the ability for an individual to survive with autonomy. Relative poverty is an approach based more upon a benchmark, that is to say the upper echelon of society versus the poor. Income distribution measures lend insight into relative poverty levels.
One interesting perspective is the Multidimensional Poverty Index (MPI). This index was created in 2010 by the Oxford Poverty & Human Development Initiative alongside the United Nations Development Programme. It leverages a variety of dimensions and applies it to the number of people and the overall intensity across the poor to create a model to capture the extent of the poverty in the region. This dimensions include health, child mortality, nutrition, standard of living, electricity, sanitation, water, shelter (via the floor), cooking fuel and assets owned.
Defining and Measuring Income Inequality
Income inequality uses the dispersion of capital to identify how economic inequality is defined among individuals in a given economy.
learning objectives
• Apply indices of income inequality to measure global economic inequality
Income inequality utilizes the dispersion of capital to identify the way in which economic inequality is defined among a group of individuals in a given economy. Simply put, economics measures income levels and purchasing power across a society to identify averages and distributions to identify the extent of inequalities. Historically this problem was limited to the scope of differences of income and assets between people, creating separate social classes. However, as economists expand their understanding of markets, it has become increasingly clear that there is a relationship between income inequality and the potential for long-term sustainable economic growth. As a result, a wide array of income inequality scales and metrics have been generated in order to identify challenges.
Inequality Metrics
In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created. Models, ratios and indices include:
• Gini Index: One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect equality of income. A 1 on this scale is essentially socialism, or the perfect distribution of capital/goods. The derivation of the Gini ratio is found via Lorenz curves, or more specifically, the ratio of two areas in a Lorenz curve diagram. The downside to this method is that it does not specifically capture where the inequality occurs, simply the degree of severity in the income gap. This demonstrates the Gini ratio across the globe, with some interesting implications for advanced economies like the U.S.
• 20:20 Ratio: This name indicates the method; the top 20% and the bottom 20% of earners are used to derive a ratio. While this is a simple method of identifying how rich the rich are (and how poor the poor are), it unfortunately only captures these outliers (obscuring the middle 60%).
• Palma Ratio: Quite similar to the 20:20 ratio, the Palma ratio underlines the ratio between the richest 10% and the poorest 40% (dividing the former by the latter). The share of the overall economy occupied by these two groups demonstrates substantial variance from economy to economy, and serves as a strong method to identify how drastic the inequity is.
• Theil Index: The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy in this context is different than that which is found in thermodynamics, primarily meaning the amount of noise or deviance from par. In this case, 0 indicates perfect equality, and 1 indicates perfect inequality. When there is perfect equality, maximum entropy occurs because earners cannot be distinguished by their incomes. The gaps between two entropies is called redundancy, which acts as a negative entropy measure in the system. Redundancy in some individuals implies scarcity of resources for others. Comparing these gaps and inequality levels (high entropy or high redundancy) is the basic premise behind the Theil Index.
• Hoover Index: Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system. In a perfectly equal economy this would equate to income levels, and the deviance from this (on a percentile scale) is representative of the inequality in the system.
To simplify the information above, the basic concept behind measuring inequality is identifying an ideal and tracking any deviance from that ideal (which would be deemed the inequality of a given system). Minimizing this inequality is the sign of a mature and advanced society with high standards of living across the board, while substantial income gaps are indicative of a developing or struggling economy. Some powerful economies, like the United States and China, demonstrate high inequality despite high economic power while others, like Switzerland or Norway, demonstrate high equality despite lower economic output. This is a critical consideration in economic policy (from a political perspective). Minimizing inequality is a central step towards an advanced society.
Defining and Measuring Economic Mobility
Economic mobility is a measurement of how capable a participant in a system can improve (or reduce) their economic status.
learning objectives
• Distinguish between types of economic mobility
Economic mobility is a measurement of how capable a participant in a system can improve (or reduce) their economic status (generally measured in monetary income). This concept of economic mobility is often considered in conjunction with ‘social mobility’, which is the capacity for an individual to change station within a society.
Types of Economic Mobility
Economic mobility can be perceived via a number of approaches, but is best summarized in the following four:
• Intergenerational: Intergenerational mobility pertains to a person’s capacity to alter their station relative to the economic status of their parents or grandparents, essentially the flexibility within a society to allow individuals to grow regardless of their initial station. Contrary to concepts of mobility in America, 42% of individuals in born into the bottom income bracket remain there. An interesting chart, measuring intergenerational income elasticity, can be found in.
• Intragenerational: Intragenerational mobility is defined by an individual’s upwards and downwards movement throughout their lifetime (both relative to their working career and their peers). This type of mobility is shorter term than intergenerational in regards to the way in which it is confined to the lifetime of that individual specifically.
• Absolute: Similar to intergenerational mobility, absolute mobility looks at how widespread economic growth improves (or reduces) an individual or a family’s income over a generational time frame. Put simply, it answers the following question: How likely is a person to exceed their parents income at a given age?
• Relative: Relative mobility, as the name implies, measures the mobility and economic growth of a particular person within the context of the system in which they work.
Closely related to the concept of economic mobility is that of socioeconomic mobility, which refers to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility, which overlaps substantially with the categories discussed above.
Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility. Some of the more well-known issues include:
• Gender: Gender is quite often a limiting factor in economic mobility, with concepts like the “glass ceiling” underlining the difficulty encountered by women in achieving high-earning status. While women have made great strides in some countries, many global economies still struggle to incorporate women into the workplace with equity.
• Race/Ethnicity: In the United States in particular there is huge inequity between Caucasian workers and that of other backgrounds (African American, Hispanic, etc.). Approaching this social tie with income inequity has taken a great deal of political reform over the years, and has much left to accomplish in terms of enabling movement across economic levels.This could in many ways be coupled with immigration, or the concept of being different socially or ethnically from a group that has historically achieved high income levels.
• Education: Access to equitable and affordable education in all places worldwide is a substantial domestic and global challenge in enabling the next generation for success. Access to the best education is highly correlated with access to the best professional opportunities, and thus the expansion and funding of effective public education lies at the center of enabling economic mobility.
Measurement Problems
Due to the high complexity of measuring equality, the accuracy of many poverty and inequality measurements can be less than ideal.
learning objectives
• Describe issues with measuring poverty and income inequality globally
As with any statistical modeling and measuring approach, there is a great deal of complexity to capture within a finite algorithmic structure, making the accuracy and efficacy of many poverty and inequality measurements less than ideal. Inequality, poverty and economic mobility in particular have a number of measurement challenges.
Gini Index
The most popular measurement of income inequality is the Gini index, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. If a system demonstrates a Gini index of 0, the implication is that income differences among any individuals in the population will be essentially zero, while a measurement of 1 is complete income disparity. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty). This criticism spans across most poverty measurement systems (Thiel entropy, the 20:20 ratio, and the Palma ratio to name a few), and ultimately implies that much of what is measured as inequality does not take into account absolute gains.
For example, if an economy were to grow by 20% over 10 years, it is perfectly possible (and indeed quite likely) that the upper 20% will capture 50% gains while the bottom 20% will only capture 10% gains. That bottom 10% (assuming inflation has been accounted for) will be gaining wealth and purchasing power in absolute terms despite the fact that the Gini index will be much worse. The Gini index still has important implications about relative inequality in this circumstance, but it neglects to point out positive gains.
Criticisms of the Poverty Line
Taking into account the problems with the Gini ratio, a concept like the poverty line does an effective job in offsetting this variability. A poverty line is the determination of a specific income level in which it is considered the absolute minimum amount of capital required for an individual or family to live (and have all necessities) over the course of one year.
While there is great absolute value in utilizing a poverty line to determining the percentage of people still surviving on less than is considered the bare minimum, there are also drawbacks to this method as well. Looking at the map, one can see that measuring the percentages of individuals under the poverty line from country to country demonstrates what appears to be a graphic for comparison. However, due to the fact that poverty lines are different in different countries (because there is no standard way in which to enforce setting and measuring the poverty line) it is not relative. As a result, there is high absolute value for each country but minimal comparative value between countries. Another prospective drawback of this method is that the poverty threshold only measures when an individual is above or below it, and not the extent to which each individual deviates. Finally, it is also important to consider less quantitative components that affect the standard of living (for example, education quality, roads, access to public transportation, access to healthcare, etc.), and thus country to country comparisons are somewhat reduced in value.
Individuals Below National Poverty Line: This graph illustrates the different percentiles of individuals under the poverty line across the world. One criticism of this method is that national poverty lines are not derived objectively in a standardized fashion, and thus there is limited value to this graphic in relative terms.
Voluntary Poverty
One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum. This is done as a result of lifestyle choice or religion, and is counted into poverty and inequality levels despite the fact that the individual being counted has actively pursued this place in society. While this is a somewhat unusual circumstance, it shifts the measurement of poverty in some regions (particularly those with a high population of certain beliefs or religions) higher than would be expected.
Key Points
• The United Nations defines poverty as the inability to obtain choices and opportunities.
• A poverty line pertains to the idea of generating an amount of income that is appropriate to ensure a minimum standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities.
• In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrate the value in technological and economic progress.
• Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard consistent over time and geographic location and relative pertaining to social benchmarks.
• In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created.
• One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect income equality.
• The 20:20 Ratio and the Palma Ratio (40:10) use percentile ratios of the richest groups and poorest groups to create scales of income inequality severity.
• The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy, in this case, means the amount of noise or deviance from par, which is expressed as a scale (0 – 1); 0 indicates perfect equality, and 1 indicates perfect inequality.
• Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system.
• This concept of economic mobility is often considered in conjunction with “social mobility,” which is the capacity for an individual to change station within a society.
• Economic mobility can be perceived via a number of approaches, but is best summarized as inter-generational, intra-generational, absolute, or relative.
• Closely related to the concept of economic mobility is that of socio-economic mobility, referring to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility.
• Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility, such as gender, race and education.
• The most popular measurement of income inequality is the Gini ratio, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty).
• The poverty line is a useful absolute measurement, but suffers from having no global standard set (for comparative value), having limited nuance to measure deviations from the poverty line, and failing to incorporate intangible societal assets such as health care.
• One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum.
• Overall, while measuring inequality is a necessary and useful economic perspective, there are inherent statistical drawbacks in mathematically approaching complex societal issues.
Key Terms
• purchasing power: The amount of goods and services that can be bought with a unit of currency or by consumers.
• Poverty line: The threshold of poverty, below which one’s income does not cover necessities.
• entropy: A measure of the amount of information and noise present in a signal.
• glass ceiling: An unwritten, uncodified barrier to further promotion or progression for a member of a specific demographic group.
• Economic mobility: The ability of an individual or family to improve their income, and social status, in an individual lifetime or between generations.
• Gini Index: A measure of income distribution.
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• Multidimensional Poverty Index. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Multidimensional_Poverty_Index. License: CC BY-SA: Attribution-ShareAlike
• Income inequality metrics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Income_inequality_metrics. License: CC BY-SA: Attribution-ShareAlike
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• glass ceiling. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/glass_ceiling. License: CC BY-SA: Attribution-ShareAlike
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• Gini coefficient. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Gini_coefficient. License: CC BY-SA: Attribution-ShareAlike
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Social Insurance
Social insurance are government-sponsored programs, such as Medicare, that provide benefits to people based on individual contributions to that program.
learning objectives
• Describe the characteristics of social insurance programs
Social insurance has been defined as a program where risks are transferred to and pooled by an organization (often governmental) that is legally required to provide certain benefits. It is any government-sponsored program with the following four characteristics:
1. The benefits, eligibility requirements, and other aspects of the program are defined by statute;
2. Explicit provision is made to account for income and expenses (often through a trust fund);
3. It is funded by taxes or premiums paid by (or on behalf of) participants (although additional sources of funding may be provided as well); and
4. The program serves a defined population, and participation is either compulsory, or the program is subsidized heavily enough that most eligible individuals choose to participate.
Social insurance differs from welfare in that the beneficiary’s contributions to the program are taken into account. A welfare program pays recipients based on need, not contributions. Medicare is an example of a social insurance program, while Medicaid is an example of a welfare one.
In the United States, Social Security, Medicare, and unemployment insurance are among the most well-known forms of social insurance.
Social Security
Social Security in the U.S. is primarily the Old-Age, Survivors, and Disability Insurance (OASDI) federal insurance program. Social Security is funded through payroll taxes called Federal Insurance Contributions Act tax (FICA) and/or Self Employed Contributions Act Tax (SECA). Tax deposits are collected by the Internal Revenue Service (IRS) and are formally entrusted to the Social Security Trust Funds. Social Security provides monetary benefits to retirees, their spouses and surviving dependent children, and disabled workers.
Social Security Poster: Social Security is one of the best-known social insurance programs in the United States. It provides benefits to retirees, surviving family members, and disabled workers who have contributed to the Social Security Trust Fund through payroll taxes.
Medicare
Medicare is a national program that guarantees access to health insurance for Americans aged 65 and older, younger people with disabilities, and people with certain chronic diseases. Medicare is funded through revenue from FICA and SECA payroll taxes, as well as through premiums paid by Medicare enrollees and general fund revenue from the federal government.
Unemployment Insurance
Unemployment insurance provides a monetary benefit to workers who have become unemployed through no fault of their own. Benefits are generally paid by state governments, and are funded in large part by state and federal payroll taxes levied against employers. These payroll taxes were established by the Federal Unemployment Tax Act (FUTA), and allow the IRS to collect federal employer taxes used to fund state workforce agencies. FUTA covers the costs of administering the Unemployment Insurance and Job Service programs in all states. In addition, FUTA pays one-half of the cost of extended unemployment benefits (during periods of high unemployment) and provides for a fund from which states may borrow, if necessary, to pay benefits.
Public Assistance
Public assistance is the provision of a minimal level of social support for all citizens.
learning objectives
• Define and describe different types of public assistance
Public Assistance
Public assistance, also referred to colloquially as welfare, is the provision of a minimal level of social support for all citizens. In most developed countries, public assistance is provided by the government, charities, social groups, and religious groups. It is funded by government agencies and private organizations.
Public assistance systems vary by country, but welfare is usually provided to individuals who are unemployed, those with an illness or disability, the elderly, those with dependent children, and veterans. Individuals must meet specific criteria to be eligible to receive public assistance.
In the United States, the funds for public assistance are given at a flat rate to each state based on population. Each state has to meet certain criteria to ensure that individuals receiving public assistance are being encouraged to work themselves out of welfare. The goal of public assistance is to support individuals who are in need of help while encouraging them to seek employment and better their lives.
Forms of Public Assistance
Public assistance is offered in a variety of forms including:
• Monetary payments: individuals are paid bi-weekly or monthly based on their income level. Individuals must apply for monetary public assistance and meet specific criteria. Monetary payments will be lessened or stopped once the individual’s income reaches a certain level. An example of monetary payments is Temporary Assistance for Needy Families (TANF), which provides a cash benefit to families in need.
• Subsidy: government funded programs that provide assistance to citizens on federal, state, local, and private levels. Subsidies help to provide food, housing, education, healthcare, and financial support to individuals in need. Examples include Medicaid.
• Vouchers: are bonds given out by the government or other welfare organizations. A voucher is worth a certain monetary value and can only be spent on specific goods.
• Housing assistance: provided by the government to ensure that individuals have shelter. In some cases individuals will receive free housing while other will receive housing at a discounted rate. Housing assistance is based on an individual’s level of income.
• Universal healthcare: health care coverage that provides health care and financial protection to all citizens. It provides a specific package of benefits to all members of society with the goal of providing financial risk protection, improved access to health services, and improved health outcomes.
• Public assistance is provided by the government, charities, social groups, and religious groups. It is funded by government agencies and private organizations.
• Public assistance systems vary by country, but welfare is usually provided to individuals who are unemployed, those with an illness or disability, the elderly, those with dependent children, and veterans.
• Forms of public assistance include monetary payments, subsidies, vouchers, housing assistance, and universal healthcare.
Key Points
• Social insurance programs share four characteristics: they have well-defined eligibility requirements and benefits, have provisions for program income and expenses, are funded by taxes or premiums paid by participants, and have mandatory or heavily subsidized participation.
• Social insurance programs differs from welfare programs in that they take participant contributions into account. Welfare benefits are based on need, not contributions.
• Social Security, Medicare, and unemployment insurance are three well-known social insurance programs in the United States.
Key Terms
• social insurance: Any government-sponsored program where risks are transferred to and pooled by an organization that is legally required to provide certain benefits.
• public assistance: Payment made to disadvantaged persons by government in order to alleviate the burdens of poverty, unemployment, disability, old age, etc.
• subsidy: Financial support or assistance, such as a grant.
• voucher: A piece of paper that entitles the holder to a discount, or that can be exchanged for goods and services.
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• Welfare. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Welfare. License: CC BY-SA: Attribution-ShareAlike
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Defining Macroeconomics
Macroeconomics is a branch of economics that focuses on the behavior and decision-making of an economy as a whole.
learning objectives
• Define Macroeconomics.
Economics is comprised of many specializations; however, the two broad sub-groupings for economics are microeconomics and macroeconomics.
Macroeconomics
Macroeconomics is a branch of economics that focuses on the behavior and decision-making of an economy as a whole. In this manner it differs from the field of microeconomics, which evaluates the motivations of and relationships between individual economic agents.
Macroeconomics: Circular Flow of the Economy: Macroeconomics simplifies the complexities of the trading activities in an economy by distilling actions to primary participants and tracing the circular flow of activity between them.
Indicators
Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions and develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending, and international trade. These variables taken as a whole comprise a grouping of variables that are referred to as economic indicators. These indicators, which are classified as leading, lagging and coincident relative to their predictive capability, in combination with one another provide economists with a directional attribution for the economy.
Macroeconomic Study
While macroeconomics is a broad field of study, there are two areas of research that are especially well publicized in the media: the evaluation of the business cycle and the growth rate of the economy. As a result, macroeconomics tends to be widely cited in discussions related to government intervention in economic expansion and contraction, as well as, with respect to the evaluation of economic policy.
Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on a national level: output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.
The Importance of Aggregate Decisions about Consumption versus Saving and Investment
Money can either be consumed, invested, or saved (deferred consumption or investment).
learning objectives
• Explain the relationship between consumption, savings, and investment.
There are three choices that market actors can make with their money. They can consume it by spending it on goods and services. For example, buying a movie ticket is spending money on consumption. They can also invest money by lending it to a company or project with the hope of getting back more money in the future. Finally, they can save it by putting it in a bank account (or keeping cash under the bed). Savings is essentially deferred consumption or investment; it is intended for use in the future.
In order to understand the effects of aggregate decisions of consumption, savings, and investment, we must look at aggregate demand (AD). AD is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels and is the demand for the gross domestic product of a country.
Components of Aggregate Demand
It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is downward sloping but in variation with microeconomics, this is as a result of three distinct effects: the wealth effect, the interest rate effect and the exchange-rate effect.
Basically individuals will consume or purchase more when they feel wealthier or have access to inexpensive funding.
The wealth effect is specifically related to the value of assets; market participants will adjust consumption in-line with their perception of the appreciation or depreciation of held assets (a home; equity investments, etc.). The interest rate effect has to do with access to inexpensive funding, which provides an incentive to increase current period expenditures; while the exchange-rate effect has to do with expenditure decisions related to imports or foreign related expenditures, as the exchange rate is perceived to be favorable to the domestic currency, expenditures on foreign items or imports will increase.
Consumption, Savings, and Investment
Aggregate demand met by the market is spending, be it on consumption, investment, or other categories.
Spending is related to income:
$\text{Income} \; – \text{Spending} = \text{Net Savings}$
Rearranging:
$\mathrm{Spending = Income \; – Net \; Savings = Income \; + Net \; Increase \; in \; Debt}$
In words: what you spend is what you earn, plus what you borrow: if you spend $110 and earned$100, then you must have net borrowed $10; conversely if you spend$90 and earn $100, then you have net savings of$10, or have reduced debt by $10, for net change in debt of –$10.
For the economy as a whole, aggregate savings is greater than or equal to investment, which is usually in the form of borrowed funds available as a result of savings. Through investment spending, savings influences aggregate demand.
Furthermore, since consumption and investment are components of GDP but saving is not, increased savings indirectly reduces GDP.
US Savings Rate: Savings have declined in the US on aggregate since the 1980s, which means that the proportion of income spent on consumption and investment increased.
The Role of the Financial System
A financial market or system is a market in which people and entities can trade financial securities, commodities, and other fungible items.
learning objectives
• Explain the importance of the financial system
Financial System
A financial market or system is a market in which people and entities can trade financial securities, commodities, and other fungible items. Securities include stocks and bonds, and commodities include precious metals or agricultural goods.
Equity Markets: Equity markets are the most closely followed of the financial markets. They provide transparent and active trading platforms that promote liquidity and access to funds to on a global scale.
There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one place, thus making it easier for them to find each other.
An economy that relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy, in contrast either to a command economy or to a non-market economy such as a gift economy.
Role of the Financial System
Financial markets are associated with the accelerated growth of an economy. A financial market helps to achieve the following non-comprehensive list of goals:
• Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments, etc. is an important role played by financial markets. Borrowers (e.g. bond issuers) are connected with lenders (e.g. bond buyers) in financial markets.
• Investment: Financial markets play a crucial role in arranging to invest funds. Both firms and individuals can invest in companies through financial markets (e.g. by buying stock).
• National Growth: An important role played by financial market is that, they contribute to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. In other words, financial markets help shift money from industry to industry or firm to firm based on the supply and demand for their products.
• Entrepreneurship growth: Financial markets allow entrepreneurs (and established firms) to access the funds needed to invest in projects or companies.
The Business Cycle: Definition and Phases
The term business cycle refers to economy-wide fluctuations in production, trade, and general economic activity.
learning objectives
• Identify features of the economic business cycle
The Business Cycle
The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide fluctuations in production, trade, and general economic activity. From a conceptual perspective, the business cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around a long-term growth trend.
Business Cycles: The phases of a business cycle follow a wave-like pattern over time with regard to GDP, with expansion leading to a peak and then followed by contraction leading to a trough.
Business Cycle Phases
Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.
An expansion is characterized by increasing employment, economic growth, and upward pressure on prices. A peak is realized when the economy is producing at its maximum allowable output, employment is at or above full employment, and inflationary pressures on prices are evident. Following a peak an economy, typically enters into a correction which is characterized by a contraction, growth slows, employment declines (unemployment increases), and pricing pressures subside. The slowing ceases at the trough and at this point the economy has hit a bottom from which the next phase of expansion and contraction will emerge.
Business Cycle Fluctuations
Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.
In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle. An expansion is the period from a trough to a peak, and a recession as the period from a peak to a trough. The NBER identifies a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production. ” This is significantly different from the commonly cited definition of a recession being signaled by two consecutive quarters of decline in real GDP.
Recessions
A recession is a business cycle contraction; a general slowdown in economic activity.
learning objectives
• Explain the connection between a recession and other macroeconomic variables
In economics, a recession is a business cycle contraction; a general slowdown in economic activity. Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock ). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock, or the bursting of an economic bubble.
Recessions and panic: Recessions are characterized as periods of fear and uncertainty; historically they also were a time of widespread panic. However, as confidence in the central bank and federal government increased, though fear and uncertainty remain, panic-conditioned “runs” as depicted in the photo above have become an element of the past.
Attributes of Recession
A recession has many attributes that can occur simultaneously, these include declines in component measures (economic indicators) of economic activity (GDP) such as consumption, investment, government spending, and net export activity. These indicators in turn, reflect underlying drivers such as employment levels and skills, household savings rates, corporate investment decisions, interest rates, demographics, and government policies.
Causes of Recession
Under ideal conditions, a country’s economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero. When these relationships become imbalanced, recession can develop within a country or create pressure for recession in another country. Policy responses are often designed to drive the economy back towards this ideal state of balance.
Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.
Policy Responses to Recession
Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow. Monetarists would favor the use of expansionary monetary policy, while Keynesian economists may advocate increased government spending to spark economic growth. Supply-side economists may suggest tax cuts to promote business capital investment. When interest rates reach the boundary of an interest rate of zero percent (zero interest-rate policy) conventional monetary policy can no longer be used and government must use other measures to stimulate recovery.
A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different. As an informal shorthand, economists sometimes refer to different recession shapes, such as V-shaped, U-shaped, L-shaped, and W-shaped recessions.
Managing the Business Cycle
When the economy is not at a steady state, the government and monetary authorities have policy mechanisms to move the economy back to consistent growth.
learning objectives
• Identify how changes in monetary and fiscal policy can manage the business cycle, and why that is desirable
The business cycle is comprised of the upward and downward movement in the level of Gross Domestic Product (GDP) over time. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession ).
Cycles in the economy: The economy moves through expansion and contraction on a routine basis; policy mechanisms allow for smoother transitions and soften landings.
Policy Responses
When the economy is not at a steady state and instead is at a point of either overheating (growing to fast) or slowing, the government and monetary authorities have policy mechanisms, fiscal and monetary, respectively, at their disposal to help move the economy back to a steady state growth trajectory. If the economy needs to be slowed, these policies are referred to as contractionary and if the economy needs to be stimulated the policy prescription is expansionary.
Expansionary Policy
Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. Fiscal authorities will increase government spending in order to revive the economy.
Expansionary monetary policy relies on the central bank increasing availability of loanable funds through three mechanisms: open market operations, discount rate, and the reserve ratio. As the supply of loanable funds increases, the interest rate is expected to decrease and thereby increase the desire to borrow funds for consumption and investment purposes.
Contractionary Policy
Contractionary fiscal policy is opposite of the action taken in an expansionary purpose, and occurs when government spending is lower than tax revenue.
Similarly, contractionary monetary policy is the opposite of expansionary monetary policy and occurs when the supply of loanable funds is limited, to reduce the access and availability to relatively inexpensive credit.
Long Run Growth
Long run growth is the increase in the market value of the goods and services produced by an economy over time.
learning objectives
• Explain the impact of consistent long-run growth on an economy.
Long run growth is the increase in the market value of the goods and services produced by an economy over time. It is conventionally measured as the percentage of increase in real gross domestic product, or real GDP. Growth is usually calculated in real terms: it is inflation-adjusted to eliminate the distorting effect of inflation on the price of goods produced. In economics, economic growth or economic growth theory typically refers to growth of potential output, which is production at full employment.
Policymakers strive for steady, continued, and consistent growth because it is predictable and manageable for both policymakers and market participants. Over long periods of time even small rates of growth, like a 2% annual increase, have large effects. For example, the United Kingdom experienced a 1.97% average annual increase in its inflation-adjusted GDP between 1830 and 2008. In 1830, the GDP was £41,373 million. It grew to £1,330,088 million by 2008 (in 2005 pounds). A growth rate that averaged 1.97% over 178 years resulted in a 32-fold increase in GDP by 2008.
Long-run growth rates: Growth in GDP can be significant, especially when annual growth rates are fairly consistent.
The Power of Compounding
The large impact of a relatively small growth rate over a long period of time is due to the power of compounding. A growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years, while a growth rate of 8% per annum (an average exceeded by China between 2000 and 2010) leads to a doubling of GDP within 10 years. Therefore, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.
Note: an easy way to approximate the doubling time of a number with a constant growth rate is to use the Rule of 72. Divide 72 by the percentage annual growth rate to get a rough estimate of the number of years until the number doubles. For example, at a 10%, divide 72 by 10 to get a doubling time of 7.2 years. The actual doubling time is 7.27 years, so the rule of 72 is a good rough approximation.
Key Points
• Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions.
• Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending and international trade.
• Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on the national level: output, unemployment, and inflation.
• Aggregate demand is downward sloping as a result of three consumption sensitivities: wealth effect, interest rate effect and foreign exchange effect.
• Spending is related to income: Income – Spending = Net Savings.
• For the economy as a whole, aggregate savings is equal to investment, which is usually in the form of borrowed funds available as a result of savings.
• An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy.
• Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one “place,” thus making it easier for them to find each other.
• Healthy financial systems are associated with the accelerated development of an economy.
• Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.
• Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.
• In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle.
• Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise.
• Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.
• Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow.
• If the economy needs to be slowed, enacted policies are referred to as being contractionary and if the economy needs to be stimulated the policy prescription is expansionary.
• Central banks use monetary policy measures to facilitate consistent economic growth, while the government uses fiscal policy.
• The government policy measures are referred to as fiscal policy.
• Growth is usually calculated in real terms, meaning that it is inflation -adjusted to eliminate the distorting effect of inflation on the price of goods produced.
• Policymakers strive for continued and consistent growth.
• The large impact of a relatively small growth rate over a long period of time is due to the power of compounding.
• A small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.
Key Terms
• Macroeconomics: The study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices.
• microeconomics: That field that deals with the small-scale activities such as that of the individual or company.
• aggregate demand: The total demand for final goods and services in the economy at a given time and price level.
• investment: A placement of capital in expectation of deriving income or profit from its use.
• entrepreneurship: The art or science of innovation and risk-taking for profit in business.
• saving: the act of storing for future use
• expansion: The act or process of expanding.
• trough: The lowest turning point of a business cycle
• peak: The highest value reached by some quantity in a time period.
• contraction: A period of economic decline or negative growth.
• recession: A period of reduced economic activity
• fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• economic growth: The increase of the economic output of a country.
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• 19.1: Measuring Output Using GDP
Gross domestic product is the market value of all final goods and services produced within the national borders of a country for a given period of time.
• 19.2: Other Measures of Output
A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region.
• 19.3: Comparing Real and Nominal GDP
Real GDP growth is the value of all goods produced in a given year; nominal GDP is value of all the goods taking price changes into account.
• 19.4: Cost of Living
Inflation is a persistent increase in the general price level, and has three varieties: demand-pull, cost-push, and built-in.
19: Measuring Output and Income
Defining GDP
Gross domestic product is the market value of all final goods and services produced within the national borders of a country for a given period of time.
learning agreements
• Distinguish between the income and expenditure approaches of assessing GDP
Gross domestic product (GDP) is the market value of all final goods and services produced within the national borders of a country for a given period of time. GDP can be determined in multiple ways. The income approach and the expenditure approach highlighted below should yield the same final GDP number.
Simple view of expenditures: In an economy, households receive wages that they then use to purchase final goods and services. Since wages eventually are used in consumption (C), the expenditure approach to calculating GDP focuses on the end consumption expenditure to avoid double counting. The income approach, alternatively, would focus on the income made by households as one of its components to derive GDP.
Expenditure Approach
The expenditure approach attempts to calculate GDP by evaluating the sum of all final good and services purchased in an economy. The components of U.S. GDP identified as “Y” in equation form, include Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).
$\mathrm{Y = C + I + G + (X − M)}$ is the standard equational (expenditure) representation of GDP.
• “C” (consumption) is normally the largest GDP component in the economy, consisting of private expenditures (household final consumption expenditure) in the economy. Personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services.
• “I” (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Spending by households (not government) on new houses is also included in Investment. “Investment” in GDP does not mean purchases of financial products. It is important to note that buying financial products is classed as ‘ saving,’ as opposed to investment.
• “G” ( government spending ) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. However, since GDP is a measure of productivity, transfer payments made by the government are not counted because these payment do not reflect a purchase by the government, rather a movement of income. They are captured in “C” when the payments are spent.
• “X” (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• “M” (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms “G”, “I”, or “C”, and must be deducted to avoid counting foreign supply as domestic.
Income Approach
The income approach looks at the final income in the country, these include the following categories taken from the U.S. “National Income and Expenditure Accounts”: wages, salaries, and supplementary labor income; corporate profits interest and miscellaneous investment income; farmers’ income; and income from non-farm unincorporated businesses. Two non-income adjustments are made to the sum of these categories to arrive at GDP:
• Indirect taxes minus subsidies are added to get from factor cost to market prices.
• Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.
Learning from GDP
GDP is a measure of national income and output that can be used as a comparison tool.
learning agreements
• Explain how GDP is calculated.
There are two commonly used measures of national income and output in economics, these include gross domestic product ( GDP ) and gross national product (GNP). These measures are focused on counting the total amount of goods and services produced within some “boundary” where the boundary is defined by either geography or citizenship.
Since GDP measures income and output, it can be used to compare two countries. The country with higher GDP is often regarded as wealthier, but, when using GDP to compare countries, it is important to remember to adjust for population.
GDP
GDP limits its focus to the value of goods or services in an actual geographic boundary of a country, where GNP is focused on the value of goods or services specifically attributable to citizens or nationality, regardless of where the production takes place. Over time GDP has become the standard metric used in national income reporting and most national income reporting and country comparisons are conducted using GDP.
GDP can be evaluated by using an output approach, income approach, or expenditure approach.
Output Approach
The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in the total output. This avoids an issue referred to as double counting, where the total value of a good is included several times in national output, by counting it repeatedly in several stages of production.
For example, in meat production, the value of the good from the farm may be $10, then$30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be$60, not the sum of all those numbers, \$90.
Formula: GDP (gross domestic product) at market price = value of output in an economy in the particular year – intermediate consumption at factor cost = GDP at market price – depreciation + NFIA (net factor income from abroad) – net indirect taxes.
Income Approach
The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation. The main types of factor income are:
• Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits);
• Interest received net of interest paid;
• Rental income (mainly for the use of real estate) net of expenses of landlords;
• Royalties paid for the use of intellectual property and extractable natural resources.
All remaining value added generated by firms is called the residual or profit or business cash flow.
Formula: GDI (gross domestic income, which should equate to gross domestic product) = Compensation of employees + Net interest + Rental & royalty income + Business cash flow
Expenditure Approach
The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output takes all the different areas in which money is spent within the region, and then combines them to find the total output.
U.S. GDP Components: The components of GDP include consumption, investment, government spending, and net exports (exports minus imports).
Formula: $\mathrm{Y = C + I + G + (X – M)}$; where: C = household consumption expenditures / personal consumption expenditures, I = gross private domestic investment, G = government consumption and gross investment expenditures, X = gross exports of goods and services, and M = gross imports of goods and services.
The Circular Flow and GDP
In economics, the “circular flow” diagram is a simple explanatory tool of how the major elements in an economy interact with one another.
learning agreements
• Evaluate the effect of the circular flow on GDP
In economics, the “circular flow” diagram is a simple explanatory tool of how the major elements as defined by the equation Y = Consumption + Investment + Government Spending + ( Exports – Imports). interact with one another. Circular flow is basically a continuous loop that for any point and time yields the value “Y” otherwise defined as the sum of final good and services in an economy, or gross domestic product ( GDP ).
Circular flow: The circular flow is a simplified view of the economy that provides an ability to assess GDP at a specific point in time.
In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services. Firms compensate households for resource utilized and households pay for goods and services purchased from firms. This portion of the circular flow contributes to expenditures on consumption, C and generates income, which is the basis for savings (equal to investment) and government spending (tax revenue generated from income).
Investment, I, is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes. I represents an expenditure on investment capital.
Income generated in the relationship between firms and households is taxed and the remaining is either consumed and or saved. Government spending, G, is based on the tax revenue, T. G can be equal to taxes, less than or more than the tax revenue and represents government expenditure in the economy.
Finally, exports minus imports, X – M, references whether an economy is a net importer or exporter (or potentially trade neutral (X – M = 0)) and the impact of this component on overall GDP. Note that if the country is a net importer the value of X – M will be negative and will have a downward impact to overall GDP; if the country is a net exporter, the opposite will be true.
Circular flow
The continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow involves two basic assumptions:
1. In any exchange process, the seller or producer receives what the buyer or consumer spends.
2. Goods and services flow in one direction and money payment flow in the opposite or return direction, causing a circular flow.
GDP Equation in Depth (C+I+G+X)
GDP is the sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M): $\mathrm{Y = C + I + G + (X – M)}$.
learning agreements
• Identify the variables that make up GDP
Gross domestic product (GDP) is defined as the sum of all goods and services that are produced within a nation’s borders over a specific time interval, typically one calendar year.
Components of GDP
GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M):
$\mathrm{Y=C+I+G+(X−M)}$
Expenditure accounts: Components of the expenditure approach to calculating GDP as presented in the National Income Accounts (U.S. Bureau of Economic Analysis).
Consumption
Consumption (C) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing. Also, it is important to note that goods such as hand-knit sweaters are not counted as part of GDP if they are gifted and not sold. Only expenditure based consumption is counted.
Investment
Investment (I) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to common usage, ‘Investment’ in GDP does not mean purchases of financial products. Buying financial products is classified as ‘ saving ‘, as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things. To count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Note that buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.
Government Spending
Government spending (G) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
Net Exports
Exports (X) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
Imports (M) represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
Sometimes, net exports is simply written as NX, but is the same thing as X-M.
Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count.
Calculating GDP
GDP can be calculated through the expenditures, income, or output approach.
learning agreements
• Identify the output approach to calculating GDP
Gross Domestic Product
Gross domestic product is one method of understanding a country’s income and allows for comparison to other countries.
Global GDP: GDP is a common measure for both inter-country comparisons and intra-country comparisons. The metric is one method of understanding economic growth within a country’s borders.
By calculating the value of goods and services produced in a country, GDP provides a useful metric for understanding the economic momentum between the major factors of an economy: consumers, firms, and the government. There are a few methods used for calculating GDP, the most commonly presented are the expenditure and the income approach. Both of these methods calculate GDP by evaluating the final stage of sales (expenditure) or income (income). However, another approach referred to as the “output approach” calculates GDP by evaluating the value of all sales and adjusting for the purchase of intermediate goods (to remove double counting).
Expenditures Approach
The most well known approach to calculating GDP, the expenditures approach is characterized by the following formula:
$\mathrm{GDP = C + I + G + (X-M)}$
where C is the level of consumption of goods and services, I is gross investment, G is government purchases, X is exports, and M is imports.
Income Approach
The income approach adds up the factor incomes to the factors of production in the society. It can be expressed as:
$\mathrm{GDP = \text{National Income (NY)} + \text{Indirect Business Taxes (IBT)} + \text{Capital Consumption Allowance and Depreciation (CCA)} + \text{Net Factor Payments to the rest of the world (NFP)}}$
Output Approach
The output approach is also called “net product” or “value added” method. This method consists of three stages:
• Estimating the gross value of domestic output;
• Determining the intermediate consumption, i.e., the cost of material, supplies, and services used to produce final goods or services;
• Deducting intermediate consumption from gross value to obtain the net value of domestic output.
$\text{Net value added} = \text{Gross value of output} – \text{Value of intermediate consumption.}$
$\text{Gross value of output} = \text{Value of the total sales of goods and services} + \text{Value of changes in the inventories.}$
The sum of net value added in various economic activities is known as GDP at factor cost. GDP at factor cost plus indirect taxes less subsidies on products is GDP at producer price. GDP at producer price theoretically should be equal to GDP calculated based on the expenditure approach. However, discrepancies do arise because there are instances where the price that a consumer may pay for a good or service is not completely reflected in the amount received by the producer and the tax and subsidy adjustments mentioned above may not adequately adjust for the variation in payment and receipt.
Other Approaches to Calculating GDP
The income approach evaluates GDP from the perspective of the final income to economic participants.
learning agreements
• Explain the income approach to calculating GDP.
Gross domestic product provides a measure of the productivity of an economy specific to the national borders of a country. It can be measured a few different ways and the most commonly used metric is the expenditure approach; however, the second most commonly used measure is the income approach. The income approach unlike the expenditure approach, which sums the spending on final goods and services across economic agents (consumers, businesses and the government), evaluates GDP from the perspective of the final income to economic participants. GDP calculated in this manner is sometimes referenced as “Gross Domestic Income” (GDI).
GDP over time: GDP is measured over consecutive periods to enable policymakers and economic agents to evaluate the state of the economy to set expectations and make decisions.
This method measures GDP by adding incomes that firms pay households for factors of production they hire- wages for labor, interest for capital, rent for land, and profits for entrepreneurship. The U.S. “National Income and Expenditure Accounts” divide incomes into five categories:
• Wages, salaries, and supplementary labor income
• Corporate profits
• Interest and miscellaneous investment income
• Farmers’ income
• Income from non-farm unincorporated businesses
Two adjustments must be made to get the GDP: Indirect taxes minus subsidies are added to get from factor cost to market prices. Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.
Income Approach Formula
GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports. Alternatively, this can be expressed as:
$\mathrm{GDP = COE + GOS + GMI + T_{P \& M} – S_{P \& M}}$
• Compensation of employees (COE) measures the total remuneration to employees for work done.
• Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses.
• Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
• TP & M is taxes on production and imports.
• SP&M is subsidies on production and imports.
The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So, adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.
By definition, the income approach to calculating GDP should be equatable to the expenditure approach $\mathrm{(Y = C + I+ G + (X – M))}$. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.
Evaluating GDP as a Measure of the Economy
The value of GDP as a measure of the quality of life for a given country may be limited.
learning agreements
• Assess the uses and limitations of GDP as a measure of the economy
Gross domestic product (GDP) due to its relative ease of calculation and definition, has become a standard metric in the discussion of economic welfare, growth and prosperity. However, the value of GDP as a measure of the quality of life for a given country may be quite poor given that the metric only provides the total value of production for a specific time interval and provides no insight with respect to the source of growth or the beneficiaries of growth. Therefore, growth could be misinterpreted by looking at GDP values in isolation.
Limitations of GDP
Simon Kuznets, the economist who developed the first comprehensive set of measures of national income, stated in his first report to the US Congress in 1934, in a section titled “Uses and Abuses of National Income Measurements”:
“Economic welfare cannot be adequately measured unless the personal distribution of income is known. And no income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income. The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income. ”
Following on his caution with respect to economic extrapolations from GDP, in 1962, Kuznets stated: “Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what. ”
The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.
Austrian School economist Frank Shostak has noted: “The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption. For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.”
GDP as an Evaluation Metric
Although GDP provides a single quantitative metric by which comparisons can be made across countries, the aggregation of elements that create the single value of GDP provide limitations in evaluating a country and its economic agents. Given the calculation of the metric, a country with wide disparities in income could appear to be economically stronger than a country where the income disparities were significantly lower (standard of living). However, a qualitative assessment would likely value the latter country compared to the former on a welfare or quality of life basis.
GDP across the globe: GDP can be adjusted to compare the purchasing power across countries but cannot be adjusted to provide a view of the economic disparities within a country.
Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.
Key Points
• GDP can be measured using the expenditure approach: $\mathrm{Y = C + I + G + (X – M)}$.
• GDP can be determined by summing up national income and adjusting for depreciation, taxes, and subsidies.
• GDP can be determined in two ways, both of which, in principle, give the same result.
• The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.
• The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation.
• The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent.
• In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services.
• Firms provide consumers with goods and services in exchange for consumer expenditure and “factors of production” from households.
• Investment is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes.
• A portion of income is also allocated to taxes (income is taxed and the remaining is either consumed and or saved); government spending, G, is based on the tax revenue, T.
• The continuous flow of production, income and expenditure is known as circular flow of income; it is circular because it has neither any beginning nor an end.
• C ( consumption ) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure ) in the economy.
• I ( investment ) includes, for instance, business investment in equipment, but does not include exchanges of existing assets.
• G ( government spending ) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government.
• X ( exports ) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• M (imports) represents gross imports.
• The expenditures approach says GDP = consumption + investment + government expenditure + exports – imports.
• The income approach sums the factor incomes to the factors of production.
• The output approach is also called the “net product” or “value added” approach.
• The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices.
• Adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.
• By definition, the income approach to calculating GDP should be equatable to the expenditure approach; however, measurement errors will make the two figures slightly off when reported by national statistical agencies.
• The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.
• A country with wide disparities in income could appear to be economically stronger, strictly using GDP, than a country where the income disparities were significantly lower (standard of living).
• Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.
Key Terms
• GDP: Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.
• gross national product: The total market value of all the goods and services produced by a nation (citizens of a country, whether living at home or abroad) during a specified period.
• gross domestic product: A measure of the economic production of a particular territory in financial capital terms over a specific time period.
• Factors of production: In economics, factors of production are inputs. They may also refer specifically to the primary factors, which are stocks including land, labor, and capital goods applied to production.
• circular flow: A model of market economy that shows the flow of dollars between households and firms.
• government spending: Includes all government consumption, investment but excludes transfer payments made by a state.
• consumption: In the expenditure approach, the amount of goods and services purchased for consumption by individuals.
• export: Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.
• import: To bring (something) in from a foreign country, especially for sale or trade.
• investment: A placement of capital in expectation of deriving income or profit from its use.
• expenditure approach: The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M)) $\mathrm{GDP = C + I + G + (X-M)}$.
• income approach: GDP based on the income approach is calculated by adding up the factor incomes to the factors of production in the society.
• output approach: GDP is calculated using the output approach by summing the value of sales of goods and adjusting (subtracting) for the purchase of intermediate goods to produce the goods sold.
• depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
• qualitative: Based on descriptions or distinctions rather than on some quantity.
• welfare: Health, safety, happiness and prosperity; well-being in any respect.
• quantitative: Of a measurement based on some number rather than on some quality.
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National Income
A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region.
learning objectives
• Explain the importance of calculating national income.
A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted national income (NNI* adjusted for natural resource depletion). All of the measures are especially concerned with counting the total amount of goods and services produced within some boundary. The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted. For instance, some measures count only goods and services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them.
Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century, the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as well-informed as possible.
Expenditure approach: The expenditure approach is a common method for evaluating the value of an economy at a given point in time.
Measuring National Income
In order to count a good or service, it is necessary to assign value to it. The value that the measures of national income and output assign to a good or service is its market value – the price when bought or sold. The actual usefulness of a product (its use-value) is not measured – assuming the use-value to be any different from its market value. Three strategies have been used to obtain the market values of all the goods and services produced: the product or output method, the expenditure method, and the income method.
Product or Output Method
The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces:
At factor cost = $\mathrm{GDP}$ at market price – depreciation + $\mathrm{NFIA}$ (net factor income from abroad) – net indirect taxes
Income Method
The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation:
$\mathrm{NDP}$ at factor cost = compensation of employees + net interest + rental and royalty income + profit of incorporated and unincorporated $\mathrm{NDP}$ at factor cost
Expenditure Method
The expenditure approach focuses on finding the total output of a nation by finding the total amount of money spent and is the most commonly used equational form:
$\mathrm{GPD=C+I+G+(X−M)}$; where $\mathrm{C}$ = household consumption expenditures / personal consumption expenditures, $\mathrm{I}$ = gross private domestic investment, $\mathrm{G}$ = government consumption and gross investment expenditures, $\mathrm{X}$ = gross exports of goods and services, and $\mathrm{M}$ = gross imports of goods and services.
Personal Income
Personal income is an individual’s total earnings from wages, investment interest, and other sources.
learning objectives
• Explain personal income
Personal income is an individual’s total earnings from wages, investment interest, and other sources.
In the United States the most widely cited personal income statistics are the Bureau of Economic Analysis’s (BEA) personal income and the Census Bureau’s per capita money income. The two statistics spring from different traditions of measurement: personal income from national economic accounts and money income from household surveys.
BEA’s personal income measures the income received by persons from participation in production, from government and business transfers, and from holding interest-bearing securities and corporate stocks. Personal income also includes income received by nonprofit institutions serving households, by private non-insured welfare funds, and by private trust funds. BEA publishes disposable personal income, which measures the income available to households after paying federal and state and local government income taxes. Income from production is generated both by the labor of individuals (for example, in the form of wages and salaries and of proprietors’ income) and by the capital that they own (in the form of rental income of persons). Income that is not earned from production in the current period—such as capital gains, which relate to changes in the price of assets over time—is excluded. BEA’s monthly personal income estimates are one of several key macroeconomic indicators that the National Bureau of Economic Research considers when dating the business cycle. Personal income and disposable personal income are provided both as aggregate and as per capita statistics. BEA produces monthly estimates of personal income for the nation, quarterly estimates of state personal income, and annual estimates of local-area personal income.
Historical personal income by educational attainment: Personal income data can provide governments with useful information in the formulation of public policy to combat income inequality.
The Census Bureau also produces alternative estimates of income and poverty based on broadened definitions of income that include many of these income components that are not included in money income. The Census Bureau releases estimates of household money income as medians, percent distributions by income categories, and on a per capita basis. Estimates are available by demographic characteristics of householders and by the composition of households.
Disposable Income
Disposable income is the income left after paying taxes.
learning objectives
• Define disposable income
Income left after paying taxes is referred to as disposable income. Disposable income is thus total personal income minus personal current taxes. In national accounts definitions:
Disposable income: Disposable income can be spent on essential or nonessential items. Alternatively, it can also be saved. It is whatever income is left after taxes.
Personal income – personal current taxes = disposable personal income
This can be restated as: consumption expenditure + savings = disposable income
For the purposes of calculating the amount of income subject to garnishment, United States federal law defines disposable income as an individual’s compensation (including salary, overtime, bonuses, commission, and paid leave) after the deduction of health insurance premiums and any amounts required to be deducted by law. Amounts required to be deducted by law include federal, state, and local taxes, state unemployment and disability taxes, social security taxes, and other garnishments or levies, but does not include such deductions as voluntary retirement contributions and transportation deductions.
Discretionary income is disposable income minus all payments that are necessary to meet current bills. It is total personal income after subtracting taxes and typical expenses (such as rent or mortgage, utilities, insurance, medical fees, transportation, property maintenance, child support, food and sundries, etc.) needed to maintain a certain standard of living. In other words, it is the amount of an individual’s income available for spending after the essentials (such as food, clothing, and shelter) have been taken care of.
Discretionary income = Gross income – taxes – all compelled payments (bills)
Disposable income is often incorrectly used to denote discretionary income. The meaning should therefore be interpreted from context. Commonly, disposable income is the amount of “play money” left to spend or save.
GDP per capita
Gross domestic product (GDP) per capita is the mean income of people in an economic unit.
Gross domestic product (GDP) per capita is also known as income per person. It is the mean income of the people in an economic unit such as a country or city. GDP per capita is calculated by dividing GDP by the total population of the country.
GDP per capita income as a measure of prosperity
GDP per capita is often used as average income, a measure of the wealth of the population of a nation, particularly when making comparisons to other nations. It is useful because GDP is expected to increase with population, so it may be misleading to simply compare the GDPs of two countries. GDP per capita accounts for population size.
Comparisons of GDP per capita: GDP per capita varies across countries and is highest among developed countries. However, GDP per capita is not an indicator of income distribution in a given country. For this reason GDP per capita may not necessarily be a barometer for the quality of life in a given country.
Per capita income is often used to measure a country’s standard of living. It is usually expressed in terms of a commonly used international currency such as the Euro or United States dollar. It is easily calculated from readily-available GDP and population estimates, and produces a useful statistic for comparison of wealth between sovereign territories. This helps countries know their development status.
However, critics contend that per capita income has several weaknesses as a measure of prosperity, including:
• Comparisons of GDP per capita over time need to take into account changes in prices. Without using measures of income adjusted for inflation, they will tend to overstate the effects of economic growth.
• International comparisons can be distorted by differences in the cost of living between countries that are not reflected in exchange rates. When looking at differences in living standards between countries, using a measure of GDP per capita adjusted for differences in purchasing power parity more accurately reflects the differences in what people are actually able to buy with their money.
• As it is a mean value, it does not reflect income distribution. If the distribution of income within a country is skewed, a small wealthy class can increase GDP per capita far above that of the majority of the population. Median income is a more useful measure of prosperity than GDP per capita because it is less influenced by outliers.
Key Points
• Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation.
• In order to count a good or service, it is necessary to assign value to it.
• Three strategies have been used to obtain the market values of all the goods and services produced: the product (or output) method, the expenditure method, and the income method.
• In the United States the most widely cited personal income statistics are the Bureau of Economic Analysis’s (BEA) personal income and the Census Bureau’s per capita money income.
• BEA’s personal income measures the income received by persons from participation in production, from government and business transfers, and from holding interest-bearing securities and corporate stocks.
• The Census Bureau also produces alternative estimates of income and poverty based on broadened definitions of income that include many of these income components that are not included in money income.
• Disposable income is total personal income minus personal current taxes.
• Discretionary income is disposable income minus all payments that are necessary to meet current bills.
• Disposable income is often incorrectly used to denote discretionary income.
• GDP per capita is often used as average income, a measure of the wealth of the population of a nation, particularly when making comparisons among nations.
• Per capita income is often used to measure a country’s standard of living.
• It is usually expressed in terms of a commonly used international currency such as the Euro or United States dollar, and can be easily calculated from readily-available GDP and population estimates.
Key Terms
• national income: The total amount of goods and services produced within some “boundary.” The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted.
• personal income: An individual’s total earnings from wages, investment enterprises, and other ventures.
• disposable income: Income left after taxes.
• Discretionary Income: Disposable income (after-tax income) minus all payments that are necessary to meet current bills.
• per capita: per person
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• Personal income in the United States. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Persona..._United_States. License: CC BY-SA: Attribution-ShareAlike
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Calculating Real GDP
Real GDP growth is the value of all goods produced in a given year; nominal GDP is value of all the goods taking price changes into account.
learning objectives
• Calculate real and nominal GDP growth
Gross Domestic Product
The Gross domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time. The GDP is the officially recognized totals. The following equation is used to calculate the GDP:
$\mathrm{GDP=C+I+G+(X−M)}$
Written out, the equation for calculating GDP is:
\[\text{GDP} = private consumption + gross investment + government investment + government spending + (exports – imports).
For the gross domestic product, “gross” means that the GDP measures production regardless of the various uses to which the product can be put. Production can be used for immediate consumption, for investment into fixed assets or inventories, or for replacing fixed assets that have depreciated. “Domestic” means that the measurement of GDP contains only products from within its borders.
Nominal GDP
The nominal GDP is the value of all the final goods and services that an economy produced during a given year. It is calculated by using the prices that are current in the year in which the output is produced. In economics, a nominal value is expressed in monetary terms. For example, a nominal value can change due to shifts in quantity and price. The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.
Nominal GDP: This image shows the nominal GDP for a given year in the United States.
Real GDP
The real GDP is the total value of all of the final goods and services that an economy produces during a given year, accounting for inflation. It is calculated using the prices of a selected base year. To calculate Real GDP, you must determine how much GDP has been changed by inflation since the base year, and divide out the inflation each year. Real GDP, therefore, accounts for the fact that if prices change but output doesn’t, nominal GDP would change.
Real GDP Growth: This graph shows the real GDP growth over a specific period of time.
In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time. The real GDP determines the purchasing power net of price changes for a given year. Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.
The GDP Deflator
The GDP deflator is a price index that measures inflation or deflation in an economy by calculating a ratio of nominal GDP to real GDP.
learning objectives
• Calculate real and nominal GDP growth
The GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is a price index that measures price inflation or deflation, and is calculated using nominal GDP and real GDP.
Nominal GDP versus Real GDP
Nominal GDP, or unadjusted GDP, is the market value of all final goods produced in a geographical region, usually a country. That market value depends on the quantities of goods and services produced and their respective prices. Therefore, if prices change from one period to the next but actual output does not, nominal GDP would also change even though output remained constant.
In contrast, real gross domestic product accounts for price changes that may have occurred due to inflation. In other words, real GDP is nominal GDP adjusted for inflation. If prices change from one period to the next but actual output does not, real GDP would be remain the same. Real GDP reflects changes in real production. If there is no inflation or deflation, nominal GDP will be the same as real GDP.
Calculating the GDP Deflator
The GDP deflator is calculated by dividing nominal GDP by real GDP and multiplying by 100.
GDP Deflator Equation: The GDP deflator measures price inflation in an economy. It is calculated by dividing nominal GDP by real GDP and multiplying by 100.
Consider a numeric example: if nominal GDP is $100,000, and real GDP is$45,000, then the GDP deflator will be 222 (GDP deflator = $100,000/$45,000 * 100 = 222.22).
In the U.S., GDP and GDP deflator are calculated by the U.S. Bureau of Economic Analysis.
Relationship between GDP Deflator and CPI
Like the Consumer Price Index (CPI), the GDP deflator is a measure of price inflation/deflation with respect to a specific base year. Similar to the CPI, the GDP deflator of the base year itself is equal to 100. Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the “basket” for the GDP deflator is allowed to change from year to year with people’s consumption and investment patterns. However, trends in the GDP deflator will be similar to trends in the CPI.
Key Points
• The following equation is used to calculate the GDP: $\mathrm{GDP = C + I + G + (X – M)}$ or GDP = private consumption + gross investment + government investment + government spending + (exports – imports).
• Nominal value changes due to shifts in quantity and price.
• In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time.
• Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.
• The GDP deflator is a measure of price inflation. It is calculated by dividing Nominal GDP by Real GDP and then multiplying by 100. (Based on the formula).
• Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation. Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output.
• Trends in the GDP deflator are similar to changes in the Consumer Price Index, which is a different way of measuring inflation.
Key Terms
• nominal: Without adjustment to remove the effects of inflation (in contrast to real).
• gross domestic product: Known also as GDP, this is a measure of the economic production of a particular territory in financial capital terms over a specific time period.
• GDP deflator: A measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is calculated by computing the ratio of nominal GDP to the real measure of GDP.
• real GDP: A macroeconomic measure of the value of the economy’s output adjusted for price changes (inflation or deflation).
• nominal GDP: A macroeconomic measure of the value of the economy’s output that is not adjusted for inflation.
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Introduction to Inflation
Inflation is a persistent increase in the general price level, and has three varieties: demand-pull, cost-push, and built-in.
learning objectives
• Distinguish between demand-pull and cost-push inflation
In economics, inflation is a persistent increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money; it is a loss of real value, as a single dollar is able to purchase fewer goods than it previously could.
Types of Inflation
The reasons for inflation depend on supply and demand. Depending on the type of inflation, changes in either supply or demand can create an increase in the price level of goods and services. In Keynesian economics, there are three types of inflation.
Demand-Pull Inflation
Demand-pull inflation is inflation that occurs when total demand for goods and services exceeds the economy’s capacity to produce those goods. Put another way, there is “too much money chasing too few goods. ” Typically, demand-pull inflation occurs when unemployment is low or falling. The increases in employment raise aggregate demand, which leads to increased hiring to expand the level of production. Eventually, production cannot keep pace with aggregate demand because of capacity constraints, so prices rise.
Demand-Pull Inflation: Demand-pull inflation is caused by an increase in aggregate demand. As demand increases, so does the price level.
Cost-Push Inflation
Cost-push inflation occurs when there is an increase in the costs of production. Unlike demand-pull inflation, cost-push inflation is not “too much money chasing too few goods,” but rather, a decrease in the supply of goods, which raises prices.
Cost-Push Inflation: As the costs of production inputs rises, aggregate supply can decrease, which increases price levels.
The reason for decreases in supply are usually related to increases in the prices of inputs. One major reason for cost-push inflation are supply shocks. A supply shock is an event that suddenly changes the price of a commodity or service. (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. One historical example of this is the oil crisis of the 1970’s, when the price of oil in the U.S. surged. Because oil is integral to many industries, the price increase led to large increases in the costs of production, which translated to higher price levels.
Built-In Inflation
Built-in inflation is the result of adaptive expectations. If workers expect there to be inflation, they will negotiate for wages increasing at or above the rate of inflation (so as to avoid losing purchasing power). Their employers then pass the higher labor costs on to customers through higher prices, which actually reflects inflation. Thus, there is a cycle of expectations and inflation driving one another.
Defining and Calculating CPI
The consumer price index (CPI) is a statistical estimate of the change in prices of goods and services bought for consumption.
learning objectives
• Assess the uses and limitations of the Consumer Price Index
Consumer Price Index
The consumer price index (CPI) is a statistical estimate of the level of prices of goods and services bought for consumption by households. It measures changes in the price level of a market basket of goods and services used by households. The CPI is calculated by collecting the prices of a sample of representative items over a specific period of time. Goods and services are divided into categories, sub categories, and sub indexes. All of the information is combined to produce the overall index of consumer expenditures. The annual percentage change in a CPI is used to measure inflation. The CPI can be used to index the real value of wages, salaries, pensions, and price regulation. It is one of the most closely watched national economic statistics.
Consumer Price Index: The graph shows the consumer price index in the United States from 1913 – 2004. The x-axis indicates year, the left y-axis indicates the Consumer Price Index, and the right y-axis indicates annual percentage change in Consumer Price Index, which can be used to measure inflation.
Calculating CPI using a Single Item
In order to calculate the CPI using a single item the following equation is used:
$\text{Current CPI}=\text{Current item price} \times \text{Base year price} \times \dfrac{\text{Current CPI}}{\text{Base year CPI}}$
Calculating the CPI for Multiple Items
When calculating the CPI for multiple items, it must be noted that many but not all price indices are weighted averages using weights that sum to 1 or 100. When calculating the average for a large number of products, the price is given a weighted average between 1 and 100 to simplify calculation. The weighting determines the importance of the quantity of the product on average. The equation for calculating the CPI for multiple items is:
CPI for multiple items=Cost of CPI market basket at current period pricesCost of CPI market basket at base period prices×100.CPI for multiple items=Cost of CPI market basket at current period pricesCost of CPI market basket at base period prices×100.
For example, imagine you buy five sandwiches, two magazines, and two pairs of jeans. In the first period, sandwiches are $6 each, magazines are$4 each, and jeans are $35 each. This will be our base period. In the second period, sandwiches are$7, magazines are $6, and jeans are$45.
$\text{Market basket at base period prices} = 5(6.00) + 2(4.00) + 2(35.00) = 108.00.$
$\text{Market basket at current period prices} = 5(7.00) + 2(6.00) + 2(45.00) = 137.00.$
$\text{CPI for multiple items}=\frac{137}{108} \times 100=127$
The CPI based on consumption is 127.
CPI Limitations
The CPI is a convenient way to calculate the cost of living and price level for a certain period of time. However, the CPI does not provide a completely accurate estimate for the cost of living. Issues that impede the accuracy of the CPI include substitution bias (consumers substituting goods for others), introducing new products, and changes in quality. The CPI can also overstate inflation because it does not always account for quality improvements or new goods and services.
GDP Deflator vs. CPI
The GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. Unlike the CPI, the GDP deflator is a measure of price inflation or deflation for a specific base year. The GDP deflator differs from the CPI because it is not based on a fixed basket of goods and services. The GDP deflator “basket” changes from year to year depending on people’s consumption and investment patterns. Unlike the CPI, the GDP deflator is not impacted by substitution biases. Despite the GDP being more flexible, the CPI is a more accurate reflection of the changes in the cost of living.
Key Points
• Inflation is an increase in price levels, which decreases the real value, or purchasing power, of money.
• Demand -pull inflation is an increase in price levels due to an increase in aggregate demand when the employment level is full or close to full.
• Cost -push inflation is an increase in price levels due to a decrease in aggregate supply. Generally, this occurs due to supply shocks, or an increase in the price of production inputs.
• The CPI is calculated by collecting the prices of a sample of representative items over a specific period of time.
• The CPI can be used to index the real value of wages, salaries, pensions, and price regulation. It is one of the most closely watched national economic statistics.
• The equation to calculate a price index using a single item is: Current CPI=Current item price×Base year price×Current CPIBase year CPICurrent CPI=Current item price×Base year price×Current CPIBase year CPI.
• The equation for calculating the CPI for multiple items is: CPI for multiple items=Cost of CPI market basket at current period pricesCost of CPI market basket at base period prices×100.CPI for multiple items=Cost of CPI market basket at current period pricesCost of CPI market basket at base period prices×100..
Key Terms
• inflation: An increase in the general level of prices or in the cost of living.
• demand-pull inflation: A rise in the price level for goods and services in an economy due to greater demand than the economy’s ability to produce those goods and services.
• cost-push inflation: A rise in the price level for goods and services in an economy due to increases in the costs of production.
• consumer price index: A statistical estimate of the level of prices of goods and services bought for consumption purposes by households.
• market basket: A list of items used specifically to track the progress of inflation in an economy or specific market.
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Defining a Market System
A market system is a way to match buyers and sellers.
Learning objectives
Identify the characteristics of a market system
In an economy, a market system is any systematic process that enables many market players to bid and ask. In other words, a market system is a place (virtual or physical) that facilitates the matching of buyers and sellers. Many markets exist, and each can be defined based on a number of characteristics, such as what is being exchanged in the market, the regulations, who is allowed to participate, and how transactions occur.
One defining component of markets is the medium of exchange, or the price. In most American markets, the medium of exchange is dollars. Both buyers and sellers look at the price to determine whether or not they want to trade. A seller has a certain minimum price at which s/he is willing to sell, though s/he would happily accept more. Likewise, a buyer has a certain maximum price at which s/he is willing to buy, though s/he would happily pay less. If the minimum the seller would accept is less than the maximum a buyer would pay, a transaction can occur. Markets help such buyers and sellers meet to trade.
In market systems, prices are discoverable; both buyers and sellers are capable of finding out the current price at which a transaction could occur. Publishing current prices is a key component with a market system. The chosen prices impact the immediate group of buyers and sellers, but also may impact long term supply and demand decisions within the market.
There are many examples of market systems. Perhaps the most famous is the stock market in which buyers and sellers trade stocks. The prices at which those sales occur is recorded, and is the basis for the stock price you may have seen in the newspaper or on TV. There are markets for many types of products other than stocks: the global oil market, your local farmers’ market, and eBay are all forms of markets with their own defining characteristics.
NASDAQ Stock Market Display: The NASDAQ is a stock market where buyers and sellers of stocks can meet and trade.
Another important component of market systems is that there is competition, which serves as the main regulatory mechanism. Based on the level of competition in a market system, economists have identified a number of different types of structures, such as monopoly, oligopoly, and perfect competition. We will go into more detail on different market structures later in the book.
Gains from Markets
Gains in a market are referred to as total welfare or economic surplus.
Learning objectives
Explain how to calculate total welfare
Gains within a market are referred to as total welfare or economic surplus. Within total welfare, economists look at consumer surplus and producer surplus. A surplus is defined as the excess of a good or service when the quantity supplied exceeds the quantity demanded; this occurs when the price is above the equilibrium price.
Economic Surpluses: The total welfare (or economic surplus) is the sum of the consumer surplus and the producer surplus.
Consumer surplus is the monetary gain that consumers receive when they purchase a good for less than the highest price they are willing to pay. For example, a customer is willing to pay \$50 for a new pair of running shoes. They are able to purchase the pair for \$35 and consumer surplus is \$15.
Producer surplus is the amount that producers benefit by selling a good at a market price that is higher than the least that they would be willing to sell it for. An example would be a manufacturer that makes jeans. The lowest price the producer is willing to sell a pair of jeans for is \$40, but the jeans actually sell for \$50. The producer surplus is \$10.
In order to calculate the total welfare, the supply and demand of the good must be used to determine the economic gain. On a demand and supply curve graph, the consumer surplus is located under the demand curve and above a horizontal line that shows the actual price of a good (equilibrium price).
When the supply of a good increases, the price falls which increases consumer surplus. When the demand for a good increases, the price increases and the supply decreases resulting in producer surplus. When a good is in high demand, consumers are willing to pay more in order to obtain the good.
Production Possibility Frontier
A production-possibility frontier (PPF) graphs the combinations for the production of two commodities with which the same amounts are used.
Learning objectives
Explain the benefits of trade and exchange using the production possibilities frontier (PPF)
Within a market system, economists use the production possibility frontier (PPF) to graph the combinations of the amounts of two commodities that can be produced using the same amount of each factor of production. A PPF graph chooses specific input quantities. As a result, it shows the maximum production level for one commodity for any production level of the other commodity. PPF is used to define production efficiency.
A common PPF: A common PPF where there is an increase in opportunity cost.
Within a PPF graph, the use of a curve or line acts as a benchmark for measuring efficiency. If a point on the graph is above the curve it indicates efficiency, while a point below the curve signifies inefficiency. For further analysis, additional information is always supplied with a PPF including the period of time taken for the observation, production technologies, and the amounts of inputs that were available.
Economists can use a PPF to illustrate a number of economic concepts including scarcity, opportunity cost, productive efficiency, allocative efficiency, and economies of scale.
When an economy is operating on the PPF curve it is efficient. It is not possible to produce more of one good without decreasing the amount produced for the other good. Likewise, if the economy is operating below the PPF curve, it is inefficient. In this case, the economy can reallocate resources and produce more of both the goods.
The PPF graph shows how resources must be shared among goods during the production process. The points of the graph show the trade -off that takes place between two goods. For example, if more of Good A needs to be produced, the amount of resources in use by Good B must be reduced and transferred to Good A. The sacrifice in production of Good B is called opportunity cost. When graphing PPF there are three types: the common, the straight line, and the inverted PPF. All three of the PPF graphs are directly influenced by the opportunity cost.
An inverted PPF: An inverted PPF where the opportunity cost is decreasing.
A straight line PPF: A straight line PPF where the opportunity cost is constant.
The slope of the PPF shows the rate at which the production of one good can be transferred to another. The slope is called the marginal rate of transformation (MRT).
Within an economy, if the capacity to produce both goods increases, the result is economic growth. Factors that influence economic capacity include technology, an increase in the supply of factors of production, and production interactions such as trade and exchange. When any of these factors are used it allows for an increase in capacity so that the production of neither good has to be sacrificed.
PPF graphs help economists study the current state of production as well as possible production scenarios. The output of the economy is impacted by many factors. When production can be graphed and monitored it allows adjustments to be made to work towards attaining economic growth and stability.
The slope of the PPF shows the rate at which the production of one good can be transferred to another. The slope is called the marginal rate of transformation (MRT).
Within an economy, if the capacity to produce both goods increases, the result is economic growth. Factors that influence economic capacity include technology, an increase in the supply of factors of production, and production interactions such as trade and exchange. When any of these factors are used it allows for an increase in capacity so that the production of neither good has to be sacrificed.
PPF graphs help economists study the current state of production as well as possible production scenarios. The output of the economy is impacted by many factors. When production can be graphed and monitored it allows adjustments to be made to work towards attaining economic growth and stability.
The Circular Flow Model
In economics, a circular flow model is a diagram that is used to represent the monetary transactions in an economy.
Learning objectives
State the function of the circular flow diagram and the production possibilities frontier
In economics, a circular flow model is a diagram that is used to represent the monetary transactions in an economy. There are two flows present within the model including flows of physical things (goods or labor) and flows of money (what pays for physical things). A circular flow model depicts the inner workings of a market system and specific portions of the economy.
The basic circular flow model consists of two sectors that determine income, expenditure, and output. A state of equilibrium is reached when there is no tendency for the levels of income (YY), expenditure (EE), and output (OO) to change (Y=E=OY=E=O). This equation means that the expenditure of buyers (households) becomes income for sellers ( firms ). The firms spend the income on factors of production, which “transfers” the income to the factor owners. The factor owners spend the income on goods which leads to the circular flow of payments.
Circular flow of goods income: The circular flow model shows the flow of payments between households and firms.
The circular flow of payments is important within an economy because it 1) measures the national income, 2) provides knowledge of interdependence, 3) illustrates the unending nature of economic activities, and 4) shows injections and leakages.
The circular flow of income follows a specific pattern: Production → Income → Expenditure → Production. This circular flow is ongoing between households and firms.
The circular flow of income can also be analyzed using the production possibility frontier (PPF). The PPF is a graph that shows the various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production. The graph shows the maximum possible production level of one commodity for any production level of the other, based on the state of technology. The PPF defines production efficiency. A point of the frontier line indicates the efficient use of available inputs, while a point beneath the curve shows inefficiency. A PPF graphs shows opportunity cost, actual output, potential output, and economic growth.
Production Possibilities Frontier Curve: The graph illustrates a typical production possibilities frontier curve. When a market is operating on the PPF it is said to be efficient.
Key Points
• Publishing current prices is a key component with a market system.
• Competition is the primary regulatory mechanism in a market system.
• Economists recognize a number of different structures of market systems based on characteristics such as the level of competition.
• Within total welfare, economists look at consumer surplus and producer surplus.
• Consumer surplus is the monetary gain that consumers receive when they purchase a good for less than the highest price they are willing to pay.
• Producer surplus is the amount that producers benefit by selling a good at a market price that is higher than the least that they would be willing to sell it for.
• In order to calculate the total welfare, the supply and demand of the good must be used to determine the economic gain.
• When the supply of a good increases, the price falls which increases consumer surplus. When the demand for a good increases, the price increases and the supply decreases resulting in producer surplus.
• A PPF graph shows the maximum production level for one commodity for any production level of the other commodity.
• If a point on the graph is above the curve it indicates efficiency, while a point below the curve signifies inefficiency.
• The PPF graph shows how resources must be shared among goods during the production process.
• Within an economy, if the capacity to produce both goods increases which results in economic growth.
• There are two flows present within the model including flows of physical things (goods or labor) and flows of money (what pays for physical things).
• The circular flow of income follows a specific pattern: Production → Income → Expenditure → Production.
• The production possibility frontier can be used to illustrate the circular flow model.
• Economists use data, statistics, and natural experiments in order to make economic “laws” that explain general patterns.
Key Terms
• price: The quantity of payment or compensation given by one party to another in return for goods or services.
• welfare: Health, safety, happiness and prosperity; well-being in any respect.
• commodity: Raw materials, agricultural and other primary products as objects of large-scale trading in specialized exchanges.
• marginal: Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
• expenditure: Act of expending or paying out.
• Factors of production: In economics, factors of production are inputs. They may also refer specifically to the primary factors, which are stocks including land, labor, and capital goods applied to production.
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Economic Growth as a Measuring Stick
Economic growth is measured as the increase in real gross domestic product (GDP) in the long-run, through higher resources or productivity.
learning OBJECTIVES
• Examine the components that cause economic growth
Economic growth can be defined as the increase in real gross domestic product (GDP) in the long-run, or as increased productivity or via an increase in the natural resources (inputs) that create output. It is important to note that real GDP adjusts for inflation, rather than looking at output in nominal dollars. Economic growth could also be described as an outward shift in the production-possibility frontier, allowing for the production of a higher quantity of goods.
Production-Possibility Frontier: This outward shift in the Production-Possibility frontier is indicative of economic growth within the economy it represents.
Standard Measures of Economic Growth
Measuring economic growth is reasonably straight-forward, primarily focusing on either increases in productivity or increases in the available production inputs in a given system. This increase in productivity is converted into a relative percent based upon previous years, and expressed as a growth or decline. For example, if a given economy is producing \$1,000,000 in 1900 and 1,050,000 in 1901, the economic growth rate (or GDP growth) will be expressed as 5%. If inflation is calculated to be 3% between 1900 and 1901, real economic growth will equate to 2%.
Alternative Economic Growth Models
While measuring real GDP is useful in some ways, and considered a standard measure of economic growth, there is a great deal more complexity than is being captured (both quantitatively and qualitatively). An outline of the perspectives of economic growth over time include:
• Classical Growth Theory: Dating back to Adam Smith and the foundation of capitalism, classical growth theory uses the production function to measure economic growth. $\mathrm{Y=f(K,L,N)}$, where Y, K, L and N represent output, capital, labor and land respectively. In this model, the overall growth of an economy will compound exponentially and capture economies of scale, implying that economic expansion via consistent growth is a reasonable proposition.
• Growth Accounting: Growth accounting came into popularity after the classical model, identifying the crucial role of technology in economic growth. Using the same classical growth equation, this method of measuring economic growth replaces the ‘land’ variable with ‘technology’ (technology including all of the contextual components that enable growth). In this scenario, technological leaps and bounds can be captured in the overall growth model.
• Salter Cycle: Economic growth is ultimately enabled by increases in productivity, and thus reductions in the required inputs to achieve each subsequent output per unit. As a result, an economy will continuously decrease price and thus increase demand, minimizing marginal utility over time and saturating markets.
• Endogenous Growth Model: This model takes into account technology, as in the growth accounting system discussed above, alongside increases in skills and intellectual capital. A more educated workforce will result in increases in real output, as will advances in technology and innovation.
• Energy Growth Theory: There has been a consistent correlation between economic growth and energy increase, alongside a paradox that increased energy and resource utilization efficiency actually increases consumption of that resource (similar to the Salter Cycle concept). As a result, energy growth theory economists identify a critical role of energy and resources in measuring overall economic growth.
How to Compare Economies Throughout History
Economies throughout history are defined by an evolution towards common currencies, global trade, and technologies driving productivity.
learning OBJECTIVES
• Describe historical trends in rates of economic growth
Comparing historical economies and economic trends over the course of human history is a difficult endeavor, as the comparisons are not always equal. The evolution of trade and the construction of measurement systems, currencies, standards, and the accuracy of historical record present a challenge to economists evaluating economies over time. That being said, timelines have been generated that capture useful insights, and modern economic comparisons (country to country) are growing increasingly accurate. Both of these perspectives shed light as to the overall patterns of economic growth over time.
Relevant Time Periods
For the sake of this discussion, four general time frames are useful to highlight:
• Stone Age: Including the Paleolithic, Mesolithic, and Neolithic time frames (up to 3500 B.C.), economics was virtually basic trade between small, local groups. This age is particularly worthy of note due to the crucial development of bartering and specialization. Specialization refers to the fact that a small group of people performing (and specializing) in different tasks can create substantially more value than every individual learning all tasks (think of Henry Ford’s assembly line).
• Antiquity: This includes the Bronze Age and the Iron Age, antiquity spans from 3500 B.C. around 500 A.D. As the names imply, the leveraging of natural resources (such as metals) were a critical step forward for trade. During this time frame the Babylonians are credited with generating the first metric to measure economic value (i.e. currency), and standardizing trade through leveraging this metric. This is an absolutely critical component to the ultimately measurement and comparison of economies from this time period forward.
• Middle Ages: The Silk Road is a famous economic historical element of this time frame, as is the creation of the first official paper currency (or banknotes) by the Tang Dynasty in China around the 9th century. The Middle Ages stretched from 500 A.D.-1500 A.D., and eventually saw the roots of accounting and financial trade roles in society.
• Modernity: From 1500 A.D. forward, trade grew increasingly global and increasingly standardized as a result. This era is marked by the Industrial Revolution, and the exponential productivity growth inherently found in technological advancement and standardized education systems. As the 20th century dawned, real world GDP is estimated to have quadrupled as a result of the advances in industry, technology and intellectual innovations. Subsequently, population expanded as well.
With these four eras in mind, it is easy to empathize with economists attempting to unveil relative economic strength in the context of capitalist evolution. The modern age provides the most consistent data in which to analyze growth.
Comparing Modern Economies
Modern economies have been consistently measured for growth over the past couple centuries, underlining useful economic data on overall growth between nations. To simplify these comparisons, economic growth is generally assessed as general GDP (or increased productivity within a nation). The figure demonstrates these comparisons between 1990 and 2006, with a few countries standing out (China in particular).
GDP Growth Across Nations: This graph underlines the important fact that economic growth is not mutually or equally distributed, resulting from a wide variety of factors with external and global systems.
Over time, countries can change significantly, and these changes must be considered in order to make accurate comparisons. Inflation, for example, changes the value of one unit of currency across time, so comparisons across time should be made using Real GDP, a GDP index, or another measure that accounts for changes in price.
There are also a number of other factors that must be taken into account such as GDP per capita, energy consumption, pollution metrics, education levels, innovation, etc. As you can imagine, it is difficult to compare countries across large time horizons, but, after controlling for as many of these effects as you can, comparisons are possible.
Economic Growth in the 20th Century: As a result of technological advances and increased intellectual capacity, real productivity increased by over 400% during this time frame.
Is Economic Growth a Good Goal?
Economic growth is typically viewed as positive, but there are mixed repercussions of increased productivity within an economic system.
learning OBJECTIVES
• Identify the value of economic growth objectives.
Throughout history, economists have typically assumed a positive relationship between economic growth (increased productivity) and the well-being of a society. It seems logical to assume that a stronger economy would create a higher standard of living. However, there is some debate surrounding the validity of this assumption. Is economic growth the appropriate objective?
Why is Growth Good?
Economic growth is the increase in the market value of the goods and services produced by an economy over time. Simply, more economic growth means that people are able to buy more of the things they like. Presumably, this translates into higher overall utility.
On a societal level, increases in GDP growth and overall productivity generates high prospective tax revenues, both on business profits and consumer purchases. Higher tax revenues will allow governments more financial flexibility to invest in social services such as education, welfare, transportation, etc.
Drawbacks to Economic Growth
There are, however, some downsides to economic growth, which are summarized in the idea of uneconomic growth. The concept of uneconomic growth postulates that the costs of economic growth – primarily environmental and social costs – may outweigh the benefits. There are a few specific observations of this that are worth noting:
• Jevon’s Paradox: Interestingly, increases in efficiency which drive increased economic growth often result in higher consumption. For example, when an economic system creates higher efficiency for generating electricity it will often increase the amount of electricity consumer in spite of that increased efficiency. This creates a culture of consumerism which is often wasteful.
• Malthusian Trap: Named after a political economist named Thomas Robert Malthus, the Malthusian trap simply states that increases in efficiency tend to result in population growth rather than wealth growth. Increased productivity within a system is only useful if it translates to an increase in per capita wealth.
• Imbalanced Distribution: Another issue is income distribution. This is what was meant by the adage that the rich get richer while the poor get poorer. It is quite common to see the rich absorb the vast majority of the value generated through increased productivity, creating a larger relative gap between the rich and the poor. In this circumstance there is limited utilitarian value to economic growth.
• Environmental Degradation: The final criticism is often the most discussed, particularly in light of the overwhelming evidence of global warming and the destructive nature of excessive consumption. It is also reasonable to consider the finite nature of natural resources (see ). Scientific modeling by environmental scientists often demonstrate significant long-term risks for the well-being of the ecosystem, posing a very real threat to the overall value in continued economic growth. Is it worth having more to consume if there is no ecosystem in which to enjoy it?
The important takeaway from this is to think carefully about the value created by economic growth. It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.
Petroleum Consumption Over Time: This figure demonstrates the risk of over-consuming our natural resources, ultimately resulting in scarcity of necessary goods. A continued drive for economic growth could lead to overconsumption of natural resources.
Key Points
• Economic growth could also be described as an outward shift in the production-possibility frontier, allowing for the generation of a higher quantity of goods.
• While measuring real GDP is useful in some ways, and considered a standard measure of economic growth, there is a great deal more complexity than is being captured (both quantitatively and qualitatively).
• Classic growth theory uses the production function to measure economic growth, which ultimately implies that economic growth constantly compounds.
• Growth accounting came into popularity after the classic model, identifying the crucial role of technology in economic growth.
• A more educated workforce will result in increases in real output, as will advances in technology and innovation.
• Comparing historical economies and economic trends over the course of human history is a difficult endeavor, as the comparisons are not always equal.
• Babylonians are credited with generating the first metric to measure economic value (i.e. currency ) and standardizing trade through leveraging this metric.
• The creation of the first official paper currency (or banknotes) by the Tang Dynasty in China around the 9th century.
• As the 20th century dawned, real world GDP is estimated to have quadrupled as a result of the advances in industry (see, technology, and intellectual innovations.
• Modern economies have been consistently measured for growth over the past couple centuries, underlining useful economic data on overall growth between nations. To simplify these comparisons, economic growth is generally assessed as general GDP.
• The relationship between economic growth and the well-being of a society has largely been viewed as positive throughout the course of history.
• Economic growth increases consumer purchasing power and leisure time along with governmental purchasing power for societal benefits.
• The concept of uneconomic growth postulates that the costs of economic growth may outweigh the benefits, those costs being the environmental and societal repercussions.
• It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.
• It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.
Key Terms
• inflation: The rise in the general level of prices of goods and services in an economy over a period of time.
• gross domestic product: A measure of the economic production of a particular territory in financial capital terms over a specific time period.
• evolution: Gradual directional change especially one leading to a more advanced or complex form; growth; development.
• Bartering: Exchange goods or services without involving money.
• economic growth: The increase of the economic output of a country.
• Jevon’s Paradox: The proposition that technological progress that increases the efficiency with which a resource is used tends to increase the rate of consumption of that resource.
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Calculating Economic Growth
Economic growth is the increase in the market value of goods and services produced by an economy over time; the percentage rate of increase in the GDP.
learning objectives
• Calculate various measures of economic growth
Economic Growth
Economic growth is defined as the increase in the market value of goods and services produced by an economy over time. It is usually measured as a percentage rate of increase in the real gross domestic product. In economics, economic growth refers to the growth of potential output. It shows how a country is developing its economy. Economic growth is directly impacted by human capital, which is the level of school or knowledge attainment in a country. The cognitive skills of a population directly impact economic growth. In general, economic growth is recorded and studied over the short-run and long-run.
Short-run Economic Growth
The business cycle refers to economy-wide fluctuations in production, trade, and economic activity over several months or years. The short-run variation in economic growth is called the business cycle. Economists use it to distinguish between short-run variations in economic growth and long-run economic growth. The cycle is made up of increases and decreases in production that occur over months and years. The changes in the business cycle are a result of fluctuations in aggregate demand.
The Business Cycle: The business cycle is used to determine the short-run variation in economic growth. Variations in the business cycle fluctuation over months and years and are attributed to fluctuations in aggregate demand.
Long-run Economic Growth
Long-run economic growth is measured as the percentage rate increase in the real gross domestic product. The GDP is defined as the market value of all officially recognized final goods and services produced within a country in a given period of time. There are three approaches used to determine the GDP:
• Product (output) approach: adds together the outputs of every class of enterprise to provide the total.
• Income approach: calculates the sum of all the producers’ incomes.
• Expenditure approach: the value of the total product must be equal to the people’s total expenditures.
In principle, all of the approaches should yield the same result for the GDP of a country.
For example, the equation for the expenditure approach is: $\mathrm{GDP = C + I + G + (X – M)}$.
Written out in full, the gross domestic product (GDP) equals private consumption (C) plus, gross investment (I), government spending (G), and the exports minus the imports (X – M).
For economic purposes, the economic growth is calculated and compared to the population, also know as per capita income (indicator of a country’s standard of living). When the per capita income increases it is called intensive growth. When the GDP growth is only caused by increases in population or territory it is called extensive growth.
Growth in the United States
U.S. Economic Growth
Throughout its history, the U.S. has experienced economic growth in varying degrees. Various historical time periods illustrate the rate of growth:
• Prior to industrialization: technological progress caused an increase in population, which was kept in check by food supply and other resources. The per capita income was limited.
• Industrial Revolution: a period of rapid economic growth. Despite the initial excess of population growth, the growth did eventually slow down; a condition called demographic transition. During the first Industrial Revolution mechanization was introduced. During the second Industrial Revolution, wind and water power replaced human and animal labor. This increased the level of production.
• 20th century growth: most economic growth in the 20th century was due to reduced inputs of labor, materials, energy, and land per unit of economic output. The growth was more balanced because more inputs were used due to the growth of output. Also, this time period experienced the production of new goods and services through innovations.
• 1920s: during this time period there was overproduction which was one cause of the Great Depression in the 1930s. Economic growth resumed following the depression and was aided by the demand for new goods and services (telephones, radios, televisions, etc. ).
• 1940 to 1970: the U.S. economy grew by an average of 3.8% and the real median household income surged 74% (2.1% a year).
• 1960s: the U.S. economy experienced its most extensive periods of economic growth from 1961 to 1969 with an expansion of 53% (5.1% a year).
• 1970s: the economy experienced slower growth after 1973. The average growth was 2.7%, there were stagnant living conditions, and household incomes increased by 10% (0.3% annually). The 1973 oil crisis caused the GDP to fall 3.7%. The GDP fell again in late 1973 to 1975 (3.1%).
• 1980s: the U.S. share of the world GDP peaked in 1985 with 23.78% of global GDP. There was a recession from 1981 to 1982 when the GDP dropped by 2.9%.
• 1990s: there was a mild recession in 1990 to 1991 when the output fell by 1.3%.
• 2000s: one of the worst recessions in recent decades occurred in 2008 when the GDP fell by 5.% in one year. The 2008 financial crisis was caused by a derivatives market, the subprime mortgage crisis, and a declining dollar value.
U.S. GDP vs. Household Income (1989-2011): This graph shows the relationship of the GDP in the United States to the household income. This period from 1989 to 2011 was hit by a number of recessions.
Growth in the Rest of the World
On a global scale, economic growth is the sum of the growth of individual countries to give a worldwide total.
learning objectives
• Describe historical growth in developing and developed countries
Economic Growth
Economic growth is the increase in the market value of goods and services produced by an economy over a period of time. It is measured as the percentage rate increase in the real gross domestic product (GDP). On a global scale, economic growth is the sum of the growth of individual countries to give a worldwide total. Economic growth and global impact varies by country based on the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity.
Share of World GDP: This image shows the share of GDP worldwide. The economic growth and global impact that each country has is influenced by the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity.
Global Economic Growth
Due to the vast number of countries globally, the world economy is usually determined in monetary terms, even in cases where no efficient market is available to evaluate goods and services. The market valuations are translated into a single monetary unit using the idea of purchasing power. Analyzing economic growth in prominent countries provides an overview of global economic growth.
Change in GDP: This graph shows the change in GDP for countries around the world for 1900 to 1999 and 1999 to 2006. The GDP for each individual country is used to determine the global economic growth.
• 1980 to 1990: during this time period the economic output of 112 countries expanded while the output of 34 countries contracted. The purchasing power expanded for 145 markets and contracted for two. The five largest contributors to global output contraction were Argentina, Saudi Arabia, Nigeria, Venezuela, and Vietnam.
• 1990 to 2000: the United States dominated expansion during these years. The economic output expanded for 122 countries and contracted for 29. The purchasing power increased for 148 markets and contracted for three. The five largest contributors to global output contraction were Italy, Finland, Bulgaria, Algeria, and the Demographic Republic of Congo.
• 2000 to 2006: Expansion in China moved the country closer to the United States. The economic output for 176 countries expanded and four contracted. The five largest contributors to the expansion were the United States, China, Germany, the United Kingdom, and France. The purchasing power increased for 180 markets. The largest global output contributors were the United States, China, India, Japan, and Russia. From 2000 to 2010 these was a rise in developing and emerging economies.
• 2007: The nominal GDP expanded in 183 countries. The largest contributors were China, the U.S., Germany, and the United Kingdom.
• 2008: the credit crisis started. Economic output expanded in 171 countries, but 11 countries experienced output contractions. The United Kingdom accounted for half the global contraction while South Korea accounted for two-fifths. The crisis impacted most countries, but it was not deep enough to reverse growth.
• 2009: the credit crisis spread. The economic output of 127 countries contracted. The United Kingdom was impacted the most, followed by Russia and Germany. 56 countries experienced expansion of economic output, including China, Japan, and Indonesia. The purchasing power contracted for 79 markets. The U.S. was the largest victim and accounted for 18%, followed by Japan and Russia. 104 markets expanded purchasing power including China, India, and Indonesia.
• 2010: the economic output expanded for 148 countries and contracted for 35. The purchasing power increased for 169 markets and contracted for 14. It was noted that banks faced a “wall” of maturing debt. The U.S. experienced economic recovery, but the global economic growth lost momentum.
• 2011 to 2012: in 2011 it was projected that global growth would drop 4% followed by another 3.5% drop in 2012.
• 2010 to 2018: it is projected that China will lead economic growth during this period. The global economic output is expected to expand by \$32.9 trillion.
Power of Annual Growth
Over long periods of time, small rates of growth have large economic effects. For example, the United Kingdom experienced a 1.97% average annual increase in its GDP from 1830 to 2008. The growth rate averaged 1.97% over 178 years and resulted in a 32-fold increase in the GDP by 2008. The GDP in 1830 was £41,373. It grew to £1,330,088 by 2008.
A growth rate of 2.5% a year leads to a doubling of the GDP within 29 years. A growth rate of 8% a year leads to a doubling of the GDP in 10 years. As a result, small differences in economic growth rates between countries can produced very different standards of living for the populations if the small growth rate continues for many years.
Catch-Up: Possible, but not Certain
Developing countries can catch up to developed countries by achieving growing faster, which is determined by a wide number of country-specific factors.
learning objectives
• Describe different factors that affect the growth rate of developing economies
Economic Growth
Economic growth is defined as the increase in the market value of the goods and services produced by an economy over time. In order to assess economic growth it must be measured. It is the percentage rate of increase in real gross domestic product (GDP). When looking at the long-term economic growth of a country, it is important to analyze the ratio of the GDP to the population (GDP per capita).
For a developing country to catch up to a developed country, it must not only grow, but grow faster than the developed country. It is possible for such accelerated growth to occur, but there are many country-specific factors that affect a country’s ability to catch up to developed countries.
Factors that Impact Economic Growth
There are specific factors that have a direct impact on the economic growth of a country. Every country is unique based on population, technology, government, wealth, etc. Economic growth can be compared between countries, although no two countries are the same. Some of the factors that impact economic growth include:
• Growth of productivity: the growth of productivity is the ratio of economic output to input (capital, labor, energy, materials, and services). When productivity increases the cost of goods decreases causing an increase in the per capita GDP. Lower prices create an increase in higher aggregate demand. The growth of productivity is the driving force behind economic growth.
• Demographics: demographics change the employment to population ratio as well as the labor force participation rate. The age structure of the population affects the labor force participation rate. For example, when women entered the workforce in the U.S. it contributed to economic growth, as did the entrance of the baby boomers into the workforce.
• Labor force participation: the rate of labor force participation impacts economic growth. It is the number of people working in the labor force. When manufacturing increased, it created a higher productivity rate, but lowered the labor force participation, prices fell, and employment shrank.
• Human capital: human capital is referred to as the skills of the population. Education is a commonly used measurement for human capital. Human capital increases the society’s skill which increases economic growth.
• Inequality: inequality in wealth and income has a negative impact on economic growth. Inequality results in high and persistent unemployment. This has a negative effect on long-run economic growth.
• Trade: international trade represents a significant part of GDP for most countries. It is the exchange of goods and services across national borders.
• Quality of life: happiness has been shown to increase with a higher GDP per capita. Quality of life is a direct result of economic growth. When poverty is alleviated and society has access to what it needs, the quality of life increases. Consistent quality of life leads to continued economic growth.
• Employment rate: in order for the employment rate to have a positive impact on economic growth there must also be increases in productivity. If employment increases, but productivity does not, then there is a higher number of working poor.
Economic Growth in Developing Countries
The economic growth of any country takes time to develop. Some countries have much larger, stronger, and more developed economies than other countries. The study of the economic aspects of development in low-income countries is called development economics. It focuses on methods for promoting economic development. All of the factors listed previously impact economic growth – most of them positively. It is possible, but not certain that smaller, underdeveloped economies can experience economic growth and catch-up to more prominent economies.
Change in GDP: This graph shows the change in GDP for various countries for the periods of 1990 to 1998 and 1990 to 2006. It is obvious that certain countries have larger and more developed economies than other countries. It is possible for countries with weaker economies to catch up with larger countries, but it is not certain.
Key Points
• In economics, economic growth refers to the growth of potential output. It shows how a country is developing its economy.
• The short-run variation in economic growth is called the business cycle. Economists use it to distinguish between short-run variations in economic growth and long-run economic growth.
• Long-run economic growth is measured as the percentage rate increase in the real gross domestic product.
• The GDP can be calculated using the product approach, income approach, or expenditure approach. The GDP is defined as the market value of all officially recognized final goods and services produced within a country in a given period of time.
• Currently, the U.S. has a mixed economy, a stable GDP growth rate, moderate unemployment, and high levels of research and capital investment.
• Throughout its history, the U.S. has experienced economic growth in varying degrees. Time periods can be broken down by century and by decades.
• The U.S. economy experienced its most extensive growth from 1961 to 1969.
• Economic growth and global impact varies by country based on the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity.
• Due to the vast number of countries globally, the world economy is usually determined in monetary terms, even in cases where no efficient market is available to evaluate goods and services.
• From 1990 to 2000 the U.S. dominated in expansion. From 2006 to 2006, China’s expansion moved closer to that of the United States. China led in expansion in 2007.
• The global credit crisis started in 2008 and expanded in 2009. By 2010, the U.S. had experienced some economic recovery while the global economic growth had lost momentum.
• From 2010 to 2018, China is expected to led in expansion. The global economic output is projected to expand.
• Every country is unique based on population, technology, government, wealth, ect. Economic growth can be compared between countries, although no two countries are the same.
• Factors that influence economic growth include: growth of productivity, demographics, labor force participation, human capital, inequality, trade, quality of life, and employment rate.
• The economic growth of any country takes time to develop. Some countries have much larger, stronger, and more developed economies than other countries.
• It is possible, but not certain that smaller, underdeveloped economies can experience economic growth and catch-up to more prominent economies.
Key Terms
• business cycle: A fluctuation in economic activity between growth and recession.
• gross domestic product: A measure of the economic production of a particular territory in financial capital terms over a specific time period.
• economic growth: The increase of the economic output of a country.
• recession: A period of reduced economic activity
• financial crisis: A period of serious economic slowdown characterized by devaluing of financial institutions often due to reckless and unsustainable money lending.
• purchasing power: The amount of goods and services that can be bought with a unit of currency or by consumers.
• demographics: The characteristics of human populations for purposes of social studies.
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The Importance of Productivity
Increasing productivity is a rare win-win, improving the standard of living from a governmental, commercial and consumer perspective.
learning objectives
• Use the production function to determine how different variables affect output and productivity
Productivity is essentially the efficiency in which a company or economy can transform resources into goods, potentially creating more from less. Increased productivity means greater output from the same amount of input. This is a value-added process that can effectively raise living standards through decreasing the required monetary investment in everyday necessities (and luxuries), making consumers wealthier (in a relative sense) and businesses more profitable.
From a broader perspective, increased productivity increases the power of an economy through driving economic growth and satisfying more human needs with the same resources. Increased gross domestic product (GDP) and overall economic outputs will drive economic growth, improving the economy and the participants within the economy. As a result, economies will benefit from a deeper pool of tax revenue to draw on in generating necessary social services such as health care, education, welfare, public transportation and funding for critical research. The benefits of increasing productivity are extremely far-reaching, benefiting participants within the system alongside the system itself.
Productivity Beneficiaries
To expand upon this, there are three useful perspectives in which to frame the value in improving productivity within a system from an economic standpoint:
• Consumers/Workers: At the most micro level we have improvements in the standard of living for everyday consumers and workers as a result of increased productivity. The more efficiency captured within a system, the lower the required inputs (labor, land and capital ) will be required to generate goods. This can potentially reduce price points and minimize the necessary working hours for the participants within an economy while retaining high levels of consumption.
• Businesses: Businesses that can derive higher productivity from a system also benefit from creating more outputs with the same or fewer inputs. Simply put, higher efficiency equates to better margins through lower costs. This allows for better compensation for employees, more working capital and an improved competitive capacity.
• Governments: Higher economic growth will also generate larger tax payments for governments. This allows governments to invest more towards infrastructure and social services (as noted above).
Factors Affecting Productivity
The final important consideration in assessing productivity potential is the production-possibility frontier (PPF), which essentially outlines the maximum production quantity of two goods (in the scope of our current technological capacity and supply). This demonstrates the confinement of productivity, and thus is well captured in the Leontief production function. The critical takeaway here is that the production fu nction will generally be affected by two things: overall supply and technological capabilities. Note that demand does not come into account in altering the production function or overall productivity potential. The illustration in the following figure demonstrates an increase in PPF, thus affecting the production function.
Production-Possibility Frontier Expansion: In this graph, the prospective production-possibility frontier shifts to the right, implying a higher supply or improved technological production ability of the two goods being discussed (in this case guns and butter).
Measuring Productivity
Productivity is represented by production functions, and is the amount of output that can be generated from a set of inputs.
learning objectives
• Discuss different ways to measure productivity and productivity growth
Productivity, in economic terms, measures inputs and outputs to derive overall production efficiency within a system. Simply put, it measures how much can you get out of what you put into a given system. Increased productivity means more output is produced from the same amount of inputs. In order to generate meaningful information about the productivity of a given system, production functions are used to measure it. Understanding the way in which productivity metrics function, one can more comprehensively grasp the concept and employ it in a meaningful way.
Production Function
From an economic standpoint, the production function demonstrates the tangible output created as a result of a production process including all tangible inputs. The objective in employing this perspective is to pursue allocative efficiency within the process (as opposed to technical or logistical efficiency, as engineers or supply chain managers may be pursuing). This means that the production function identifies optimal inputs (and consequent outputs) to satisfy the needs of a given population via a particular production process. While different economic perspectives often identify different factors of production (i.e. inputs in the system), it is useful to identify the following:
• Land/Natural Resources: Products of nature that have economic value, including metals/agriculture/livestock/land/etc.
• Capital: This is a broad term, capturing more than just financing and investment. Capital can also be fixed capital (i.e. machinery, equipment, buildings, computers, etc.) or working capital (i.e. goods, inventory and liquid assets). Concepts of human, intellectual and social capital is also highlighted, separate from the concept of labor below, which can affect the efficiency of a process.
• Labor: The human skills, time and efforts necessary to add value to the production process. This can range from highly tangible inputs (working hours, products assembled) to highly intangible inputs (entrepreneurship, experience, technology skills, etc.).
Conceptually, the production function makes certain assumptions of the maximum potential production, availability of inputs and demand for outputs to create a boundary of potential production. This will include the derivation of a marginal product for each factor (see ), or essentially the extra output that can be created for each additional unit of input. Naturally, this is theoretically subjected to the concept of diminishing marginal returns, where the marginal product of a given input (in the figure we are illustrating labor) will fall as the starting points for quantity rise.
Product Function: This graph illustrates the way in which a production function identifies the relationship between a quantity of inputs and the resulting output of a given product. This takes into account marginal and average product, which are indicative of the change in efficiency based upon inputs.
Forms of the Production Function
There are a variety of ways to approach the measuring of productivity in the context of production functions:
• Functional Form: One way a production function can be illustrated is through the following equation $Q=f(X_1,X_2,X_3,…,X_n)$. In this circumstance ‘Q’ is the quantity of output while each ‘x’ is a factor input.
• Linear Form: While this is generally not practical in practice, it is also possible to represent this in a linear mathematical fashion if parameters (a, b, c, and d below) are identified: $Q=a+bX_1+cX_2+dX_3+…$
• Cobb-Douglas Production Function: One of the most useful frameworks, that allow for a technological relationship to be illustrated between the amount of two (or more) inputs is the Cobb-Douglas model. This is most often used to illustrate how physical capital and labor effect one another (see ). In the equation, ‘Y’ is total production while ‘L’ is labor, ‘K’ is capital, ‘A’ is total factor productivity and the alpha and beta are the elasticity of the two inputs. $Y=AL^βK^α$
• Leontief Production Function: The Leontief Production Function assumes a technologically pre-determined set of proportions for the factors of production (i.e. no ability to substitute between factors. This is specifically designed to capture minimums or limiting cases of production. The ‘z’s in the equation are inputs of specific goods while the a and b represent the technological determined constants and ‘q’ being the overall output: $q=\mathrm{Min}(\frac{z_1}{a},\frac{z_2}{b})$
Cobb-Douglas Production Function: This is an illustration of a two-input Cobb-Douglas Production Function, where the ability to benchmark an output in comparison to two separate quantities of inputs is feasible.
Impacts of Technological Change on Productivity
Technological advances play a crucial role in improving productivity, and thus the standard of living in a system.
learning objectives
• Analyze how changes in technology affect productivity and productivity growth
Productivity measures the way in which an economic system or business can leverage available functional inputs to generate meaningful outputs. This concept drives economies towards higher degrees of efficiency in production and thus higher economic growth and standards of living. As a result, improving productivity is a critical objective for societies to increase their relative wealth. Technological advances play a crucial role in improving productivity, and thus the standard of living in a system.
Production-Possibility Frontier
Productivity growth is bound by what is called the production-possibility frontier (PPF), which essentially stipulates a series of maximum amounts of two commodities that can be generated using a fixed amount the relevant factors of production. In the context of a given PPF, only an increase in overall supply of inputs or a technological advancement will allow for the PPF to shift out and allow for an increase in potential outputs of both goods simultaneously (represented by point ‘X’ in the figure). The shift due to changes in technology represents increased productivity. This is a critical component in understanding the role of technology in productivity, as it is a primary influence on increasing the prospective production possibilities.
Production-Possibility Frontier (PPF): This graph illustrates the varying theoretical takeaways from a PPF chart. On this, points B, C, and D all lie on a maximum output level, while A is representative of a realistic but inefficient amount. X is beyond the scope of the PPF graph, and thus requires a technological improvement or increase in supply.
Technological Advances: Past, Present, and Future
The variance in technological advances that have driven productivity upwards is remarkable, underlining the ongoing importance of focusing on technology as a primary change agent. Innovative advances in technologies can be either leaps or increments, although the larger technological advances tend to take the limelight. In general, there are a particularly notable categories:
• Energy: Historically, animals and humans were the primary energy input for the generation of products. This was extremely expensive and time-consuming relative to more modern ways to power things, and has been improved upon dramatically over time. Electricity, heat, steam, water, solar, and a wide variety of other energy capturing methodologies have dramatically increased efficiency while freeing up man hours.
• Transportation and Industrial Machinery: Trade has been a part of human history for nearly as long as civilizations knew of one another, bartering being the a central component of human interaction. The improvement of trade venues, such as boats, cars, planes, trains, etc. have enabled rapid increases in trade quantity and efficiency. Similarly, industrial machinery utilizing similar vehicles have enabled mass increases in scale and efficiency, particularly agriculture.
• Communication: Needless to say, the internet and mobile communications have rapidly expedited the transmission of knowledge, data, information, and networking. This has resulted in a massive increase in synergy across the world, alongside the development of economic learning and development.
• Logistics: Increases in technological systems is generally considered to be a tangible innovation, but is not limited to such. Improvements in the ways in which we do things is often just as useful. Henry Ford is a classic example of this, innovating the assembly line to maximize the efficiency the production process through strategic implementation of labor roles.
Implications on Productivity
Measuring the effects of technology on productivity is a difficult pursuit. It is generally approached through metrics such as Gross Domestic Product (GDP), GDP per capita, and Total Factor Productivity (TFP). The former two attempt to capture the overall output of a given economy from a macro-environmental perspective. The latter is slightly more interesting, attempting to measure technologically driven advancement through noting increases in overall output without increases in inputs. This is done through utilizing production function equations and identifying when the output is greater than the supposed input, implying an advance in the external technological environment. This system is more specifically tailored for technological change than GDP.
Wheat Yield: Over the past 60 years, wheat yield (PPF) has dramatically improved as a result of critical technological and logistic advancements.
Key Points
• Productivity is essentially the efficiency in which a company or economy can transform resources into goods, potentially creating more from less.
• Productivity can effectively raise living standards through decreasing the required monetary investment in everyday necessities (and luxuries), making consumers wealthier and business more profitable and in turn enabling higher government tax revenues.
• Economists looking to measure this productivity within a given system generally leverage production functions to determine how different factors of production (i.e. inputs ) affect the overall output.
• The final important consideration in assessing productivity potential is the production-possibility frontier (PPF), which outlines the maximum production quantity of two goods in the scope of our current technological capacity and supply.
• From an economic standpoint, the production function demonstrates the tangible output created as a result of a production process including all tangible inputs.
• The objective in employing this perspective is to pursue allocative efficiency within the process (as opposed to technical or logistical efficiency, as engineers or supply chain managers may be pursuing).
• Generally speaking, the factors of production include land, labor and capital.
• There are a variety of ways to approach the measuring of productivity in the context of production functions, including the functional form, the linear form, the Cobb-Douglas production Function and the Leontief Production Function.
• Productivity growth is bound by what is called the production-possibility frontier (PPF), which essentially stipulates a series of maximum amounts of two commodities that can be generated using a fixed amount the relevant factors of production.
• The variance in technological advances that have driven productivity upwards is remarkable, underlining the ongoing importance of focusing on technology as a primary change agent.
• Advances in energy systems, transportation, communication, logistics, and a variety of other technological trajectories have greatly enabled an increased standard of living through advancing productivity.
• Measuring the affects of technology on productivity is a difficult pursuit. It is generally approached through metrics such as Gross Domestic Product ( GDP ), GDP per capita, and Total Factor Productivity (TFP).
Key Terms
• productivity: the rate at which goods or services are produced by a standard population of workers.
• Production function: Relates physical output of a production process to physical inputs or factors of production.
• Allocative efficiency: A type of economic efficiency in which economy/producers produce only those types of goods and services that are more desirable in the society and also in high demand.
• Liquid assets: An asset in the form of money or cash in hand, or an asset which can be quickly converted into cash without losing much value.
• Production-Possibility Frontier (PPF): A graph that shows the various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production.
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Determinants of Long-Run Growth
Long-run growth is defined as the sustained rise in the quantity of goods and services that an economy produces.
learning objectives
• Predict how population growth will affect the level of capital per worker
Long-Run Growth
Economic growth is the increase in the market value of the goods and services that an economy produces over time. It is measured as the percentage rate change in the real gross domestic product (GDP).
Measuring the GDP: Economic growth is the percentage rate increase in the GDP. Long-run growth is directly impacted by the GDP.
Long-run growth is defined as the sustained rise in the quantity of goods and services that an economy produces. The GDP of a country is closely tied to the growth of the population in addition to prices and supply and demand.
Determinants of Long-Run Growth
There are specific determinants that impact the long-run growth of an economy:
• Growth of productivity: is the ratio of economic outputs to inputs ( capital, labor, energy, materials, and services). When the productivity increases the cost of goods is lowered. Lower prices increase the demand for the product or service. An increase in demand can lead to higher revenue.
• Demographic changes: demographic factors influence economic growth by changing the employment to population ratio. Factors include the quantity and quality of available natural resources. Age structure of the population also influences employment and long-run growth.
• Labor force participation: the amount of labor force participation and the size of economic sectors influence economic growth. The labor force participation is the amount of workers available. In countries with high development and industrialization, labor force participation is high because of low birth and death rates.
Inflation and Excessive Growth
When the economic growth matches the growth of money supply, an economy will continue to grow and thrive. In this case, population growth would increase, but the need for goods and services would also increase. As a result, more jobs would be available and the employment rate would also increase.
However, when economic growth is not balanced, the result can include inflation and excessive growth. Inflation occurs when the price of goods and services are rising which causes purchasing power to fall if wages don’t also rise. A decrease in the demand for goods and services will lead to a decrease in revenue and employment. A high rate of population growth will cause less capital per worker, lower productivity, and lower GDP growth.
Inflation: Inflation occurs when the price of goods and services are rising which causes purchasing power to fall if wages don’t also rise. Inflation is a negative effect of economic growth that is not balanced.
When the GDP growth is only caused by increases in population (not increases in supply, demand, revenue) the growth is excessive. In order for an economy to be successful, it must meet the needs of the population (supply, demand, revenue, and employment). When a population grows too fast the economic system cannot support the changes. Excessive growth leads to an imbalance in supply and demand and higher levels of unemployment. The quality of living decreases when the economy cannot support the population growth.
Aggregate Production
The aggregate production function examines how the productivity depends on the quantities of physical capital per worker and human capital per worker.
learning objectives
• Discuss how aggregate production impacts long-run growth
Aggregate Production
The aggregate production function examines how productivity, or real GDP per worker, depends on the quantities of physical capital per worker and human capital per worker. The production function relates the physical outputs of production to the physical inputs or factors of production. The aggregate production takes the physical outputs and inputs into account to determine the allocative efficiency of the economy as a whole.
Aggregate production functions create an estimated framework to determine how much of an economy’s growth is related to changes in capital or changes in technology. Production functions assume that the maximum output is attainable from a given set on inputs. The aggregate production function describes the boundary representing the limit of output attainable from each feasible combination of input.
To understand how the aggregate production impacts long-run growth, it is important to understand the stages of production:
• Stage 1: the variable input is being used with increasing output per unit. The average physical product is at its maximum.
• Stage 2: output increases at a decreasing rate and the average and marginal physical product are declining. The average product of fixed inputs are still rising. The optimum input/output combination will be reached.
• Stage 3: variable input is too high relative to the available fixed inputs. The output of both fixed and variable input declines.
Aggregate Production and Long-Run Growth
The long-run growth of a firm can change the scale of operations by adjusting the level of inputs that are fixed in the short-run, which shifts the production function upward as plotted against the variable input. Aggregate production functions study the short-run inputs and outputs of a firm or economy. The results allow adjustments to be made which improves the long-run growth by balancing the inputs and outputs.
Changing Worker Productivity
In economics and long-run growth, worker productivity is influenced directly by fixed capital, human capital, physical capital, and technology.
learning objectives
• Examine the role of human capital in production and economic growth
Worker Productivity
In economics and long-run growth, worker productivity is influenced directly by fixed capital. The four types of fixed capital include: useful machines, instruments of the trade; buildings as the means of procuring revenue; improvements of land; and the acquired and useful abilities of all the inhabitants or members of society.
One way to increase worker productivity is to invest in better machinery, for example. A worker with a more productive tool in more productive.
Another way to increase productivity is to find ways to increase the revenue of the product generated by the workers. Since productivity is measured in dollars per worker, being able to generate more revenue from the same output is reflected in an increase in worker productivity.
Perhaps most interesting, though, is how to change worker productivity through human capital.
Human Capital
Human capital is defined as the stock of competencies, knowledge, social and personal attributes, including creativity, embodied in the ability to perform labor so as to produce economic value. Many economic theories tie education to economic growth explaining that it is an investment in human capital development. Human capital has been shown to increase economic development, productivity growth, and innovation.
Education: Education increases human capital and worker productivity.
A human resource is transformed into human capital with the effective inputs of education, health, and moral values. When individuals and societies invest in human capital it strengthens the future of the long-run economic growth. The qualitative and quantitative progress of a country is inevitable when human development is a priority. Over time, when worker productivity increases the quality and quantity of the goods and services will also increase.
Importance of Worker Productivity
When a society invests in human capital, it increases worker productivity and economic growth. Human capital and increased worker productivity are critical because they are different from the tangible monetary capital or revenue. It is important thought that an economy recognizes the importance of monetary capital. Worker productivity in the long-run is related to real income. If the real income falls over time it will negatively impact worker productivity. Economic revenue goes up and down due to shocks in the business cycle. Human capital grows cumulatively over a long period of time. When a society focuses on human capital and in turn worker productivity, the long-run economic growth will be steady. Economic inputs towards education, health, and worker productivity impacts future generations by ensuring that they will be more advanced and efficient than the current generation. The increase in worker efficiency is the direct result of a superior quality of manpower created through increased human capital.
Technological Change
In economics, technological change is a term used to describe the change in a set of feasible production possibilities.
learning objectives
• Assess the value of technology to a nation’s economic growth
Technological Change
In economics, growth is defined as the increase in output per capita of a country over a long period of time. One primary factor that influences the growth of an economy is technological change. Technological change is a term used to describe the change in a set of feasible production possibilities. Technological improvement has the ability to increase the amount of output an economy can produce, even if the level of inputs remains constant.
Technological Change: Technological change causes the production possibility frontier to shift outward and initiate economic growth.
Technology and Long-Run Growth
Technology is defined as the making, modification, usage, and knowledge of tools, machines, techniques, systems, and methods of organization in order to solve a problem, improve a preexisting solution to a problem, or achieve a goal. In economics, improvements in technology have helped develop more advanced economies (for example, today’s global economy).
ENIAC: ENIAC, the first general purpose computer, was a technological advancement that affected both productivity and the types of outputs that could be produced.
In a developing country, the government works to ensure that the technologies, skills, knowledge, and methods of manufacturing are tested and developed so that they can be passed on to a broader audience. The expansion and sharing of technology leads to the further development of goods, processes, applications, materials, and services. All of these areas are critical to the advancement of an economy in the long-run.
The field of economics is constantly evolving as is the production of goods and services. In order to advance and continue to grow all markets need to make use of new technology to stay competitive. In the case of long-run economic growth, using the most advanced technology provides a market with a competitive advantage. Advances in technology creates an increased level of output with the same inputs, which improves productivity.
Government Activity
Government activity and policies have a direct impact on long-run growth. It can invest, and operate through monetary and fiscal policy.
learning objectives
• Discuss the long-run implications on growth from government policies
Economic Growth
In macroeconomics, long-run growth is the increase in the market value of goods and services produced by an economy over a period of time. The long-run growth is determined by percentage of change in the real gross domestic product (GDP). In order for an economy to experience positive long-run growth its outputs and inputs must be in balance for an increase to occur in supply, demand, revenue, and employment. The long-run economic growth is determined by short-run economic decisions.
Gross Domestic Product: The change in GDP is used to determine economic growth within a country.
Government Activity
Government activity and policies have a direct impact on long-run growth. Long-run growth can be redirected and improved when changes are made to short-run actions. When an economy or industry experiences imbalanced in economic growth, the government can respond in order to assist in securing the market. Examples of possible government activity include:
• Investment: the government can stimulate economic growth by investing in the economy. Examples of stimulants include investing in market production, infrastructure, education, and preventative health care. This is especially important when excessive growth occurs. The government must stimulate economic growth to meet the needs of an increasing population.
• Monetary policy: the government enacts monetary policies to keep the growth rate of money steady. This helps to control excess inflation and excess short-term growth, both of which can negatively affect long-run growth. It’s important to note, however, that fiscal policy can also affect the level of inflation within an economy.
• Fiscal Policy: Choices in tax structure, government spending, and economic regulation can all impact long-run growth by affecting the choices that businesses and individuals make.
Government activity impacts long-run growth. It is critical that increasing populations have access to productive resources. It is also important that markets stay balanced in order to be successful and thrive.
Arguments in Favor and Opposed to Economic Growth
Economic growth has the potential to make all people richer, but may have downsides such as increased inequality and environmental impacts.
learning objectives
• Compare and contrast the consequences of economies in which growth is a goal
Economic Growth
Economic growth is defined as the increase in the market value of goods and services produced by an economy over a period of time. It is measured as the percentage increase in the real gross domestic product (GDP). In other words, economic growth is an expansion of the economic output of a country. Over the long-run economists might look at the per-capita rate of GDP growth (the growth of the ratio of GDP to the population).
GDP: The percentage increase in the GDP of a country is used to measure the country’s economic growth.
Arguments in Favor of Growth
There are numerous arguments in support of economic growth that describe its positive impact on society. Arguments in favor of economic growth include:
• Increased productivity: in countries that experience positive economic growth, the growth is often attributed to an increase in human and physical capital. Also, economic growth is usually accompanied by new and improved technological innovations.
• Expansion of power: economic growth is influential within a country even if the percentage of growth is small. With a small growth rate, a country will experience a substantial increase in power over the long-run. For example, a growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years. In contrast, a growth rate of 8% per annum leads to a doubling of the GDP within 10 years. The power expansion associated with economic growth has long-run influences on a country.
• Quality of life: the quality of life increases in countries that experience economic growth. Economic growth alleviates poverty by increasing employment opportunities and labor productivity. It has been found that happiness increases with a higher GDP per capita, up to a level of at least \$15,000 per person.
Arguments Opposed to Growth
There are a series of arguments that are opposed to economic growth. Arguments opposed to growth include:
• Resource depletion: economic growth has the potential to deplete resources if science and technology do not produce viable substitutes or new resources. Also, some arguments state that better technology and more efficient production will deplete resources quicker in the long-run even though advancements are perceived as positive right now.
• Environmental impact: some argue that a narrow view of economic growth combined with globalization could collapse the world’s natural resources. Portions of society have advocated the ideas of uneconomic growth and de-growth (economic contraction) in an attempt to lessen these effects of economic growth.
• Equitable growth: it has been found that while economic growth has a positive impact on society as a whole, it is common that poor sections of society are not able to participate in economic growth. Economic growth has many positive effects, but a society must not favor economic growth over solving pressing social issues such as poverty. For example, in a country with low inequality, a country with a growth rate of 2% per head and 40% of the population living in poverty can halve the poverty in 10 years. In contrast, if the same country has high inequality it will take nearly 60 years to achieve the same level of poverty reduction.
Key Points
• Economic growth is the increase in the market value of the goods and services that an economy produces over time. It is measured as the percentage rate change in the real gross domestic product ( GDP ).
• Determinants of long-run growth include growth of productivity, demographic changes, and labor force participation.
• When the economic growth matches the growth of money supply, an economy will continue to grow and thrive.
• Inflation occurs in an economy when the prices of goods and services continue to rise while the purchasing power decreases.
• When the GDP growth is only caused by increases in population, the growth is excessive.
• Aggregate production functions create an estimated framework to determine how much of an economies’ growth is related to changes in capital or changes in technology.
• The aggregate production function describes the boundary representing the limit of output attainable from each feasible combination of input.
• The aggregate production takes the physical outputs and inputs into account to determine the allocative efficiency of the economy as a whole.
• The long-run growth of a firm can change the scale of operations by adjusting the level of inputs that are fixed in the short-run, which shifts the production function upward as plotted against the variable input.
• Human capital is defined as the stock of competencies, skills, and knowledge that allows individuals to produce economic value.
• Human capital has been show to increase economic development, productivity growth, and innovation.
• When individuals and societies invest in human capital it strengthens the future of the long-run economic growth. The qualitative and quantitative progress of a country is inevitable when human development is a priority.
• When a society invests in human capital, it increases worker productivity and economic growth. Human capital grows cumulatively over a long period of time.
• Growth is defined as the increase in output per capita of a country over a long period of time. One primary factor that influences the growth of an economy is technological change.
• When looking at long-run growth, technological change in the economic environment makes production more or less efficient.
• Technology is defined as the making, modification, usage, and knowledge of tools, machines, techniques, systems, and methods of organization in order to solve a problem, improve a preexisting solution to a problem, or achieve a goal.
• The expansion and sharing of technology leads to the further development of goods, processes, applications, materials, and services. All of these areas are critical to the advancement of an economy in the long-run.
• Long-run growth is the increase in the market value of goods and services produced by an economy over a period of time.
• The government may choose to invest in projects that are associated with long-term growth, such as infrastructure.
• Monetary and fiscal policy are used to regulate the economy, economic growth, and inflation so that long-run growth is possible.
• Government activities used to improve long-run growth include stimulating economic growth, enacting monetary policies, fixing the exchange rates, and using wage and price controls.
• Over the long-run economic growth looks at the growth of the ratio of GDP to the population. Economic growth is an expansion of the economic output of a country.
• Arguments in support of economic growth include increased productivity, the expansion of power, and an increase in the quality of life.
• Arguments opposed to economic growth include resource depletion, environmental impacts, and equitable growth.
Key Terms
• inflation: An increase in the general level of prices or in the cost of living.
• economic growth: The increase of the economic output of a country.
• physical capital: A physical factor of production (or input into the process of production), such as machinery, buildings, or computers.
• human capital: The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.
• productivity: A ratio of production output to what is required to produce it (inputs).
• human capital: The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.
• technology: The study of or a collection of techniques.
• output: Production; quantity produced, created, or completed.
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• quality of life: The general well-being of societies, including not only wealth and employment, but also the environment, physical and mental health, education, recreation and leisure time, and social belonging.
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Incentivizing Saving and Investment
The government can incentivize savings and investment by changing the relative cost of taking each action.
learning objectives
• Explain how the governments incentivize saving and investment
Governments have a strong interest in affecting the savings and investments in an economy. Both savings and investment affect the overall economy. For example, if an economy is overheating, a government might want to disincentivize investment or consumption, and would therefore be interested in increasing the savings rate. If an economy is in a recession, a government would want to encourage savers to start spending or investing their money.
US Savings Rate: The US government may want to increase the savings rate if the economy is in a downturn, and increase it if the economy is overheating.
There are a number of ways in through which a government can incentivize savings and investment. Broadly, each incentive adjusts the cost of saving or investing. We will discuss two main ways to affect the savings and investment rates here.
Monetary Policy
One of the main tools of central banks is the interest rate that it charges banks to hold their money overnight. This rate is ultimately passed on to the bank’s depositors. Depositors, in turn, adjust their levels of savings and investment based on that rate.
Take, for example, a high interest rate. At a high interest rate, it is very expensive to borrow money: investors will not want to invest because they have to pay a lot of interest on their loans. Savers, on the other hand, love high interest rates: they earn a lot simply by keeping their cash in the bank. High interest rates encourage savings and discourage investment.
The precise opposite is true for low interest rates. When rates are low, investors know they can borrow money to finance investments cheaply. At the same time, savers aren’t earning much by keeping their money in the bank. Low interest rates encourage investment and discourage savings.
Much of a central bank’s actions are focused on adjusting how much people save and invest.
Taxes
The government can also incentivize savings and investment in a number of ways. The most common way of doing so is by adjusting tax rates. Governments offer individuals and firms who take the action it desires. For example, a government can offer a tax break to companies that are investing in a desirable area (e.g. medicine). It can also encourage savings through tax breaks. Roth IRAs are an instrument for saving for retirement that the US has made tax exempt (under certain conditions). In the first example, the government uses tax reductions to encourage investment for companies. In the second, the government encourages saving by helping savers earn more of the interest they earn over time in the savings vehicle.
Improving Education and Health Outcomes
A country can impact its long-term growth by affecting human capital through education and healthcare investments.
learning objectives
• Analyze the long-run implications on growth from education and healthcare policies
Both education and healthcare are important because they have short- and long-term costs, and significantly affect the level of human capital in an economy. If a country can set up its education and healthcare systems to maximize the growth of human capital, it can also significantly impact its long-term economic growth prospects.
Education Economics and Policies
Education economics studies economic issues related to education, such as the demand for education and the financial cost of education. It studies the relationship between schooling and the labor market. By making educational policies and spending money now, a country ensures that it will have the necessary human capital to expand its economy.
Human capital requires investment, but also provides economic returns. As education increases human capital increases, countries will also expect to see higher productivity, wages, and the GDP.
Impact of Education on GDP: This graph shows the positive relationship between education and per capita GDP of a country. As the number of years of education within a country increase, so does the per capita GDP.
Economics is one field of study that researches the effectiveness of education policies. Education policies are designed to cover all education fields from early childhood education through college graduate programs. Policies focus on school size, class size, school choice, tracking, teacher education and certification, teacher pay, teaching methods, curricular content, and graduation requirements. To ensure economic growth, a country must have strong education policies.
Health Economics and Policies
Health economics is the branch of economics that focuses on issues relating to the efficiency, effectiveness, value, and behavior in the production and consumption of health and healthcare. In this field, economists study the function of healthcare systems and public health-affecting behaviors. Health economics focuses on the following topics:
• What influences health
• What is health and what is its value
• What is the demand for healthcare
• What is the supply for healthcare
• Macro-economic evaluation at treatment level
• Market equilibrium
• Evaluation of the whole healthcare system
• Planning, budgeting, and monitoring the system
Although health is not directly related to human capital, it is obvious that without health and life human capital will be impacted negatively. Health policies are the decisions, plans, and actions that are undertaken in a country to achieve specific healthcare goals. According to the World Health Organization, a successful health policy defines a vision for the future, it outlines national priorities regarding health, and it builds a consensus and informs the public.
Health policies can have positive long-run effects on not only human capital, but also economic growth as a whole. Health policies are designed to educate society and improve the current and long-term health of a country. Examples of health policy topics include: vaccination policies, tobacco control, and pharmaceutical policies.
Furthermore, healthcare can constitute a large part of a country’s expenditures. Determining the structure of the healthcare system (private, public, regulated, etc.) can have large economic consequences, and therefore is of great interest to the government.
Defining and Defending Property Rights
Property rights are theoretical constructs that determine how a resource is used and owned.
learning objectives
• Explain the economic consequences of property rights
Property Rights
Property rights are theoretical constructs that determine how a resource is used and owned. Resources can be owned and used by governments, collective bodies, or individuals. There are four broad components of property rights. They are the right to:
• use the good,
• earn income from the good,
• transfer the good to others, and
• enforce the property rights.
Property usually refers to ownership and control over a good or resource. Ownership means that the entity or individual has the rights to the proceeds of the output that the property generates.
Types of Property Rights
Property rights are determined based on the level of transaction costs associated with the rights. The transaction costs are the costs of defining, monitoring, and enforcing the property rights. The four types of property rights are:
• Open access property: this type of property is not owned by anyone. For this reason, no one can exclude anyone else from using it. It is possible though that one’s person use of the property will reduce the quantity available to others. Open access property is not managed by anyone and access to it is not controlled. Examples include the atmosphere or ocean fisheries.
• State property: also known as public property, this type of property is owned by all, but its access and use is controlled by the state. An example would be a national park.
• Common property: also called collective property, this type of property is owned by a group of individuals. The joint owners control the access, use, and exclusion of the property.
• Private property: use of this type of property is exclude. Private property use and access is managed and controlled by a private owner or a legal group of owners.
Defending Property Rights
For any good, property rights must be monitored and the possession of the rights must be enforced. The rights are put in place to control, monitor, and exclude the use of the stated property. Property rights protect not only land, but also goods, services, and finances associated with the land itself. Corruption impacts the private and public sectors because it increases the cost of doing business and distorts markets.
The concept of property rights are closely related to the law in terms of defending the rights. There is a difference between an economist’s view of property rights and the view of the law, but both work together to reach the final goal of securing and maintaining the rights. For example, suppose a thief steals a good. The thief has economic property right to the good because it is in his possession – he has the ability to use the good. However, the thief does not have legal property right to use the good – by law he is not permitted to have access to or use of the good. Economics sets the property rights and the law is used to enforce the rights. Each of the four types of property rights differ in the amount of money and defense needed to ensure that the rights are upheld. The greater the restrictions that property rights place, the more likely that defense of the rights will be needed.
Yosemite National Park: This picture is a view at Yosemite National Park. National parks in the United States are state property. Access and use of the park is controlled and enforced by the state.
Promoting Free Trade
Government can promote free trade by reducing tariffs, quotas, and non-tariff barriers.
learning objectives
• Describe the effects of free trade and trade barriers on long run growth
Free trade is a policy by which a government does not discriminate against imports or interfere with exports by applying tariffs (to imports), subsidies (to exports), or quotas. According to the law of comparative advantage, the policy permits trading partners mutual gains from trade of goods and services.
Government Barriers to Free Trade
There are a number of barriers to free trade that governments can mitigate, most importantly, tariffs (government imposed import taxes) and quotas (government imposed limits on the quantity of a good that can be imported). Tariffs and quotas are explicit government policies that are designed to protect domestic producers, even if they are not the most efficient producers.
Loss Due to Tariffs: There are a number of reasons why governments place tariffs or other barriers to free trade, but they necessarily reduce overall societal welfare. Governments can promote free trade and impact economic growth.
In addition to tariffs and quotas, there are a number of other barriers to free trade that countries use. Broadly, they are categorized as non-tariff barriers (NTBs). NTBs come in a variety of forms. One example of an NTB are product standard requirements. A country can set high quality standards for a product, knowing that not all foreign producers will be able to meet the standard. Another way that countries can implement NTBs is through customs procedures. Countries can force foreign exporters to fill out arduous paperwork over the course of months, and perhaps in a language the foreign producer does not speak. NTBs act just like tariffs and quotas in that they are barriers to free trade.
Government Promotion of Free Trade
Countries that recognize the benefits for growth from promoting free trade can take unilateral, bilateral, or multilateral action to reduce some of these barriers to trade.
Unilateral promotion of free trade is when a country decides to reduce its own trade barriers without any promise of action from its trading partners. This would lead to a reduction in import prices, but could be unpopular with domestic industries who are not afforded lower barriers in the countries with which they wish to trade.
Bilateral promotion of free trade is when two countries come to an agreement to reduce barriers together. This solves the problem of one country giving the benefit of reduced barriers to foreign exporters without any promise of similar benefits in return.
Multilateral promotion of free trade is when a group of countries agree to reduce their barriers together. Examples of multilateral promotion of free trade are trade agreements such as the North American Free Trade Agreement (NAFTA) in which the US, Mexico, and Canada agreed to allow free trade among one another.
Reducing barriers to free trade may be politically difficult, but due to the law of comparative advantage, will allow for increased overall surplus for each trading partner in the long run.
Investing in Research and Development
The government can establish intellectual property laws, directly conduct research, or finance research and development.
learning objectives
• Describe the appropriate role of government in research and development
The government has the ability to encourage or discourage research and development. The government can do so by creating a good structure of intellectual property protection, called, broadly, patent law. It can also directly intervene and encourage or discourage research and development in a specific area of interest to the government or society that is not currently being addressed by the market.
Investing in research and development is important because it can result in new products, technologies, or processes. Thus, research and development can improve productivity or simply improve the welfare of society.
This atom will first discuss how the government can establish a patent system, and then ways in which it can directly affect the level of research and development in an economy.
Patents
Patents are temporary monopolies granted to inventors by the government, in exchange for public disclosure of how the invention works. They are one of the basic forms of intellectual property. Essentially, a patent gives the holder the right to exclude others from, among other things, using, selling, and making the claimed invention.
Patents and, more broadly, intellectual property rights, are important because they encourage investment in research. Without intellectual property protection, researchers would be worried that, once they make a breakthrough, competitors would simply sell their product. The original researcher would have made the investment in the research, but would have to compete with others once the research becomes able to generate revenue.
Direct Government Research
When the government directly conducts research, it hires its own scientists, engineers, etc. to study a particular issue. For example, NASA is a government agency that also does research.
Indirect Government Research
The government also finances research and development that it does not directly conduct. Such financing often takes the form of grants given to researchers in companies or organizations by the government. The government incentivizes the researches by making the research financially affordable (or more affordable). Not all research is financed, however. The grants are given to projects that are valuable either to the government or to society as a whole. Such grants can be viewed through the lens of market failure: the open market is not financing a socially or government-desirable project, so the government steps in to correct the failure.
NASA’s Research and Development: The moon landing was the result of research and development conducted directly by a government agency.
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Defining Inflation
Inflation is an increase in average price levels.
Learning objectives
• Use the quantity theory of money to explain inflation
Inflation is a persistent increase in the general price level of goods and services in an economy over a period of time. Specifically, the rate of inflation is the percent increase of prices from the start to the end of the given time period (usually measured annually).
When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.
The decrease in purchasing power means that inflation is good for debtors and bad for creditors. Since debtors usually pay back loans in a nominal amount, they want to give up the least purchasing power possible. For example, if you borrowed money and have to pay back $100 next year, you’d like that$100 to be worth as little as possible. Conversely, creditors don’t like inflation because the money they are getting paid is can purchase less than if there were no inflation.
What Causes Inflation?
When looking at individual goods, price changes may result from changes in consumer preferences, changes in the price of inputs, changes in the price of substitute or complement goods, or many other factors. When looking at the inflation rate for an entire economy, however, these microeconomic factors are relatively unimportant.
Instead, most economists agree that in the long run, inflation depends on the money supply. Specifically, the money supply has a direct, proportional relationship with the price level, so if, for example, the currency in circulation increased, there would be a proportional increase in the price of goods. To understand this, imagine that tomorrow, every single person’s bank account and salary doubled. Initially we might feel twice as rich as we were before, but prices would quickly rise to catch up to the new status quo. Before long, inflation would cause the real value of our money to return to its previous levels. Thus, increasing the supply of money increases the price levels. This idea is known as the quantity theory of money.
Inflation and the Money Supply: While the two variables are not exactly equivalent in the short run, over time the money supply has had a direct relationship to the level of inflation. This is consistent with the quantity theory of money.
In mathematical terms, the quantity theory of money is based upon the following relationship: M x V = P x Q; where M is the money supply, V is the velocity of money, P is the price level, and Q is total output. In the long run, the velocity of money (that is, how quickly money flows through the economy) and total output (that is, an economy’s Gross Domestic Product) are exogenous. If all other factors are held constant, an increase in M will require an increase in P. Thus, an increase in the money supply requires an increase in the price level (inflation).
While most agree with the basic principles behind the quantity theory of money in the long run, many argue that it does not apply in the short run. John Maynard Keynes, for example, disagreed that V and Q are exogenous and stable in the near-term, and therefore a change in the money supply may not produce a proportional change in the price level. Instead, for example, an increase in the money supply could boost total output or cause the velocity of money to fall.
Measuring Inflation
Inflation is measured as a percentage rate of change in the level of prices.
Learning objectives
• Describe inflation and how to measure it
The inflation rate is widely calculated by calculating the movement or change in a price index, usually the consumer price index (CPI) The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a “typical consumer”.
CPI is usually expressed as an index, which means that one year is the base year. The base year is given a value of 100. The index for another year (say, year 1) is calculated by
$\mathrm{CPI_{year \; 1}=(\dfrac{Basket \; Cost_{year \; 1}}{Basket \; Cost_{base \; year}}) \times 100}$
The percent change in the CPI over time is the inflation rate.
For example, assume you spend your money on bread, jeans, DVDs, and gasoline, and you’d like to measure the inflation that you experience with this basket of goods. In the base period you purchased three loaves of bread ($4 each), two pairs of jeans ($30 each), five DVDs ($20 each), and 10 gallons of gasoline ($3.50 each). The price of the basket of goods in the base period is the total money spent on this quantity of items at the base period prices; in this case, this equals $207. Now imagine that in the current period, bread still costs$4, jeans are $35, DVDs are$18, and gasoline is $4. Using the quantities from the base period, the total cost of the market basket in the current period is$212. The price index is $(212/207) \times 100$, or 102.4. This means that the inflation rate between the base period and the current period was 2.4%.
In everyday life, we experience inflation as a loss in the purchasing power of money. When the inflation rate is 2.4%, it means that a dollar can buy 2.4% fewer goods and services than it could in the previous period. When inflation is steady, incomes will generally compensate for the effects of inflation by rising or falling at approximately the same rate as the general price level. Money saved as currency, however, will lose its value if inflation occurs.
U.S. Inflation Rate: The U.S. inflation rate is measured by comparing the price of goods in one year to the price of goods in a previous base year.
Price Indices and the Rate of Change of Prices
Price indices are tools used to measure price changes for a specific subset of goods and services.
Learning objectives
• Explain how inflation is measured through price indices
Price Indices
Price indices are tools used to measure price changes for a specific subset of goods and services. A price index is a statistic designed to help compare how a normalized average of prices differ between time periods. Broad price indices, such as the consumer price index (CPI) or the GDP deflator are often used to measure inflation throughout the entire economy, while narrower ones, such as the consumer price index for the elderly (CPI-E) measure the inflation experienced by specific groups of people or industries.
In order to calculate a price index, one must specify a base period and a basket of goods. The base period is the time period against which costs in other periods will be compared. Most often, the base period for an index is a single year and normalized. For example, a the CPI could select 1950 as the base year. In 1950, the CPI would have a value of 100 (this is notthe cost of the basket, just a normalized value). Suppose that in 1960, the cost of the basket has increased 15%. The CPI in 1960 would then be listed as 115 (15% greater than the base year).
The basket of goods determines which prices are being compared. If a price index wanted to measure the inflation experienced by young people on the west coast of the United States, for example, it would first have to calculate which goods these particular consumers purchase and in what quantities. For example, this population may spend 40% of its income on housing, 10% on food, 10% on transportation, 20% on entertainment, and 20% on surfing supplies. The basket of goods should reflect these proportions.
Calculating Price Indices
There are different ways to calculate price indices. Suppose we want to find the inflation rate for consumers who, in the base period, bought an average of five CDs ($10 each), eight cans of soda ($1.5 each), and two pairs of shoes ($40 each). In the current period, the same type of consumer bought an average of four CDs ($12 each), six cans of soda ($2 each), and two pair of shoes ($45 each). One very basic approach to finding this price index might multiply the items’ cost and the quantity bought in the base period, and compare that to the cost and quantity in the current period. This calculation would give:
$5 \times 10+8 \times 1.5+2 \times 40 = 142 (\text{base period})$
$4 \times 12+6 \times 2+2 \times 45 = 150 (\text{current period})$
$\text{Price index} = (\frac{150}{142}) \times 100 = 105.6$
This would show that inflation was 5.6%.
However, this is not a very practical way to measure the change in prices since it compares two different baskets of goods. In this type of approach, a higher index number in the current period might mean that prices have gone up, but it might also mean that incomes have risen and people are simply buying more goods. The Laspeyres index and the Paasche index are two price indexes that attempt to compensate for this difficulty.
The most commonly used formula is a form of the Laspeyres price index, which determines a basket of goods during a base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a later period of time. Using the example above, the base period index would be $5 \times 10+8 \times 1.5+2 \times 40=142$, and the current period index would be $5 \times 12+8 \times 2+2 \times 45 = 166$. The Laspeyres price index is $(166/142) \times 100=116.9$, giving an inflation rate of 16.9%.
An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s total price, and compares that price to what the current basket of goods would have cost in the base period. Again, using the above example, the base period index would be $4 \times 10+6 \times 1.5+2 \times 40=129$, and the current period index would be $4 \times 12+6 \times 2+2 \times 45=150$. The Paasche index is $(150/129) \times 100=116.3$, giving an inflation rate of 16.3%.
Common Price Indices
Two common price indices are the Consumer Price Index (CPI) and the Producer Price Index (PPI). The CPI reflects changes in the prices of goods and services typically purchased by consumers, and includes price changes in imported goods. The CPI is often used to measure changes in the cost of living.
Consumer Price Index and Inflation: The above graph shows the annual inflation rate and the consumer price index from 1913 to 2003. As long as the inflation rate was above zero, the CPI was increasing.
The PPI, on the other hand, reflects changes in the revenue that producers receive in return for goods and services. The PPI, unlike the CPI, includes price changes for goods produced within the US but exported abroad. It also does not include sales and excise taxes, nor does it include distribution costs. While we often expect the CPI and PPI to show similar rates of inflation, they measure two different sets of price changes.
The Costs of Inflation
The costs of inflation include menu costs, shoe leather costs, loss of purchasing power, and the redistribution of wealth.
Learning objectives
• Show inflation’s impact on purchasing power
Economists generally regard a relatively low, stable level of inflation as desirable. When inflation is stable and expected, the economy is generally able to adjust easily to slowly rising prices. Further, a low level of inflation encourages people to invest their money in productive projects rather than keeping savings in the form of unproductive currency, since inflation will slowly erode the value of money. However, inflation does have some economic costs, especially when it is high or unexpected.
Menu Costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. With high inflation, firms must change their prices often in order to keep up with economy-wide changes, and this can be a costly activity: explicitly, as with the need to print new menus, and implicitly, as with the extra time and effort needed to change prices constantly.
Menu Costs: The cost to a restaurant to change the prices on menus is incurred even with low and expected inflation.
Shoeleather Costs
Shoeleather cost refers to the cost of time and effort that people spend trying to counteract the effects of inflation, such as holding less cash, investing in different currencies with lower levels of inflation, and having to make additional trips to the bank. The term comes from the fact that more walking is required (historically, although the rise of the Internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly. A significant cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were less or no inflation.
Loss of Purchasing Power
By definition, inflation causes the value of an individual dollar to decrease over time. Each dollar has less purchasing power with inflation. Thus, individuals who have the same wage next year as this year will be able to purchase less. Purchasing power can be maintained if wages increase exactly at the rate of inflation, but this is not always the case. When wages increase less than the rate of inflation, people lose purchasing power.
Redistribution of Wealth
The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation, those segments in society which own physical assets (e.g. property or stocks) benefit from the price of their holdings going up, while those who seek to acquire them will need to pay more for them.
Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people income is fixed.
Other Costs
Other costs of high and/or unexpected inflation include the economic costs of hoarding and social unrest. When prices are rising quickly, people will buy durable and nonperishable goods quickly as a store of wealth, to avoid the losses expected from the declining purchasing power of money. This can create shortages of hoarded goods and removes an economy from the efficient equilibrium. Further, inflation can lead to social unrest. For example, rises in the price of food is considered to be a contributing factor to the 2010-2011 Tunisian revolution and the 2011 Egyptian revolution (though it was certainly not the only one).
Hyperinflation in Zimbabwe: The photo shows bills worth millions and billions of dollars that were printed by the Zimbabwe government as a response to massive inflation. At one point the 50 billion dollar note was worth less than three US dollars.
Distribution Effects of Inflation
Unexpectedly high inflation tends to transfer wealth from creditors to debtors and from the rich to the poor.
Learning objectives
• Discuss how inflation affects distribution and creates winners and losers
Whether one regards inflation as a “good” thing or a “bad” thing depends very much on one’s economic situation. Assuming that loans must be paid back according to a nominal amount (i.e. the borrower must pay back $100 in one year), inflation is good for borrowers and bad for lenders. When there is inflation, the value of the money borrowers pay back is less. When inflation is expected, it has few distribution effects between borrowers and lenders. This is because the inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation. For example, if the real cost of borrowing money is 3% and inflation is expected to be 4%, the nominal interest rate on a loan would be 7%. If the inflation rate unexpectedly jumps to 8% after the loan is made, however, then the creditor is essentially transferring purchasing power to the borrower. Since it benefits debtors and hurts creditors, in practice unexpected inflation is often a transfer of wealth from the rich to the poor. Interest Rates and Inflation: Part of the reason that lenders charge interest is to recoup the cost of inflation over time. In general, this means that those with savings in the form of currency or bonds lose money from inflation. The lower purchasing power of money erodes the value of currency, and inflation reduces the real interest rate earned on bonds. Those with negative savings (debt) or savings in the form of stocks, however, are better off with higher inflation. Debtors find themselves paying a lower real interest rate than expected, and stocks tend to rise in value to reflect the inflation level. In demographic terms, this often manifests as a transfer from older individuals, who are wealthier and tend to hold their savings in more conservative assets such as cash and bonds, to younger individuals, who have more debt and tend to hold their savings in more aggressive assets such as stocks. Deflation Deflation is a decrease in the general price levels of goods and services. Learning objectives • Define deflation and analyze its effects Deflation Deflation is a decrease in the general price levels of goods and services. It occurs when the inflation rate falls below 0%. When this happens, the nominal prices of goods are falling on average and the purchasing power of money is increasing. Effects of Deflation While there are some problems associated with high levels of inflation, economists generally believe that deflation is a more serious problem because it increases the real value of debt and may worsen recessions. Suppose you are a borrower that has borrowed$100 at a 5% interest rate to pay back in one year. Next year, you will give your lender $105 regardless of inflation. If there is no inflation,$105 next year buys the same amount as it does today. If there is inflation, $105 next year buys less than$105 does today. And if there is deflation, $105 next year buys more than$105 does today.
Deflation is good for lenders and bad for borrowers: when loans are paid back, the cash is worth more. Thus, deflation discourages borrowing, and by extension, consumption and investment today.
What Causes Deflation?
There are several theories about the causes of deflation. In the IS/LM model, deflation is caused by a shift in the supply and demand curve for goods and services. If there is a fall in how much the whole economy is willing to buy, for example, then the general demand curve shifts to the left and overall prices fall. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Unemployment rises and investment falls, which in turn leads to further reductions in aggregate demand. This cycle of continuing inflation is called a deflationary spiral.
Recall that in monetarist theory, $\text{Money Supply} \times \text{Velocity of Money} = \text{Price Level} \times \text{Output}$. According to monetarist economists, therefore, deflation is caused by a reduction in the money supply, a reduction in the velocity of money, or an increase in the number of transactions. However, any of these may occur separately without causing deflation as long as they are offset by another change – for example, the velocity of money could rise and the money supply could fall without causing a change in price levels.
The Great Depression: Most economists agree that the high levels of deflation during the 1930s made the Great Depression much more severe and long-lasting. It discouraged consumption, borrowing, and investment that would increase economic activity.
Key Points
• Inflation refers to the average changes in price economy-wide, not the change in price in a particular industry. Further, inflation refers to the rate of change in prices, not the level of prices at any one time.
• Most economists agree that in the long run, inflation depends on the money supply.
• The idea that increasing the supply of money increases the price levels is known as the quantity theory of money.
• In mathematical terms, the quantity theory of money is based upon the following relationship: M x V = P x Q; where M is the money supply, V is the velocity of money, P is the price level, and Q is total output.
• While most agree with the basic principles behind the quantity theory of money in the long run, many argue that it does not apply in the short run.
• Economists typically measure the price level with a price index.
• A price index is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%.
• The price index is the proportion of the cost of a basket of goods in one period to the cost of the same basket of goods in a previous base period. If the price index is currently 103, for example, the inflation rate was 3% between the base period and today.
• Price indices are often normalized and compared to a base year.
• The basket of goods determines which prices are being compared.
• The most commonly used formula is the Laspeyres price index, which determines a basket of goods during a base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a later period of time.
• An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s total price, and compares that price to what the current basket of goods would have cost in the base period.
• The Consumer Price Index (CPI) and the Producer Price Index (PPI) are commonly used inflation indices. The CPI reflects changes in the prices of goods and services typically purchased by consumers.
• The PPI reflects changes in the revenue that producers receive for goods and services.
• In economics, a menu cost is the cost to a firm resulting from changing its prices. With high inflation, firms must change their prices often in order to keep up with economy-wide changes.
• Shoe leather cost refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank.
• Money loses value with inflation, leading to a drop in the purchasing power of an individual dollar. Unless wages increase with inflation, individuals’ purchasing power will also drop.
• Unexpected inflation redistributes wealth from creditors to debtors.
• Other costs of high and/or unexpected inflation include the economic costs of hoarding and social unrest.
• Inflation is good for borrowers and bad for lenders because it reduces the value of the money paid back to the lenders.
• The inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation. When the inflation rate rises or falls unexpectedly, wealth is redistributed between creditors and debtors.
• In general, this means that those with savings in the form of currency or bonds lose money from inflation. Those with negative savings (debt) or savings in the form of stocks, however, are better off with higher inflation.
• In demographic terms, unexpected inflation often manifests as a wealth transfer from older individuals to younger individuals.
• When deflation occurs, the general price level is falling and the purchasing power of money is increasing.
• While there are problems associated with high inflation, economists generally believe that deflation is a more serious problem because it increases the real value of debt and may worsen recessions.
• Deflation discourages consumption because consumers know that if they wait to make a purchase, the price will likely drop.
• Deflation discourages borrowing and investment because the real value of the money to be repaid will be higher than the real value of the money borrowed.
• Some economists believe that deflation is caused by a fall in the general level of demand, while others attribute it to a fall in the money supply.
Key Terms
• money supply: The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.
• velocity of money: The average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time.
• inflation: An increase in the general level of prices or in the cost of living.
• market basket: A list of items used specifically to track the progress of inflation in an economy or specific market.
• purchasing power: The amount of goods and services that can be bought with a unit of currency or by consumers.
• cost of living: The average cost of a standard set of basic necessities of life, especially of food, shelter and clothing
• price index: A statistical estimate of the level of prices of some class of goods or services.
• menu costs: The cost to a firm resulting from changing its prices.
• shoeleather costs: The cost of time and effort that people spend trying to counter-act the effects of inflation.
• nominal interest rate: The rate of interest before adjustment for inflation.
• Real interest rate: The rate of interest an investor expects to receive after allowing for inflation.
• deflationary spiral: A situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.
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Defining Unemployment
Unemployment, also referred to as joblessness, occurs when people are without work and actively seeking employment.
learning objectives
• Classify the different measures and types of unemployment
Unemployment, also referred to as joblessness, occurs when people are without work and are actively seeking employment. During periods of recession, an economy usually experiences high unemployment rates. There are many proposed causes, consequences, and solutions for unemployment.
Types of Unemployment
• Classical: occurs when real wages for jobs are set above the market-clearing level. It causes the number of job seekers to be higher than the number of vacancies.
• Cyclical: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. Demand for goods and services decreases, less production is needed, and fewer workers are needed.
• Structural: occurs when the labor market is not able to provide jobs for everyone who wants to work. There is a mismatch between the skills of the unemployed workers and the skills needed for available jobs. It differs from frictional unemployment because it lasts longer.
• Frictional: the time period in between jobs when a worker is searching for work or transitioning from one job to another.
• Hidden: the unemployment of potential workers that is not taken into account in official unemployment statistics because of how the data is collected. For example, workers are only considered unemployed if they are looking for work so those without jobs who have stopped looking are no longer considered unemployed.
• Long-term: usually defined as unemployment lasting longer than one year.
Measuring Unemployment
Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of all individuals currently employed in the workforce. The final measurement is called the rate of unemployment.
Unemployment Rate: Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of individual employed in the labor force.
Effects of Unemployment
When unemployment rates are high and steady, there are negative impacts on the long-run economic growth. Unemployment wastes resources, generates redistributive pressures and distortions, increases poverty, limits labor mobility, and promotes social unrest and conflict. The effects of unemployment can be broken down into three types:
• Individual: people who are unemployed cannot earn money to meet their financial obligations. Unemployment can lead to homelessness, illness, and mental stress. It can also cause underemployment where workers take on jobs that are below their skill level.
• Social: an economy that has high unemployment is not using all of its resources efficiently, specifically labor. When individuals accept employment below their skill level the economies efficiency is reduced further. Workers lose skills which causes a loss of human capital.
• Socio-political: high unemployment rates can cause civil unrest in a country.
Reducing Unemployment
There are numerous solutions that can help reduce the amount of unemployment:
• Demand side solutions: many countries aid unemployed workers through social welfare programs. Individuals receive unemployment benefits including insurance, compensation, welfare, and subsidies to aid in retraining. An example of a demand side solution is government funded employment of the able-bodied poor.
• Supply side solutions: the labor market is not 100% efficient. Supply side solutions remove the minimum wage and reduce the power of unions. The policies are designed to make the market more flexible in an attempt to increase long-run economic growth. Examples of supply side solutions include cutting taxes on businesses, reducing regulation, and increasing education.
Defining Full Employment
Full employment is defined as an acceptable level of unemployment somewhere above 0%; there is no cyclical or deficient-demand unemployment.
learning objectives
• Define full employment
Full Employment
In macroeconomics, full employment is the level of employment rates where there is no cyclical or deficient-demand unemployment. Mainstream economists define full employment as an acceptable level of unemployment somewhere above 0%. Full employment represents a range of possible unemployment rates based on the country, time period, and political biases.
U.S. Unemployment: The graph shows the unemployment rates in the United States. Full employment is defined as “ideal” unemployment. It is important because it keeps inflation under control.
Ideal Unemployment
Full employment is often seen as an “ideal” unemployment rate. Ideal unemployment excludes types of unemployment where labor-market inefficiency is reflected. Only some frictional and voluntary unemployment exists, where workers are temporarily searching for new jobs. This classifies the unemployed individuals as being without a job voluntarily. Ideal unemployment promotes the efficiency of the economy.
Lord William Beveridge defined “full employment” as the situation where the number of unemployed workers equaled the number of job vacancies available. He preferred that the economy be kept above the full employment level to allow for maximum economic production.
Non-Accelerating Inflation Rate of Unemployment (NAIRU)
The full employment unemployment rate is also referred to as “natural” unemployment. In an effort to avoid this normative connotation, James Tobin introduced the term “Non-Accelerating Inflation Rate of Unemployment” also known as the NAIRU. It corresponds to the level of unemployment when real GDP equals potential output. The NAIRU has been called the “inflation threshold. ” The NAIRU states the inflation does not rise or fall when unemployment equals the natural rate.
As an example, the United States is committed to full employment. The “Full Employment Act” was passed in 1946 and revised in 1978. It states that full employment in the United States is no more than 3% unemployment for persons 20 and older, and 4% for persons aged 16 and over.
Types of Unemployment: Frictional, Structural, Cyclical
In economics, unemployment is occurs when people are without work while actively searching for employment.
learning objectives
• Discuss structural unemployment, frictional unemployment, and the natural unemployment rate
Unemployment
In economics, unemployment occurs when people are without work while actively searching for employment. The unemployment rate is a percentage, and calculated by dividing the number of unemployed individuals by the number of all currently employed individuals in the labor force. The causes, consequences, and solutions vary based on the specific type of unemployment that is present within a country.
U.S. Unemployment: This graph shows the average duration of unemployment in the United States from 1950-2010. Unemployment occurs when there are more individuals seeking jobs than there are vacancies.
Structural Unemployment
Structural unemployment is one of the main types of unemployment within an economic system. It focuses on the structural problems within an economy and inefficiencies in labor markets. Structural unemployment occurs when a labor market is not able to provide jobs for everyone who is seeking employment. There is a mismatch between the skills of the unemployed workers and the skills needed for the jobs that are available. It is often impacted by persistent cyclical unemployment. For example, when an economy experiences long-term unemployment individuals become frustrated and their skills become obsolete. As a result, when the economy recovers they may not fit the requirements of new jobs due to their inactivity.
Retraining: When there is structural unemployment, workers may seek to learn different skills so that they can apply to new types of jobs.
Frictional Unemployment
Frictional unemployment is another type of unemployment within an economy. It is the time period between jobs when a worker is searching for or transitioning from one job to another. Frictional unemployment is always present to some degree in an economy. It occurs when there is a mismatch between the workers and jobs. The mismatch can be related to skills, payment, work time, location, seasonal industries, attitude, taste, and other factors. Frictional unemployment is influenced by voluntary decisions to work based on each individual’s valuation of their own work and how that compares to current wage rates as well as the time and effort required to find a job.
Cyclical Unemployment
Cyclical unemployment is a type of unemployment that occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. In an economy, demand for most goods falls, less production is needed, and less workers are needed. With cyclical unemployment the number of unemployed workers is greater that the number of job vacancies.
The Natural Unemployment Rate
The natural unemployment rate, sometimes called the structural unemployment rate, was developed by Friedman and Phelps in the 1960s. It represents the hypothetical unemployment rate that is consistent with aggregate production being at a long-run level. The natural rate of unemployment is a combination of structural and frictional unemployment. It is present in an efficient and expanding economy when labor and resource markets are at equilibrium. The natural unemployment rate occurs within an economy when disturbances are not present.
Key Points
• Types of unemployment determine what the causes, consequences, and solutions. The types of unemployment include: classical, cyclical, structural, frictional, hidden, and long-term.
• Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of all the individuals currently employed in the work force.
• When unemployment rates are high and steady, there are negative impacts on the long-run economic growth.
• Demand side and supply side solutions are used to reduce unemployment rates.
• Full employment represents a range of possible unemployment rates based on the country, time period, and political biases.
• Full employment is often seen as an “ideal” unemployment rate. Ideal unemployment excludes types of unemployment where labor-market inefficiency is reflected.
• The full employment unemployment rate is also referred to as “natural” unemployment.
• The Non-Accelerating Inflation Rate of Unemployment (NAIRU) corresponds to the unemployment rate when real GDP equals potential output.
• Structural unemployment focuses on the structural problems within an economy and inefficiencies in labor markets.
• Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another.
• Cyclical unemployment is a type of unemployment that occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Classical unemployment occurs when real wages for a jobs are set above the marketing clearing level.
• The natural unemployment rate represents the hypothetical unemployment rate that is consistent with aggregate production being at a long-run level.
Key Terms
• unemployment: The state of being jobless and looking for work.
• full employment: A state when an economy has no cyclical or deficient-demand unemployment.
• structural unemployment: A mismatch between the requirements of the employers and the properties of the unemployed.
• frictional unemployment: When people being temporarily between jobs, searching for new ones.
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Measuring the Unemployment Rate
The labor force is the actual number of people available for work; economists use the labor force participation rate to determine the unemployment rate.
learning objectives
• Classify the six measures of unemployment calculated by the Bureau of Labor Statistics (BLS)
Unemployment Rate
Unemployment occurs when people are without work and are actively seeking employment. In an economy, the labor force is the actual number of people available for work. Economists use the labor force participation rate to determine the unemployment rate.
Unemployment can be broken down into three types of unemployment:
• Cyclical unemployment: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Structural unemployment: occurs when the labor market is unable to provide jobs for everyone who wants to work. There is a mismatch between the skills of the unemployed workers and the skills necessary for the jobs available.
• Frictional unemployment: the time period between jobs when a worker is looking for a job or transitioning from one job to another.
Measuring Unemployment
The U.S. Bureau of Labor Statistics measures employment and unemployment for individuals over the age of 16. The unemployment rate is measured using two different labor force surveys.
• The Current Population Survey (CPS): also known as the “household survey” the CPS is conducted based on a sample of 60,000 households. The survey measures the unemployment rate based on the ILO definition.
• The Current Employment Statistics Survey (CES): also known as the “payroll survey” the CES is conducted based on a sample of 160,000 businesses and government agencies that represent 400,000 individual employees.
The unemployment rate is also calculated using weekly claims reports for unemployed insurance. The government provides this data. The unemployment rate is updated on a monthly basis.
Six Measures of Unemployment
The U.S. Bureau of Labor Statistics uses six measurements when calculating the unemployment rate. The measures range from U1 – U6 and were reported from 1950 through 2010. They calculate different aspects of unemployment. The measures are:
Unemployment Rate: The U.S. Bureau of Labor Statistics used the six employment measures to calculate the unemployment rate in the United States from 1950 to 2010.
• U1: the percentage of labor force unemployed for 15 weeks or longer.
• U2: the percentage of labor force who lost jobs or completed temporary work.
• U3: the official unemployment rate that occurs when people are without jobs and they have actively looked for work within the past four weeks.
• U4: the individuals described in U3 plus “discouraged workers,” those who have stopped looking for work because current economic conditions make them think that no work is available for them.
• U5: the individuals described in U4 plus other “marginally attached workers,” “loosely attached workers,” or those who “would like” and are able to work, but have not looked for work recently.
• U6: the individuals described in U5 plus part-time workers who want to work full-time, but cannot due to economic reasons, primarily underemployment.
Shortcomings of the Measurement
Unemployment is not an absolute calculation and it is prone to errors and biases related to data assembly and inconsistencies in reporting.
learning objectives
• Describe the rates in the U.S. of those who are employed, unemployed, and not in the labor force
Unemployment
Unemployment, also called joblessness, occurs when people are without work and are actively seeking employment. Unemployment is measured in order to determine the unemployment rate. The rate is a percentage that is calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the labor force.
U.S. Unemployment Rate: This image shows the unemployment rates by county throughout the United States in 2008. The unemployment rate is the percentage of unemployment calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the labor force.
Measurements
In order to find the rate of unemployment, four methods are used:
• Labor Force Sample Surveys: provide the most comprehensive results. Calculates unemployment by different categories such as race and gender. This method is the most internationally comparable.
• Official Estimates: combines information from the three other methods. The method is not the preferred method to use when calculating the rate of unemployment.
• Social Insurance Statistics: these statistics are calculated based on the number of individuals receiving unemployment benefits. The method is criticized because unemployment benefits can expire before an individual finds employment which makes the calculations inaccurate.
• Employment Office Statistics: only include a monthly total of unemployed individuals who enter unemployment offices. This method is the least effective for measuring unemployment.
Measurement Shortcomings
The measurement of unemployment is not an absolute calculation and is prone to errors. For example, the unemployment rate does not take into account individuals who are not actively seeking employment, such as individuals attending college or even individuals who are in U.S. prisons. Individuals who are self-employed, those who were forced to take early retirement, those with disability pensions who would like to work, and those who work part-time and seek full-time employment are not factored in to the unemployment rate. Some individuals also choose not to enter the labor force and these statistics are also not considered. By not including all underemployed or unemployed individuals in the measurement of the unemployment rate, the calculation does not provide an accurate assessment of how unemployment truly impacts society. Errors and biases are also present due to data assembly and reporting inconsistencies.
Typical Lengths of Unemployment
Short-term unemployment is any period of joblessness that lasts fewer than 27 weeks. Long-term unemployment lasts 27 or more weeks.
learning objectives
• Distinguish between short-term and long-term unemployment and the impact on people and economy
Unemployment
Unemployment, also referred to as joblessness, occurs when people are without work and actively seeking employment. Generally, unemployment is high during recessions. Individuals struggle to find work when there are more job-seekers than vacant positions.
There are three types of unemployment:
• Cyclical: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. The demand for most goods and services declines, less production is needed, and fewer workers are needed. Wages are sticky and do not fall to meet the equilibrium level which results in mass unemployment.
• Structural: occurs when the labor market is not able to provide jobs for everyone who wants to work. There is a mismatch between the skills of the workers and the skills needed for the jobs that are available.Structural unemployment is similar to frictional unemployment, but it lasts longer.
• Frictional: when a worker is searching for a job or transitioning from one job to another. Frictional unemployment is always present in an economy.
Lengths of Unemployment
Short-term unemployment is considered any unemployment period that lasts less than 27 weeks. The unemployment period is temporary and often includes the time needed to switch from one job to another. Also, if an individual is searching for employment the search period is relatively short.
Long-term unemployment is classified as unemployment that lasts for 27 weeks or longer. Being unemployed for a long period of time can have substantial impacts on individuals. Jobs skills, certifications, and qualifications lessen over time. When the job market finally increases many individuals will no longer match the requirements for the new positions. Long-term unemployment can also result in older workers taking early retirement.
Average Length of Unemployment: This graph shows the average length of unemployment in the United States from 1950-2010. Short-term unemployment is considered less than 27 weeks, while long-term unemployment is joblessness that lasts 27 weeks or longer.
Social and Individual Impacts
Unemployment can have lasting impacts of individual people as well as the economy as a whole.
• Social: Within the economy, long-term unemployment increases the inequality present in the economy and impedes long-run economic growth. Unemployment wastes resources and generates redistributive pressures and distortions within the economy. When unemployment is high, the economy is not using all of the available resources, specifically labor. Unemployment can also reduce the efficiency of the economy because unemployed workers are willing to accept employment that is below their skill level.
• Individual: For individual people, unemployment increases poverty, creates poor labor mobility, and impacts self-esteem. When individuals are unemployed they are unable to meet their financial obligations. It is not uncommon for social unrest and conflict that get worse during times of mass unemployment.
Key Points
• Unemployment occurs when people are without work and are actively seeking employment.
• There are three types of unemployment: cyclical, structural, and frictional.
• The CPS and CES are two surveys that the U.S. Bureau of Labor Statistics uses to determine the unemployment rate for households, businesses, and government agencies.
• The U.S. Bureau of Labor Statistics uses six measurements when calculating the unemployment rate. The measures range from U1 – U6 and were reported from 1950 through 2010. They calculate different aspects of unemployment.
• The rate of unemployment is a percentage that is calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the work force.
• The rate of unemployment is calculated using four methods: the Labor Force Sample Surveys, Official Estimates, Social Insurance Statistics, and Employment Office Statistics.
• The measurement of unemployment does have some shortcomings based on who is and is not measured.
• By not including all under-employed or unemployed individuals in the measurement of the unemployment rate, the calculation does not provide an accurate assessment of how unemployment truly impacts society.
• Unemployment occurs when people are without work and are actively seeking employment.
• Unemployment impacts the economy and society by increasing inequality, impeding long-term economic growth, wasting resources, and reducing economic efficiency.
• Unemployment impacts individuals because they are not able to meet their financial obligations which can lead to poverty, poor labor mobility, and low self-esteem. Unemployment is also know to cause civil unrest and conflict.
Key Terms
• unemployment: The state of being jobless and looking for work.
• labor force: The collective group of people who are available for employment, i.e. including both the employed and the unemployed.
• poverty: The quality or state of being poor or indigent; want or scarcity of means of subsistence; indigence; need.
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Reasons for Unemployment
There are three reasons for unemployment which are categorizes as frictional, structural, and cyclical unemployment.
learning objectives
• Explain why the unemployment rate may fluctuate
There are four types of unemployment. The distinction between them is important to economists because the policy prescriptions for addressing each type vary.
Natural Level of Unemployment
The natural level of unemployment is the unemployment rate when an economy is operating at full capacity. This is the unemployment rate that occurs when production is at its long-run level, removing any temporary fluctuations and frictions. It is mainly determined by an economy’s production possibilities and economic institutions. At this level of unemployment, the quantity of labor supplied equals the quantity of labor demanded, though this does not imply that unemployment is zero. The reason why the natural rate of unemployment is still positive is due to frictional and structural unemployment.
Frictional Unemployment
Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment exists because both jobs and workers are heterogenous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to skills, payment, work-time, location, seasonal industries, attitude, taste, and a multitude of other factors.
There is always at least some frictional unemployment in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment.
Though economists accept that some frictional unemployment is okay because both potential workers and employers take some time to find the best employee-position match, too much frictional unemployment is undesirable. Governments will seek ways to reduce unnecessary frictional unemployment through multiple means including providing education, advice, training, and assistance such as daycare centers.
Structural Unemployment
Structural unemployment is a form of unemployment where, at a given wage, the quantity of labor supplied exceeds the quantity of labor demanded, because there is a fundamental mismatch between the number of people who want to work and the number of jobs that are available. The unemployed workers may lack the skills needed for the jobs, or they may not live in the part of the country or world where the jobs are available. It is generally considered to be one of the “permanent” types of unemployment, where improvement if possible, will only occur in the long run.
A common cause of structural unemployment is technological change. With the advent of telephones, for example, some telegraph operators were put out of work. Their inability to find work was due to an oversupply of skilled telegraph operators relative to the demand for workers with that ability.
Cyclical Unemployment
Of course, the economy may not be operating at its natural level of employment, so unemployment may be above or below its natural level. This is often attributed to the business cycle: the expansion and contraction of the economy around the long-term growth trend. During periods in the business cycle when the economy is producing below its long-run, optimum level, firms demand fewer workers and the result is cyclical unemployment. In this case the long-run demand for labor is higher than the temporary demand, so the rate of unemployment is higher than its natural rate.
U.S. Unemployment Rate: The short-term fluctuations in the graph are the result of cyclical unemployment that changes when economic activity is above or below its long-term potential. Over time, unemployment has returned to about 5%, which is the approximate natural rate of unemployment.
Impact of Public Policy on Unemployment
Public policy seeks to minimize unemployment by providing information, training, facilities, and other programs to assist the unemployed.
learning objectives
• Review the importance of unemployment benefits in the American social welfare program
Most governments strive to achieve low levels of unemployment. However, the types of policies differ depending on what type of unemployment they address.
Frictional Unemployment
Frictional unemployment is the period between jobs in which an employee is searching for or transitioning from one job to another. It exists because the labor market is not perfect and there may be mismatches between job-seekers and jobs before workers are hired for the right position. If the search takes too long and mismatches are too frequent, the economy suffers, since some work will not get done.
Governments can enact policies to try to reduce frictional unemployment. These include offering advice and resources for job-seekers and providing clear and transparent information on available jobs and workers. This can take the form of free career counseling and job boards or job fairs. The government can provide facilities to increase availability and flexibility – for example, providing daycare may allow part-time or non-workers to transition into full-time jobs, and public transportation may widen the number of jobs available to somebody without a car. The government may also fund publicity campaigns or other programs to combat prejudice against certain types of workers, jobs, or locations.
On the other hand, some frictional unemployment is a good thing – if every worker was offered, and accepted, the first job they encountered, the distribution of workers and jobs would be quite inefficient. Many governments offer unemployment insurance to both alleviate the short-term hardship faced by the unemployed and to allow workers more time to search for a job. These benefits generally take the form of payments to the involuntarily unemployed for some specified period of time following the loss of the job. In order to achieve the goal of reducing frictional unemployment, governments typically require beneficiaries to actively search for a job while receiving payments and do not offer unemployment benefits to those who are fired or leave their job by choice.
Structural Unemployment
Structural unemployment is due to more people wanting jobs than there are jobs available. The unemployed workers may lack the skills needed for the jobs, or they may not live in the part of the country or world where the jobs are available.
Public policy can respond to structural unemployment through programs like job training and education to equip workers with the skills firms demand. A worker who was trained in an obsolete field, such as a typesetter who lost his job when printing was digitized, may benefit from free retraining in another field with strong demand for labor.
Job Training Programs: Many organizations seek to minimize structural unemployment by offering job training and education to provide workers with in-demand skills.
Impact of Unions on Unemployment
If the labor market is competitive, unions will typically raise wages but increase unemployment.
learning objectives
• Discuss the impact of unionization on unemployment
A union is a formal organization of workers who have banded together to achieve common goals such as protecting the integrity of its trade, achieving higher pay, increasing the number of employees an employer hires, and better working conditions. They function by negotiating with employers to create a collective agreement that applies to all union members and typically lasts for a set time period. For example, in a unionized industry, rather than each employee negotiating his or her own vacation time with the employer, a union will negotiate with the firm in order to create a contract governing vacation time that applies to every union member. This gives workers as a whole a stronger bargaining position when negotiating working conditions and pay.
Trade unions in their current form became popular during the industrial revolution, when most jobs required little skill or training and therefore almost all of the bargaining power fell with employers rather than employees. While unions have many goals, their primary objective has historically been to achieve higher wages for members of the union – that is, those who are already employed in an industry.
Unions are able to raise wages because, when they are powerful, they may turn the labor market into a monopoly market. Rather than a competitive market with many buyers (employers) and sellers (employees), there are many buyers but only one seller: the union. Like any monopoly market, the outcome will be an equilibrium with higher prices and lower supply than in the competitive equilibrium. In the case of the labor market, this means that wages will be higher, but so will unemployment. This is illustrated in the graphic, in which a union successfully raises the wage rate above the equilibrium wage. The gap between the point where the new wage rate intersects the demand curve and where it intersects the supply curve represents the resulting unemployment.
Raising Wages Above Equilibrium: If a union is able to raise the minimum wage for their members above the equilibrium wage, then wages will be higher but fewer workers will be employed.
Many economists criticize unionization, arguing that it frequently produces higher wages at the expense of fewer jobs. Essentially, unionization benefits the already employed at the expense of the unemployed. Further, by charging higher prices than the equilibrium wage rate, unions promote deadweight loss. Critics also argue that if some industries are unionized and others are not, wages will decline in non-unionized industries.
Unions in Imperfect Labor Markets
The above arguments assume that without unions, the labor market would be competitive – that is, there would be many buyers and many sellers of labor. In this competitive equilibrium, the wage rate would equal the marginal revenue product of labor and the outcome would be efficient. In reality this is often not the case. Rather, many industries are dominated by only a few firms, making the labor market an oligopsony – a market with many sellers of labor but only a few buyers. In an oligopsony firms have the advantage over workers, and wages may be lower than they would be at the competitive equilibrium.
If we assume that the labor market is imperfect and that wages are naturally lower than the marginal revenue product of labor, unions may increase efficiency by raising wage rates closer to the efficient level. In this case, wages will rise without a resulting rise in unemployment.
Unions, Productivity, and Unemployment
The above arguments focus on how unions affect unemployment by negotiating for higher wages, but unions may also affect unemployment in other ways. Many argue that unions are capable of raising productivity by reducing turnover, increasing coordination between workers and management, and by increasing workers’ motivation. More productive workers means a higher marginal product of labor. Since the demand for labor is determined by its marginal product, increased productivity will cause demand to shift to the right and lead to an efficient equilibrium with both higher wages and lower unemployment.
Efficiency Wage Theory
Efficiency wage theory is the idea that firms may permanently hold to a real wage greater than the equilibrium wage.
learning objectives
• Define Efficiency Wage Theory
Efficiency-Wage Theory
The market-clearing wage is the wage at which supply equals demand; there is no excess supply of labor (unemployment) and no excess demand for labor (labor shortage). In the basic economic theory, in the long run the economy will achieve this market-clearing equilibrium and will experience the natural level of unemployment. However, firms may choose to pay wages higher than the market-clearing equilibrium in order to incentivize increased worker productivity or to reduce turnover. This is called efficiency-wage theory.
Why Pay Efficiency Wages?
There are several theories of why managers might pay efficiency wages:
• Avoiding shirking: If it is difficult to measure the quantity or quality of a worker’s effort, there may be an incentive for him or her to “shirk” (do less work than agreed). The manager thus may pay an efficiency wage in order to increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking.
• Minimizing turnover: As mentioned above, by paying above-market wages, the worker’s motivation to leave the job and look for a job elsewhere will be reduced. This strategy makes sense when it is expensive to train replacement workers.
• Selection: If job performance depends on workers’ ability and workers differ from each other in those terms, firms with higher wages will attract more able job-seekers, and this may make it profitable to offer wages that exceed the market clearing level.
Consequence of Efficiency Wage
The consequence of the efficiency wage theory is that the market for labor does may not clear and unemployment may be persistently higher than its natural rate. Instead of market forces causing the wage rate to adjust to the point at which supply equals demand, the wage rate will be higher and supply will exceed demand. This produces higher wages for those who are employed but higher levels of unemployment.
Job Creation and Destruction
Jobs are created when workers become more productive, the price of output increases, or when total economic output increases.
learning objectives
• Summarize how jobs are created and destroyed on a firm, industry, and economy wide level
Job Creation at the Microeconomic Level
Firms decide to create or lose jobs based on the price of output, the price of inputs, and the marginal productivity of inputs. Firms will continue to demand labor until the marginal revenue product of labor equals the wage rate – that is, until the marginal benefit of one more employee equals the marginal cost of that employee. For example, suppose a shoe factory can sell shoes for \$50 a pair, and hiring an additional employee to work for an hour allows the factory to produce one extra pair of shoes. As long as the wage rate is less than \$50/hour, the firm can increase its profit by hiring more worker and producing more shoes. Eventually, however, the factory will become crowded, workers will need to wait in line for access to necessary tools and machinery, or the supply of materials will fail to keep up with the production pace. This will cause the marginal productivity of labor to fall, so that an additional hour of work produces less than one extra pair of shoes. If the prevailing wage rate is \$25/hour, the firm will hire until it takes two hours of work to produce one pair of shoes. At this point, the marginal benefit of hiring labor is \$25, equal to the marginal cost.
Factors that increase the productivity of labor will increase demand for labor and create jobs. Suppose a new type of sewing machine is invented that is smaller and allows shoemakers to work more quickly. This increases the productivity of labor, so that at its previous employment levels the firm can now earn \$35 for every hour of labor it employs. Just as before, the firm will create more jobs and continue to hire until the marginal revenue product of labor is again equal to the wage rate. Similarly, if the price of output rises firms will hire more employees. If the price of shoes increases to \$60, for example, workers that were previously making \$25 worth of shoes in an hour will be making \$30 worth of shoes each hour instead. Since the wage rate is still \$25, the firm will hire more workers until the marginal revenue product of labor is equal to the wage rate.
Job Creation at the Macroeconomic Level
At a macroeconomic level, jobs are created when the general level of output rises and jobs are destroyed when the general level of output falls. The quantity of labor employed and the wage rate are determined by the intersection of labor supply (the number of people willing to enter the workforce at any given wage) and the labor demand (the amount of labor producers are willing to employ at any given wage rate). Labor supply is based primarily upon the size of the population and therefore remains fairly stable. The labor demand, however, shifts to the left when an economy’s output falls, since firms will need fewer workers to produce fewer goods. Likewise, labor demand shifts to the right when an economy’s output rises. These shifts will destroy job and lower wages or create jobs and increase wages, respectively.
Output and Employment: As this hypothetical graph shows, when output (GDP) is rising, jobs are created and unemployment falls. When output is falling, jobs are destroyed and unemployment rises.
One reason that economic activity might rise or fall is the business cycle. The business cycle refers to the periods of expansions and contractions in the level of economic activities around the long-term growth trend. This is typically due to an increase or decrease in the economy-wide demand for consumer goods, but these cycles could also take place due to changes in production technology, changes in governmental policy, and many other factors.
At the macroeconomic level jobs may also shift between industries due to changes in demand or technology. For example, when health researchers uncovered facts about the health risks of smoking, the demand for cigarettes dropped and many jobs were lost in the tobacco industry. As for technology, the invention of the telephone created many jobs in telecommunications, but destroyed most of the jobs associated with telegraphs.
Key Points
• The natural rate of unemployment is the unemployment rate when the economy is producing at its full potential output. This natural rate is positve, rather than zero, due to frictional and structural unemployment.
• Frictional unemployment is caused by an inability for workers and employers to find each other immediately.
• Structural unemployment is caused by mismatches between the skills offered by potential employees and those sought by employers.
• Cyclical unemployment occurs whenever the economy is not operating at its full, long-term potential. During low periods in the business cycle, firms demand fewer workers and the result is an unemployment level above the natural rate.
• Policies to combat unemployment differ depending on the type of unemployment.
• Policies to combat frictional unemployment include providing free and clear information to help match available job-seekers and jobs, providing facilities to increase availability and flexibility, and combating prejudice against certain types of workers, jobs, or locations.
• Unemployment insurance alleviates the short-term hardship faced by the unemployed and allows workers more time to search for a job that fits their skills and preferences.
• Job training and education to equip workers with the skills firms demand are public policy responses to structural unemployment.
• Unions function by negotiating with employers to create a collective agreement that applies to all union members and typically lasts for a set time period.
• Unions are able to raise wages because, when they are powerful, they may turn the labor market into a monopoly market.
• Many economists criticize unionization, arguing that it frequently produces higher wages at the expense of fewer jobs. Essentially, unionization benefits the already employed at the expense of the unemployed.
• In labor markets that are not competitive, the equilibrium without unionization may result in wages that are lower than the competitive equilibrium. In this case, unions may be able to raise wages without increasing unemployment.
• Efficiency wages are wages that are higher than the market equilibrium. Firms that pay efficiency wages could lower their wages and hire more workers, but choose not to do so.
• Some reasons that managers might choose to pay efficiency wages are to avoid shirking, reduce turnover, and attract productive employees.
• The consequence of the efficiency wage theory is that the market for labor does may not clear, even in the long run, and unemployment may be persistenly higher than its natural rate.
• Firms will continue to demand labor until the marginal revenue product of labor equal the wage rate – that is, until the marginal benefit of one more employee equals the marginal cost of that employee.
• Any factor that increases the marginal revenue product of labor or that decreases the marginal cost of labor will create jobs.
• At a macroeconomic level, jobs are created when the general level of output rises and jobs are destroyed when the general level of output falls.
• In general, output rises when the demand for consumer goods increases. Thus, factors that stimulate consumer demand also encourage job creation.
Key Terms
• structural unemployment: A mismatch between the requirements of the employers and the properties of the unemployed.
• frictional unemployment: When people being temporarily between jobs, searching for new ones.
• cyclical unemployment: A type of unemployment explained by the demand for labor going up and down with the business cycle.
• unemployment insurance: Insurance against loss of earnings during the time that an able-bodied worker is involuntarily unemployed.
• bargaining power: The ability to influence the setting of prices or wages, usually arising from some sort of monopoly or monopsony position — or a non-equilibrium situation in the market.
• oligopsony: An economic condition in which a small number of buyers exert control over the market price of a commodity.
• marginal product of labor: the change in output that results from employing an added unit of labor.
• shirking: To provide less quality work than is required.
• turnover: The number of times a worker is replaced after leaving.
• marginal productivity: The extra output that can be produced by using one more unit of the input
• business cycle: A fluctuation in economic activity between growth and recession.
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The Phillips Curve
The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation increases.
learning objectives
• Review the historical evidence regarding the theory of the Phillips curve
The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis.
Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.
History
The early idea for the Phillips curve was proposed in 1958 by economist A.W. Phillips. In his original paper, Phillips tracked wage changes and unemployment changes in Great Britain from 1861 to 1957, and found that there was a stable, inverse relationship between wages and unemployment. This correlation between wage changes and unemployment seemed to hold for Great Britain and for other industrial countries. In 1960, economists Paul Samuelson and Robert Solow expanded this work to reflect the relationship between inflation and unemployment. Because wages are the largest components of prices, inflation (rather than wage changes) could be inversely linked to unemployment.
The theory of the Phillips curve seemed stable and predictable. Data from the 1960’s modeled the trade-off between unemployment and inflation fairly well. The Phillips curve offered potential economic policy outcomes: fiscal and monetary policy could be used to achieve full employment at the cost of higher price levels, or to lower inflation at the cost of lowered employment. However, when governments attempted to use the Phillips curve to control unemployment and inflation, the relationship fell apart. Data from the 1970’s and onward did not follow the trend of the classic Phillips curve. For many years, both the rate of inflation and the rate of unemployment were higher than the Phillips curve would have predicted, a phenomenon known as “stagflation. ” Ultimately, the Phillips curve was proved to be unstable, and therefore, not usable for policy purposes.
US Phillips Curve (2000 – 2013): The data points in this graph span every month from January 2000 until April 2013. They do not form the classic L-shape the short-run Phillips curve would predict. Although it was shown to be stable from the 1860’s until the 1960’s, the Phillips curve relationship became unstable – and unusable for policy-making – in the 1970’s.
The Relationship Between the Phillips Curve and AD-AD
Changes in aggregate demand cause movements along the Phillips curve, all other variables held constant.
learning objectives
• Relate aggregate demand to the Phillips curve
The Phillips Curve Related to Aggregate Demand
The Phillips curve shows the inverse trade-off between rates of inflation and rates of unemployment. If unemployment is high, inflation will be low; if unemployment is low, inflation will be high.
The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship between inflation, which affects the price level aspect of aggregate demand, and unemployment, which is dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are actually closely related.
To see the connection more clearly, consider the example illustrated by. Let’s assume that aggregate supply, AS, is stationary, and that aggregate demand starts with the curve, AD1. There is an initial equilibrium price level and real GDP output at point A. Now, imagine there are increases in aggregate demand, causing the curve to shift right to curves AD2 through AD4. As aggregate demand increases, unemployment decreases as more workers are hired, real GDP output increases, and the price level increases; this situation describes a demand-pull inflation scenario.
Phillips Curve and Aggregate Demand: As aggregate demand increases from AD1 to AD4, the price level and real GDP increases. This translates to corresponding movements along the Phillips curve as inflation increases and unemployment decreases.
As more workers are hired, unemployment decreases. Moreover, the price level increases, leading to increases in inflation. These two factors are captured as equivalent movements along the Phillips curve from points A to D. At the initial equilibrium point A in the aggregate demand and supply graph, there is a corresponding inflation rate and unemployment rate represented by point A in the Phillips curve graph. For every new equilibrium point (points B, C, and D) in the aggregate graph, there is a corresponding point in the Phillips curve. This illustrates an important point: changes in aggregate demand cause movements along the Phillips curve.
The Long-Run Phillips Curve
The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run.
learning objectives
• Examine the NAIRU and its relationship to the long term Phillips curve
The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this relationship in the long run? According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.
Natural Rate Hypothesis
The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.
An Example
To get a better sense of the long-run Phillips curve, consider the example shown in. Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This is shown as a movement along the short-run Phillips curve, to point B, which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms in order to produce more output to meet rising demand, and unemployment will decrease. However, due to the higher inflation, workers’ expectations of future inflation changes, which shifts the short-run Phillips curve to the right, from unstable equilibrium point B to the stable equilibrium point C. At point C, the rate of unemployment has increased back to its natural rate, but inflation remains higher than its initial level.
NAIRU and Phillips Curve: Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.
The reason the short-run Phillips curve shifts is due to the changes in inflation expectations. Workers, who are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace with inflation increases (the movement from A to B), so their real wages have been decreased. As such, in the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers (the movement from B to C). Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.
The NAIRU theory was used to explain the stagflation phenomenon of the 1970’s, when the classic Phillips curve could not. According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not affected, leading to high inflation and high unemployment.
The Short-Run Phillips Curve
The short-run Phillips curve depicts the inverse trade-off between inflation and unemployment.
learning objectives
• Interpret the short-run Phillips curve
The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.
Short-Run Phillips Curve: The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips curve (in red), which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate.
Consider the example shown in. When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.
Historical application
During the 1960’s, the Phillips curve rose to prominence because it seemed to accurately depict real-world macroeconomics. However, the stagflation of the 1970’s shattered any illusions that the Phillips curve was a stable and predictable policy tool. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run. Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. With more people employed in the workforce, spending within the economy increases, and demand-pull inflation occurs, raising price levels.
Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and unemployment, but this relationship can only exist in the short run. The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history.
Relationship Between Expectations and Inflation
There are two theories of expectations (adaptive or rational) that predict how people will react to inflation.
learning objectives
• Distinguish adaptive expectations from rational expectations
The short-run Phillips curve is said to shift because of workers’ future inflation expectations. Yet, how are those expectations formed? There are two theories that explain how individuals predict future events.
Real versus Nominal Quantities
To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. Suppose you are opening a savings account at a bank that promises a 5% interest rate. This is the nominal, or stated, interest rate. However, suppose inflation is at 3%. The real interest rate would only be 2% (the nominal 5% minus 3% to adjust for inflation).
The difference between real and nominal extends beyond interest rates. In an earlier atom, the difference between real GDP and nominal GDP was discussed. The distinction also applies to wages, income, and exchange rates, among other values.
Adaptive Expectations
The theory of adaptive expectations states that individuals will form future expectations based on past events. For example, if inflation was lower than expected in the past, individuals will change their expectations and anticipate future inflation to be lower than expected.
To connect this to the Phillips curve, consider. Assume the economy starts at point A at the natural rate of unemployment with an initial inflation rate of 2%, which has been constant for the past few years. Accordingly, because of the adaptive expectations theory, workers will expect the 2% inflation rate to continue, so they will incorporate this expected increase into future labor bargaining agreements. This way, their nominal wages will keep up with inflation, and their real wages will stay the same.
Expectations and the Phillips Curve: According to adaptive expectations theory, policies designed to lower unemployment will move the economy from point A through point B, a transition period when unemployment is temporarily lowered at the cost of higher inflation. However, eventually, the economy will move back to the natural rate of unemployment at point C, which produces a net effect of only increasing the inflation rate.According to rational expectations theory, policies designed to lower unemployment will move the economy directly from point A to point C. The transition at point B does not exist as workers are able to anticipate increased inflation and adjust their wage demands accordingly.
Now assume that the government wants to lower the unemployment rate. To do so, it engages in expansionary economic activities and increases aggregate demand. As aggregate demand increases, inflation increases. Because of the higher inflation, the real wages workers receive have decreased. For example, assume each worker receives \$100, plus the 2% inflation adjustment. Each worker will make \$102 in nominal wages, but \$100 in real wages. Now, if the inflation level has risen to 6%. Workers will make \$102 in nominal wages, but this is only \$96.23 in real wages.
Although the workers’ real purchasing power declines, employers are now able to hire labor for a cheaper real cost. Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP. On, the economy moves from point A to point B.
However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to increase their real purchasing power to previous levels, which raises labor costs for employers. As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point C.
This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation.
Rational Expectations
The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates.
As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at point A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly. They will be able to anticipate increases in aggregate demand and the accompanying increases in inflation. As such, they will raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period when their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to point B.
In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers. They can act rationally to protect their interests, which cancels out the intended economic policy effects. Efforts to lower unemployment only raise inflation.
Shifting the Phillips Curve with a Supply Shock
Aggregate supply shocks, such as increases in the costs of resources, can cause the Phillips curve to shift.
learning objectives
• Give examples of aggregate supply shock that shift the Phillips curve
The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. In the 1960’s, economists believed that the short-run Phillips curve was stable. By the 1970’s, economic events dashed the idea of a predictable Phillips curve. What could have happened in the 1970’s to ruin an entire theory? Stagflation caused by a aggregate supply shock.
Stagflation and Aggregate Supply Shocks
Stagflation is a combination of the words “stagnant” and “inflation,” which are the characteristics of an economy experiencing stagflation: stagnating economic growth and high unemployment with simultaneously high inflation. The stagflation of the 1970’s was caused by a series of aggregate supply shocks. In this case, huge increases in oil prices by the Organization of Petroleum Exporting Countries (OPEC) created a severe negative supply shock. The increased oil prices represented greatly increased resource prices for other goods, which decreased aggregate supply and shifted the curve to the left. As aggregate supply decreased, real GDP output decreased, which increased unemployment, and price level increased; in other words, the shift in aggregate supply created cost-push inflation.
Aggregate Supply Shock: In this example of a negative supply shock, aggregate supply decreases and shifts to the left. The resulting decrease in output and increase in inflation can cause the situation known as stagflation.
Shifting the Phillips Curve
The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually exclusive; it was not possible to have high levels of both within an economy. Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation.
Disinflation
Disinflation is a decline in the rate of inflation, and can be caused by declines in the money supply or recessions in the business cycle.
learning objectives
• Identify situations with disinflation
Inflation is the persistent rise in the general price level of goods and services. Disinflation is a decline in the rate of inflation; it is a slowdown in the rise in price level. As an example, assume inflation in an economy grows from 2% to 6% in Year 1, for a growth rate of four percentage points. In Year 2, inflation grows from 6% to 8%, which is a growth rate of only two percentage points. The economy is experiencing disinflation because inflation did not increase as quickly in Year 2 as it did in Year 1, but the general price level is still rising. Disinflation is not to be confused with deflation, which is a decrease in the general price level.
Causes
Disinflation can be caused by decreases in the supply of money available in an economy. It can also be caused by contractions in the business cycle, otherwise known as recessions. The Phillips curve can illustrate this last point more closely. Consider an economy initially at point A on the long-run Phillips curve in. Suppose that during a recession, the rate that aggregate demand increases relative to increases in aggregate supply declines. This reduces price levels, which diminishes supplier profits. As profits decline, employers lay off employees, and unemployment rises, which moves the economy from point A to point B on the graph. Eventually, though, firms and workers adjust their inflation expectations, and firms experience profits once again. As profits increase, employment also increases, returning the unemployment rate to the natural rate as the economy moves from point B to point C. The expected rate of inflation has also decreased due to different inflation expectations, resulting in a shift of the short-run Phillips curve.
Disinflation: Disinflation can be illustrated as movements along the short-run and long-run Phillips curves.
Inflation vs. Deflation vs. Disinflation
To illustrate the differences between inflation, deflation, and disinflation, consider the following example. Assume the following annual price levels as compared to the prices in year 1:
• Year 1: 100% of Year 1 prices
• Year 2: 104% of Year 1 prices
• Year 3: 106% of Year 1 prices
• Year 4: 107% of Year 1 prices
• Year 5: 105% of Year 1 prices
As the economy moves through Year 1 to Year 4, there is a continued growth in the price level. This is an example of inflation; the price level is continually rising. However, between Year 2 and Year 4, the rise in price levels slows down. Between Year 2 and Year 3, the price level only increases by two percentage points, which is lower than the four percentage point increase between Years 1 and 2. The trend continues between Years 3 and 4, where there is only a one percentage point increase. This is an example of disinflation; the overall price level is rising, but it is doing so at a slower rate.
Between Years 4 and 5, the price level does not increase, but decreases by two percentage points. This is an example of deflation; the price rise of previous years has reversed itself.
Key Points
• The relationship between inflation rates and unemployment rates is inverse. Graphically, this means the short-run Phillips curve is L-shaped.
• A.W. Phillips published his observations about the inverse correlation between wage changes and unemployment in Great Britain in 1958. This relationship was found to hold true for other industrial countries, as well.
• From 1861 until the late 1960’s, the Phillips curve predicted rates of inflation and rates of unemployment. However, from the 1970’s and 1980’s onward, rates of inflation and unemployment differed from the Phillips curve’s prediction. The relationship between the two variables became unstable.
• Aggregate demand and the Phillips curve share similar components. The rate of unemployment and rate of inflation found in the Phillips curve correspond to the real GDP and price level of aggregate demand.
• Changes in aggregate demand translate as movements along the Phillips curve.
• If there is an increase in aggregate demand, such as what is experienced during demand-pull inflation, there will be an upward movement along the Phillips curve. As aggregate demand increases, real GDP and price level increase, which lowers the unemployment rate and increases inflation.
• The natural rate of unemployment is the hypothetical level of unemployment the economy would experience if aggregate production were in the long-run state.
• The natural rate hypothesis, or the non-accelerating inflation rate of unemployment (NAIRU) theory, predicts that inflation is stable only when unemployment is equal to the natural rate of unemployment. If unemployment is below (above) its natural rate, inflation will accelerate (decelerate).
• Expansionary efforts to decrease unemployment below the natural rate of unemployment will result in inflation. This changes the inflation expectations of workers, who will adjust their nominal wages to meet these expectations in the future. This leads to shifts in the short-run Phillips curve.
• The natural rate hypothesis was used to give reasons for stagflation, a phenomenon that the classic Phillips curve could not explain.
• The long-run Phillips curve is a vertical line at the natural rate of unemployment, but the short-run Phillips curve is roughly L-shaped.
• The inverse relationship shown by the short-run Phillips curve only exists in the short-run; there is no trade-off between inflation and unemployment in the long run.
• Economic events of the 1970’s disproved the idea of a permanently stable trade-off between unemployment and inflation.
• Nominal quantities are simply stated values. Real quantities are nominal ones that have been adjusted for inflation.
• Adaptive expectations theory says that people use past information as the best predictor of future events. If inflation was higher than normal in the past, people will expect it to be higher than anticipated in the future.
• Rational expectations theory says that people use all available information, past and current, to predict future events. If inflation was higher than normal in the past, people will take that into consideration, along with current economic indicators, to anticipate its future performance.
• According to adaptive expectations, attempts to reduce unemployment will result in temporary adjustments along the short-run Phillips curve, but will revert to the natural rate of unemployment. According to rational expectations, attempts to reduce unemployment will only result in higher inflation.
• In the 1970’s soaring oil prices increased resource costs for suppliers, which decreased aggregate supply. The resulting cost-push inflation situation led to high unemployment and high inflation ( stagflation ), which shifted the Phillips curve upwards and to the right.
• Stagflation is a situation where economic growth is slow (reducing employment levels) but inflation is high.
• The Phillips curve was thought to represent a fixed and stable trade-off between unemployment and inflation, but the supply shocks of the 1970’s caused the Phillips curve to shift. This ruined its reputation as a predictable relationship.
• Disinflation is not the same as deflation, when inflation drops below zero.
• During periods of disinflation, the general price level is still increasing, but it is occurring slower than before.
• The short-run and long-run Phillips curve may be used to illustrate disinflation.
Key Terms
• Phillips curve: A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.
• stagflation: Inflation accompanied by stagnant growth, unemployment, or recession.
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• Natural Rate of Unemployment: The hypothetical unemployment rate consistent with aggregate production being at the long-run level.
• non-accelerating inflation rate of unemployment: (NAIRU); theory that describes how the short-run Phillips curve shifts in the long run as expectations change.
• Phillips curve: A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.
• adaptive expectations theory: A hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past.
• rational expectations theory: A hypothesized process by which people form their expectations about what will happen in the future based on all relevant information.
• supply shock: An event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
• disinflation: A decrease in the inflation rate.
• inflation: An increase in the general level of prices or in the cost of living.
• deflation: A decrease in the general price level, that is, in the nominal cost of goods and services.
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Defining Aggregate Expenditure: Components and Comparison to GDP
Aggregate expenditure is the current value of all the finished goods and services in the economy.
learning objectives
• Define aggregate expenditure
Aggregate Expenditure
In economics, aggregate expenditure is the current value of all the finished goods and services in the economy. It is the sum of all the expenditures undertaken in the economy by the factors during a specific time period. The equation for aggregate expenditure is: $\mathrm{AE = C + I + G + NX}$.
Written out the equation is: aggregate expenditure equals the sum of the household consumption (C), investments (I), government spending (G), and net exports (NX).
• Consumption (C): The household consumption over a period of time.
• Investment (I): The amount of expenditure towards the capital goods.
• Government expenditure (G): The amount of spending by federal, state, and local governments. Government expenditure can include infrastructure or transfers which increase the total expenditure in the economy.
• Net exports (NX): Total exports minus the total imports.
The aggregate expenditure determines the total amount that firms and households plan to spend on goods and services at each level of income.
Comparison to GDP
The aggregate expenditure is one of the methods that is used to calculate the total sum of all the economic activities in an economy, also known as the gross domestic product (GDP). The gross domestic product is important because it measures the growth of the economy. The GDP is calculated using the Aggregate Expenditures Model.
Aggregate Expenditure: This graph shows the aggregate expenditure model. It is used to determine and graph the real GPD, potential GDP, and point of equilibrium. A shift in supply or demand impacts the GDP.
An economy is at equilibrium when aggregate expenditure is equal to the aggregate supply (production) in the economy. The economy is not in a constant state of equilibrium. Instead, the aggregate expenditure and aggregate supply adjust each other toward equilibrium.
When there is excess supply over the expenditure, there is a reduction in either the prices or the quantity of the output which reduces the total output (GDP) of the economy.
In contrast, when there is an excess of expenditure over supply, there is excess demand which leads to an increase in prices or output (higher GDP). A rise in the aggregate expenditure pushes the economy towards a higher equilibrium and a higher potential of the GDP.
Aggregate Expenditure at Economic Equilibrium
An economy is said to be at equilibrium when aggregate expenditure is equal to the aggregate supply (production) in the economy.
learning objectives
• Identify the assumptions fundamental to classical economics in regards to aggregate expenditure at economic equilibrium
Aggregate Expenditure
In economics, aggregate expenditure is the current value (price) of all the finished goods and services in the economy. The equation for aggregate expenditure is $\mathrm{AE = C+ I + G + NX}$.
Written out in full, the equation reads: aggregate expenditure = household consumption (C) + investments (I) + government spending (G) + net exports (NX).
Aggregate expenditure is a method that is used to calculate the total value of economic activities, also referred to as the gross domestic product ( GDP ). The GDP of an economy is calculated using the aggregate expenditure model.
Economic Equilibrium
An economy is said to be at equilibrium when aggregate expenditure is equal to the aggregate supply (production) in the economy. The economy is constantly shifting between excess supply (inventory) and excess demand. As a result, the economy is always moving towards an equilibrium between the aggregate expenditure and aggregate supply. On the aggregate expenditure model, equilibrium is the point where the aggregate supply and aggregate expenditure curve intersect. An increase in the expenditure by consumption (C) or investment (I) causes the aggregate expenditure to rise which pushes the economy towards a higher equilibrium.
Aggregate Expenditure – Equilibrium: In this graph, equilibrium is reached when the total demand (AD) equals the total amount of output (Y). The equilibrium point is where the blue line intersects with the black line.
Classical Economics – Aggregate Expenditure
Classical economists believed in Say’s law, which states that supply creates its own demand. This idea stems from the belief that wages, prices, and interest rage were all flexible. Classical economics states that the factor payments (wage and rental payments) made during the production process create enough income in the economy to create a demand for the products that were produced. This belief is parallel to Adam Smith’s invisible hand – markets achieve equilibrium through the market forces that impact economic activity.
The classical aggregate expenditure model is: $\mathrm{AE = C + I}$.
Classical Aggregate Expenditure: This graph shows the classical aggregate expenditure where C is consumption expenditure and I is aggregate investment. The aggregate expenditure is the aggregate consumption plus the planned investment ($\mathrm{AE = C + I}$).
The aggregate expenditure equals the aggregate consumption plus planned investment. Classical economics assumes that the economy works on a full-employment equilibrium, which is not always true. In reality, many economists argue that the economy operates at an under-employment equilibrium.
Graphing Equilibrium
An economy is said to be at equilibrium when the aggregate expenditure is equal to the aggregate supply (production) in the economy.
learning objectives
• Demonstrate how aggregate demand and aggregate supply determine output and price level by using the AD-AS model
Aggregate Supply and Aggregate Demand
In economics, the aggregate supply (AS) is the total supply of goods and services that firms in an economy produce during a specific time period. It represents the total amount of goods and services that firms are willing to sell at a given price level. The aggregate supply curve is graphed as a backwards L-shape in the short-run and vertical in the long-run.
Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It shows the amounts of goods and services that will be purchased at all the possible price levels. When aggregate demand increases its graph shifts to the right. It shifts to the left when it decreases which shows a fall in output and prices.
The aggregate supply and aggregate demand determine the output and price for goods and services. The AD-AS model is used to graph the aggregate expenditure and the point of equilibrium.
AD-AS Model: This graph shows the AD-AS model where P is the average price level and Y* is the aggregate quantity demanded. The model is used to show how increases in aggregate demand leads to increases in prices (inflation) and in output.
AD-AS Model: This graph shows the AD-AS model where P is the average price level and Y* is the aggregate quantity demanded. The model is used to show how increases in aggregate demand leads to increases in prices (inflation) and in output.
Aggregate Expenditure
Aggregate expenditure is the current value of all the finished goods and services in the economy. The equation for aggregate expenditure is: $\mathrm{AE = C + I + G + NX}$.
The aggregate expenditure equals the sum of the household consumption (C), investments (I), government spending (G), and net exports (NX).
Graphing Equilibrium
The AD-AS model is used to graph the aggregate expenditure at the point of equilibrium. The AD-AS model includes price changes. An economy is said to be at equilibrium when the aggregate expenditure is equal to the aggregate supply (production) in the economy. It is important to note that the economy does not stay in a state of equilibrium. The aggregate expenditure and aggregate supply adjust each other towards equilibrium. When there is excess supply over expenditure, there is a reduction in the prices or the quantity or output. When there is an excess of expenditure over supply, then there is excess demand which leads to an increase in prices out output. In an effort to adjust and reach equilibrium, the economy constantly shifts between excess supply and excess demand. This shift is graphed using the AD-AS model which determines the output and price for the good or service.
The Multiplier Effect
When the fiscal multiplier exceeds one, the resulting impact on the national income is called the multiplier effect.
learning objectives
• Explain the fiscal multiplier effect
The Fiscal Multiplier and the Multiplier Effect
In economics, the fiscal multiplier is the ratio of change in the national income in relation to the change in government spending that causes it (not to be confused with the monetary multiplier). National income can change as a direct result in a change in spending whether it is private investment spending, consumer spending, government spending, or foreign export spending. When the fiscal multiplier exceeds one, the resulting impact on the national income is called the multiplier effect.
Cause of the Multiplier Effect
The multiplier is influenced by an incremental amount of spending that leads to higher consumption spending, increased income, and then even more consumption. As a result, the overall national income is greater than the initial incremental amount of spending. Simply put, an initial shift in aggregate demand may cause a change in aggregate output (as well as the aggregate income it creates) that is a multiplier of the initial change.
Use of the Multiplier Effect
The multiplier effect is a tool that is used by governments to attempt to stimulate aggregate demand in times of recession or economic uncertainty. The government invests money in order to create more jobs, which in turn will generate more spending to stimulate the economy. The goal is that the net increase in disposable income will be greater than the original investment.
1953 U.S. Recession: This graph shows the economic recession that occurred in the U.S. in 1953. During recessions, the government can use the multiplier effect in order to stimulate the economy.
Criticisms
Although the multiplier effect usually measures values of one, there have been cases where multipliers of less than one are measured. This suggests that types of government spending can crowd out private investment or consumer spending that would have taken place without the government spending. Crowding out can occur because the initial increase in spending can cause an increase in the interest rates or the price level.
It has been argued that when a government relies heavily on fiscal multipliers, externalities such as environmental degradation, unsustainable resource depletion, and social consequences can be neglected. Over reliance on fiscal multipliers can cause increased government spending on activities that create negative externalities (pollution, climate change, and resource depletion) instead of positive externalities (increased educational standards, social cohesion, public health, etc.).
Key Points
• The aggregate expenditure is the sum of all the expenditures undertaken in the economy by the factors during a specific time period. The equation is: AE = C + I + G + NX.
• The aggregate expenditure determines the total amount that firms and households plan to spend on goods and services at each level of income.
• The aggregate expenditure is one of the methods that is used to calculate the total sum of all the economic activities in an economy, also known as the gross domestic product ( GDP ).
• When there is excess supply over the expenditure, there is a reduction in either the prices or the quantity of the output which reduces the total output (GDP) of the economy.
• When there is an excess of expenditure over supply, there is excess demand which leads to an increase in prices or output (higher GDP).
• In economics, aggregate expenditure is the current value ( price ) of all the finished goods and services in the economy. The equation for aggregate expenditure is AE = C+ I + G + NX.
• In the aggregate expenditure model, equilibrium is the point where the aggregate supply and aggregate expenditure curve intersect.
• The classical aggregate expenditure model is: AE = C + I.
• Classical economics states that the factor payments made during the production process create enough income in the economy to create a demand for the products that were produced.
Key Terms
• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
• expenditure: Act of expending or paying out.
• gross domestic product: A measure of the economic production of a particular territory in financial capital terms over a specific time period.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• aggregate supply: The total supply of goods and services that firms in a national economy plan on selling during a specific time period.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• multiplier effect: A factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.
• fiscal multiplier: The ratio of a change in national income to the change in government spending that causes it.
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Explaining Fluctuations in Output
In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long run, only aggregate supply affects output.
learning objectives
• Differentiate between short-run and long-run effects of nominal fluctuations
Economic Output
In economics, output is the quantity of goods and services produced in a given time period. The level of output is determined by both the aggregate supply and aggregate demand within an economy. National output is what makes a country rich, not large amounts of money. For this reason, understanding the fluctuations in economic output is critical for long term growth. There are a series of factors that influence fluctuations in economic output including increases in growth and inputs in factors of production. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.
Aggregate Supply and Aggregate Demand
Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price in an economy. The aggregate demand is the total amounts of goods and services that will be purchased at all possible price levels.
In a standard AS-AD model, the output (Y) is the x-axis and price (P) is the y-axis. Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet to determine the output of a good or service.
Short-run vs. Long-run Fluctuations
Supply and demand may fluctuate for a number of reasons, and this in turn may affect the level of output. There are noticeable differences between short-run and long-run fluctuations in output.
Over the short-run, an outward shift in the aggregate supply curve would result in increased output and lower prices. An outward shift in the aggregate demand curve would also increase output and raise prices. Short-run nominal fluctuations result in a change in the output level. In the short-run an increase in money will increase production due to a shift in the aggregate supply. More goods are produced because the output is increased and more goods are bought because of the lower prices.
AS-AD Model: This AS-AD model shows how the aggregate supply and aggregate demand are graphed to show economic output. The AD curve shifts to the right which increases output and price.
In the long-run, the aggregate supply curve and aggregate demand curve are only affected by capital, labor, and technology. Everything in the economy is assumed to be optimal. The aggregate supply curve is vertical which reflects economists’ belief that changes in aggregate demand only temporarily change the economy’s total output. In the long-run an increase in money will do nothing for output, but it will increase prices.
Classical Theory
Classical theory, the first modern school of economic thought, reoriented economics from individual interests to national interests.
learning objectives
• Identify the assumptions fundamental to classical economics
Classical Theory
Classical theory was the first modern school of economic thought. It began in 1776 and ended around 1870 with the beginning of neoclassical economics. Notable classical economists include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus, and John Stuart Mill. During the period in which classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain. It was not possible for a society to grow as a unit unless its members were committed to working together. Classical theory reoriented economics away from individual interests to national interests. Classical economics focuses on the growth in the wealth of nations and promotes policies that create national expansion. During this time period, theorists developed the theory of value or price which allowed for further analysis of markets and wealth. It analyzed and explained the price of goods and services in addition to the exchange value.
Adam Smith: Adam Smith was one of the individuals who helped establish classical economic theory.
Classical Theory Assumptions
Classical theory was developed according to specific economic assumptions:
• Self-regulating markets: classical theorists believed that free markets regulate themselves when they are free of any intervention. Adam Smith referred to the market’s ability to self-regulate as the “invisible hand” because markets move towards their natural equilibrium without outside intervention.
• Flexible prices: classical economics assumes that prices are flexible for goods and wages. They also assumed that money only affects price and wage levels.
• Supply creates its own demand: based on Say’s Law, classical theorists believed that supply creates its own demand. Production will generate an income enough to purchase all of the output produced. Classical economics assumes that there will be a net saving or spending of cash or financial instruments.
• Equality of savings and investment: classical theory assumes that flexible interest rates will always maintain equilibrium.
• Calculating real GDP: classical theorists determined that the real GDP can be calculated without knowing the money supply or inflation rate.
• Real and Nominal Variables: classical economists stated that real and nominal variables can be analyzed separately.
Keynesian Theory
Keynesian economics states that in the short-run, economic output is substantially influenced by aggregate demand.
learning objectives
• Differentiate “Chicago School” or “Austrian School” economists from “Keynesian School” economists
Keynesian Theory
In economics, the Keynesian theory was first introduced by British economist John Maynard Keynes in his book The General Theory of Employment, Interest, and Money which was published in 1936 during the Great Depression. Keynesian economics states that in the short-run, especially during recessions, economic output is substantially influenced by aggregate demand (the total spending in the economy). According to the Keynesian theory, aggregate demand does not necessarily equal the productive capacity of the economy. Keynesian theorists believe that aggregate demand is influenced by a series of factors and responds unexpectedly. The shift in aggregate demand impacts production, employment, and inflation in the economy.
John Maynard Keynes: John Maynard Keynes introduced Keynesian theory in his book, The General Theory of Employment, Interest, and Money.
Economic Thought
At the time that Keynesian theory was developed, mainstream economic thought believed that the economy existed in a state of general equilibrium. The belief was that the economy naturally consumes whatever it produces because the act of producing creates enough income in the economy for that consumption to take place.
Keynesian theory has certain characteristic beliefs:
• Unemployment is the result of structural inadequacies within the economic system. It is not a product of laziness as believed previously.
• During a recession, the economy may not return naturally to full employment. The government must step in and utilize government spending to stimulate economic growth. A lack of investment in goods and services causes the economy to operate below its potential output and growth rate.
• An active stabilization policy is needed to reduce the amplitude of the business cycle. Keynesian economists believed that aggregate demand for goods and services not meeting the supply was one of the most serious economic problems.
• Excessive saving, saving beyond investment, is a serious problem that encouraged recession and even depression.
• Cutting wages will not cure a recession.
• Overcoming an economic depression requires economic stimulus, which could be achieved by cutting interest rates and increasing the level of government investment.
Schools of Economic Thought
It is important to understand the stances of the various school of economic thought. Although the beliefs of each school vary, all of the schools of economic thought have contributed to economic theory is some way.
The Keynesian School of economic thought emphasized the need for government intervention in order to stabilize and stimulate the economy during a recession or depression. In contrast, the Chicago School of economic thought focused price theory, rational expectations, and free market policies with little government intervention. The Austrian School of economic thought focused on the belief that all economic phenomena are caused by the subjective choices of individuals. Unlike other schools, the Austrian school focused on individual actions instead of society as a whole.
Key Points
• In the short run, output is determined by both the aggregate supply and aggregate demand within an economy. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.
• Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet.
• According to Hume, in the short-run, and increase in the money supply will lead to an increase in production.
• According to Hume, in the long-run, an increase in the money supply will do nothing.
• When classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain.
• Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion.
• Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments.
Key Terms
• nominal: Without adjustment to remove the effects of inflation (in contrast to real).
• economic output: The productivity of a country or region measured by the value of goods and services produced.
• self-regulating: Describing something capable of controlling itself.
• Keynesian Economics: A school of thought that is characterized by a belief in active government intervention in an economy and the use of monetary policy to promote growth and stability.
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Introducing Aggregate Demand
Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time.
learning objectives
• Define Aggregate Demand
Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time. Unlike other illustrations of demand, it is inclusive of all amounts of the product or service purchased at any possible price level. Simply put, AD is the sum of all demand in an economy. It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).
Demand Sources
• Consumption (C): This is the simplest and largest component of aggregate demand (usually 40-60% of all demand), and is often what is intuitively thought of as demand. Consumption is just the amount of consumer spending executed in an economy. Taxes play a role in this exchange as well (i.e. sales tax).
• Investment (I): Investment is a relatively large portion of demand as well, and is referred to as Gross Domestic Fixed Capital Formation. This is the money spent by firms on capital investment (new machinery, factories, stocks, etc.). Investment equates to about 10% of GDP in most economies.
• Government Spending (G): This is referred to as General Government Final Consumption, and is the expenditure by the government. This can include welfare, social services, education, military, etc. Fiscal policy is the way in which governments can alter this spending to drive economic change.
• Net Export (NX): This can be put simply as the sale of goods to foreign countries subtracted by the purchase of goods from other countries (X-M). Trade surpluses and deficits can occur based on whether or not exports or imports are higher.
In summary, the calculation of aggregate demand can be represented as follows: $\mathrm{AD = C + I + G + (X-M)}$. The full sum of all demand in an economy takes into account each of these factors in a quantitative way. This curve is illustrated in the figure.
Aggregate Demand and Supply: This graph demonstrates the basic relationship between aggregate demand and aggregate supply. The aggregate demand curve is derived via the consumption, investment, government spending, and net export.
The Role of Debt
Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand. From a quantitative perspective this is simply expressed as: Spending = Income + Net Increase in Debt. Spending capital prior to the receipt of capital is an important consideration at both the consumer level and the government level (deficit spending).
The Aggregation Problem
There are some limitations to the aggregation perspective, generally summarized as the aggregation problem. The difficulty arises in treating all consumer preferences (and thus their respective demands) as homogeneous and continuous. As the numbers of consumers, the tastes of consumers and the distribution levels of incomes will alter, so too will the demand curve. This can create inaccurate assumptions in AD inputs. Simply, there is some loss of accuracy in combining such a diverse array of economic inputs.
The Slope of the Aggregate Demand Curve
Due to Pigou’s Wealth Effect, the Keynes’ Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.
learning objectives
• Explain the factors that influence the slope of the aggregate demand curve
Aggregate demand (AD) is the total demand for all goods within a given market at a given time, or the summation of demand curves within a system. Understanding the basic graphical representation of this curve is useful in grasping the implications of AD on an economic system, as well as the distinct effects which drive it. As a result of Keynes’ interest rate effect, Pigou’s wealth effect, and the Mundell-Fleming exchange rate effect, the AD curve is downward sloping.
Keynes’ Interest Rate Effect
The critical point from Keynes’s perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. If prices fall, a given amount of money will increase in value. This will drive up interest rates and investments. It is important to note that insufficient demand in a market will not go on forever.
In understanding this fully, it is useful to look at an IS-LM graph (see ). There are only two times when the Keynes observation on the interest rate effect will be inaccurate, and that is if the IS (investment savings) curve were to be vertical or if the LM ( liquidity preference money supply) curve were to be horizontal. This makes sense if you think about it, it would basically equate to a liquidity trap. A vertical IS curve or a horizontal LM curve would essentially negate the way in which interest rates could affect aggregate demand.
IS-LM Model: The IS-LM model takes investments and savings and compares that to liquidity and the overall money supply. It is highly useful in understanding macroeconomics from a Keynesian perspective. Interest rates (i) are on the vertical axis, and output (y) is on the horizontal axis.
Pigou’s Wealth Effect
In the context of the above discussion on Keynes, Pigou’s Wealth Effect underlines the fact that liquidity traps are not sustainable. The simplest way to explain the Wealth Effect is that an increase in spending will denote an increase in wealth. In many ways, what Pigou is putting forward is the idea that downwards spiral on the IS-LM model, as predicted by Keynes due to deflation, will be counterbalanced by an increase in real wages and thus an increase in expenditure. In other words, a decrease in employment and prices will eventually see higher purchasing power and an increase in spending, creating wealth.
Mundell-Fleming Exchange Rate Effect
Perhaps the most complex of the three inputs underlined in deriving aggregate demand is the Mundell-Fleming Exchange Rate Effect. Just like the previous two, this builds off of the IS-LM model in a way that discusses it in the context of an open economy (as opposed to a closed system). It essentially takes into account a new factor (in addition to interest rates and outputs, as the traditional IS-LM model incorporates). This new factor is the exchange rates, as the name implies. Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy. This is sometimes referred to as the ‘impossible trinity,’ implying that trade-offs must be made. This concept is illustrated fairly well in this figure, where ‘FE’ is fixed expenditure.
Mundell-Fleming Fixed Exchange Rate Illustration: An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal.
Conclusion
While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper. The analysis of interest rates displayed above, through the wealth effect in particular, offsets the negative spiral that could occur as a result of deflation and decreased employment. These effects also play a crucial role in understanding the way in which the larger and more complex environment, including investments and fiscal and monetary policy, will retain this downwards slope.
Reasons for and Consequences of Shifts in the Aggregate Demand Curve
An increase in any of the four inputs into AD will result in higher real output or an increase in prices.
learning objectives
• Describe exogenous events that can shift the aggregate demand curve
Aggregate demand (AD) is the summation of all demand within a given economy at a given time.
Inputs
There are four inputs to consider in calculating AD (and deriving the graphical curve which represents it): consumption (C), investment (I), government spending (G), and net exports (NX, which is exports (X) – imports (I)). Changes in these inputs will have some influence on the AD curve. For example, an increase in total expenditures will result in a shift rightwards, while a decrease in expenditure will result in a shift to the left.
Aggregate Demand Curves
Two specific AD representations are useful to consider:
• Keynesian Cross: The Keynesian Cross is a simple illustration of the relationship between aggregate demand and desired total spending (linear at 45 degrees). The intersecting AD line will generally have an upwards slope, under the assumption that increased national output should result in increased disposable income.
• Aggregate Demand/Aggregate Supply Model ($\mathrm{\frac{AD}{AS}}$):The x-axis represents the overall output, while the y-axis represents the price level. The aggregate quantity demanded ($\mathrm{Y = C + I + G + NX}$) is calculated at every given aggregate average price level.
Exogenous Effects
There are a variety of direct and indirect consequences to AD shifts. For the purpose of this discussion, the key consequences to keep in mind are changes in output and price. Below are some of the driving forces that will shift aggregate demand to the right:
• An exogenous increase in consumer spending;
• An exogenous increase in investment spending on physical capital;
• An exogenous increase in intended inventory investment;
• An exogenous increase in government spending on goods and services;
• An exogenous increase in transfer payments from the government to the people;
• An exogenous decrease in taxes levied;
• An exogenous increase in purchases of the country’s exports by people in other countries; and
• An exogenous decrease in imports from other countries.
Short-term Implications
As noted above, any increase in the overall AD will result in an outwards (right-ward) shift of the AD curve. (Conversely, a decrease in aggregate demand will cause a leftward shift of the AD curve. ) This means that an increase in any of the four inputs to AD will result in a higher quantity of real output or an increase in prices across the board (this is also known as inflation). However, different levels of economic activity will result in different combinations of output and price increases.
is useful for understanding the distribution between price increases and output increases that will result in a given economy when AD increases. To put simply, the lower the utilization of available resources in a system, the more an increase in AD will result in higher output and thus higher employment and GDP growth. However, as the system evolves and aligns itself closer to the highest potential output (optimal utilization of resources or Y*), scarcity will naturally cause the prices to increase more than the overall output in a system. This is somewhat intuitive economically when scarcity and utilization are taken into account. The more difficult it is to generate a supply increase the more likely a shift in AD will drive up prices.
Aggregate Supply/Aggregate Demand: This graph illustrates the relationship between price and output within a given economic system in the context of aggregate demand and supply.
Key Points
• To put it simply, AD is the sum of all demand in an economy. It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).
• In summary, the calculation of aggregate demand can be represented as follows: AD = Consumption + Investment + Government spending + Net export (exports – imports).
• Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand.
• There is some loss of accuracy in combining such a diverse array of economic inputs when calculating aggregate demand.
• Pigou’s Wealth Effect, the Keynes’ Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect are all theoretical inputs that reaffirm a downwards slope for aggregate demand (AD).
• The critical takeaway from Keynes’s perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. As a result, insufficient AD is not sustainable in a given system.
• The simplest way to put to wealth effect is that an increase in spending will denote an increase in wealth.
• Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy.
• While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper.
• There are four basic inputs to consider in calculating AD: consumption (C), investment (I), government spending (G) and net exports (NX, which is exports (X) – imports (I)).
• There are a variety of direct and indirect consequences in AD shifts. For the purpose of this discussion, it is most important to keep in mind changes in output and price.
• As the system moves closer to the highest potential output (optimal utilization of resources, or Y*), scarcity will naturally cause prices to increase more than the overall output in a system.
• As the system moves closer to the highest potential output (or optimal utilization of resources, or Y*), scarcity will naturally see the prices increases more so than the overall output in a system.
Key Terms
• expenditure: The act of incurring a cost or pay out.
• aggregate demand: In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level.
• liquidity trap: Injections of cash into the private banking system by a central bank fail to lower interest rates and stimulate economic growth.
• exogenous: Received from outside a group
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Introducing Aggregate Supply
Aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period.
Learning objectives
• Define Aggregate Supply
Aggregate Supply
In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. It is the total amount of goods and services that the firms are willing to sell at a given price level in the economy. Aggregate supply is the relationship between the price level and the production of the economy.
Aggregate Supply: Aggregate supply is the total quantity of goods and services supplied at a given price. Its intersection with aggregate demand determines the equilibrium quantity supplied and price.
Short-run Aggregate Supply
In the short-run, the aggregate supply is graphed as an upward sloping curve. The equation used to determine the short-run aggregate supply is: $\mathrm{Y = Y^* + α(P-P_e)}$. In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and Pe is the expected price level from consumers.
The short-run aggregate supply curve is upward sloping because the quantity supplied increases when the price rises. In the short-run, firms have one fixed factor of production (usually capital ). When the curve shifts outward the output and real GDP increase at a given price. As a result, there is a positive correlation between the price level and output, which is shown on the short-run aggregate supply curve.
Long-run Aggregate Supply
In the long-run, the aggregate supply is graphed vertically on the supply curve. The equation used to determine the long-run aggregate supply is: $\mathrm{Y = Y^*}$. In the equation, Y is the production of the economy and Y* is the natural level of production of the economy.
The long-run aggregate supply curve is vertical which reflects economists’ beliefs that changes in the aggregate demand only temporarily change the economy’s total output. In the long-run, only capital, labor, and technology affect aggregate supply because everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it is the slowest aggregate supply curve.
The Slope of the Short-Run Aggregate Supply Curve
In the short-run, the aggregate supply curve is upward sloping.
Learning objectives
• Summarize the characteristics of short-run aggregate supply
Aggregate Supply
Aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific period of time. It is the total amount of goods and services that firms are willing to sell at a given price level.
Short-run Aggregate Supply Curve
In the short-run, the aggregate supply curve is upward sloping. There are two main reasons why the quantity supplied increases as the price rises:
1. The AS curve is drawn using a nominal variable, such as the nominal wage rate. In the short-run, the nominal wage rate is fixed. As a result, an increasing price indicates higher profits that justify the expansion of output.
2. An alternate model explains that the AS curve increases because some nominal input prices are fixed in the short-run and as output rises, more production processes encounter bottlenecks. At low levels of demand, large numbers of production processes do not make full use of their fixed capital equipment. As a result, production can be increased without much diminishing returns. The average price level does not have to rise much in order to justify increased production. In this case, the AS curve is flat. Likewise, when demand is high, there are few production processes that have unemployed fixed outputs. Any increase in demand production causes the prices to increase which results in a steep or vertical AS curve.
Short-run Aggregate Supply Equation
The equation used to calculate the short-run aggregate supply is: $\mathrm{Y = Y^* + α(P-P_e)}$. In the equation, Y is the production of the economy, Y* is the natural level of production, coefficient is always positive, P is the price level, and Pe is the expected price level.
In the short-run, firms possess fixed factors of production, including prices, wages, and capital. It is possible for the short-run supply curve to shift outward as a result of an increase in output and real GDP at a given price. As a result, the short-run aggregate supply curve shows the correlation between the price level and output.
Aggregate Supply Curve: This graph shows the aggregate supply curve. In the short-run the aggregate supply curve is upward sloping. When the curve shifts outward, it is due to an increase in output and real GDP.
The Slope of the Long-Run Aggregate Supply Curve
The long-run aggregate supply curve is perfectly vertical; changes in aggregate demand only cause a temporary change in total output.
Learning objectives
• Assess factors that influence the shape and movement of the long run aggregate supply curve
Aggregate Supply
In economics, aggregate supply is defined as the total supply of goods and services that firms in a national economy are willing to sell at a given price level.
Long-run in Economics
The long-run is the conceptual time period in which there are no fixed factors of production; all factors can be changed. In the long-run, firms change supply levels in response to expected economic profits or losses.
Long-run Aggregate Supply Curve
In the long-run, only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it shifts the slowest of the three ranges of the aggregate supply curve. The long-run aggregate supply curve is perfectly vertical, which reflects economists’ belief that the changes in aggregate demand only cause a temporary change in an economy’s total output. In the long-run, there is exactly one quantity that will be supplied.
Aggregate Supply: This graph shows the aggregate supply curve. In the long-run the aggregate supply curve is perfectly vertical, reflecting economists’ belief that changes in aggregate demand only cause a temporary change in an economy’s total output.
The long-run aggregate supply curve can be shifted, when the factors of production change in quantity. For example, if there is an increase in the number of available workers or labor hours in the long run, the aggregate supply curve will shift outward (it is assumed the labor market is always in equilibrium and everyone in the workforce is employed). Similarly, changes in technology can shift the curve by changing the potential output from the same amount of inputs in the long-term.
For the short-run aggregate supply, the quantity supplied increases as the price rises. The AS curve is drawn given some nominal variable, such as the nominal wage rate. In the short run, the nominal wage rate is taken as fixed. Therefore, rising P implies higher profits that justify expansion of output. However, in the long run, the nominal wage rate varies with economic conditions (high unemployment leads to falling nominal wages — and vice-versa).
The equation used to calculate the long-run aggregate supply is: $\mathrm{Y = Y^*}$. In the equation, Y is the level of economic production and Y* is the natural level of production.
Moving from Short-Run to Long-Run
In the short-run, the price level of the economy is sticky or fixed; in the long-run, the price level for the economy is completely flexible.
Learning objectives
• Recognize the role of capital in the shape and movement of the short-run and long-run aggregate supply curve
In economics, the short-run is the period when general price level, contractual wages, and expectations do not fully adjust. In contrast, the long-run is the period when the previously mentioned variables adjust fully to the state of the economy.
Aggregate Supply
Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price level.
When capital increases, the aggregate supply curve will shift to the right, prices will drop, and the quantity of the good or service will increase.
Short-run Aggregate Supply
During the short-run, firms possess one fixed factor of production (usually capital). It is possible for the curve to shift outward in the short-run, which results in increased output and real GDP at a given price. In the short-run, there is a positive relationship between the price level and the output. The short-run aggregate supply curve is an upward slope. The short-run is when all production occurs in real time.
Aggregate Supply: This graph shows the relationship between aggregate supply and aggregate demand in the short-run. The curve is upward sloping and shows a positive correlation between the price level and output.
Long-run Aggregate Supply
In the long-run only capital, labor, and technology impact the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run supply curve is static and shifts the slowest of all three ranges of the supply curve. The long-run curve is perfectly vertical, which reflects economists’ belief that changes in aggregate demand only temporarily change an economy’s total output. The long-run is a planning and implementation stage.
Moving from Short-run to Long-run
In the short-run, the price level of the economy is sticky or fixed depending on changes in aggregate supply. Also, capital is not fully mobile between sectors.
In the long-run, the price level for the economy is completely flexible in regards to shifts in aggregate supply. There is also full mobility of labor and capital between sectors of the economy.
The aggregate supply moves from short-run to long-run when enough time passes such that no factors are fixed. That state of equilibrium is then compared to the new short-run and long-run equilibrium state if there is a change that disturbs equilibrium.
Reasons for and Consequences of Shifts in the Short-Run Aggregate Supply Curve
The short-run aggregate supply shifts in relation to changes in price level and production.
Learning objectives
• Identify common reasons for shifts in the short-run aggregate supply curve, Explain the consequences of shifts in the short-run aggregate supply curve
Aggregate Supply
The aggregate supply is the relation between the price level and production of an economy. It is the total supply of goods and services that firms in a national economy plan on selling during a specific time period at a given price level.
Short-run Aggregate Supply
In the short-run, the aggregate supply curve is upward sloping because some nominal input prices are fixed and as the output rises, more production processes experience bottlenecks. At low levels of demand, production can be increased without diminishing returns and the average price level does not rise. However, when the demand is high, few production processes have unemployed fixed inputs. Any increase in demand and production increases the prices. In the short-run, the general price level, contractual wage rates, and expectations many not fully adjust to the state of the economy.
Shifts in the Short-run Aggregate Supply
The short-run aggregate supply shifts in relation to changes in price level and production. The equation used to determine the short-run aggregate supply is: $\mathrm{Y = Y^*}$. Y is the production of the economy, Y* is the natural level of production, coefficient α is always positive, P is the price level, and Pe is the expected price level.
In the short-run, examples of events that shift the aggregate supply curve to the right include a decrease in wages, an increase in physical capital stock, or advancement of technology. The short-run curve shifts to the right the price level decreases and the GDP increases. When the curve shifts to the left, the price level increases and the GDP decreases.
Any event that results in a change of production costs shifts the short-run supply curve outwards or inwards if the production costs are decreased or increased. Factors that impact and shift the short-run curve are taxes and subsides, price of labor (wages), and the price of raw materials. Changes in the quantity and quality of labor and capital also influence the short-run aggregate supply curve.
Short-run Aggregate Supply: This graph shows the Aggregate Suppy-Aggregate Demand model. In regards to aggregate supply, increases or decreases in the price level and output cause the aggregate supply curve to shift in the short-run.
Key Points
• Aggregate supply is the relationship between the price level and the production of the economy.
• In the short-run, the aggregate supply is graphed as an upward sloping curve.
• The short-run aggregate supply equation is: $\mathrm{Y = Y^* + α(P-P_e)}$. In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and Pe is the expected price level from consumers.
• In the long-run, the aggregate supply is graphed vertically on the supply curve.
• The equation used to determine the long-run aggregate supply is: $\mathrm{Y = Y^*}$. In the equation, Y is the production of the economy and Y* is the natural level of production of the economy.
• The AS curve is drawn using a nominal variable, such as the nominal wage rate. In the short-run, the nominal wage rate is fixed. As a result, an increasing price indicates higher profits that justify the expansion of output.
• The AS curve increases because some nominal input prices are fixed in the short-run and as output rises, more production processes encounter bottlenecks.
• In the short-run, the production can be increased without much diminishing returns. The average price level does not have to rise much in order to justify increased production. In this case, the AS curve is flat.
• When demand is high, there are few production processes that have unemployed fixed outputs. Any increase in demand production causes the prices to increase which results in a steep or vertical AS curve.
• The long-run is a planning and implementation phase. It is the conceptual time period in which there are no fixed factors of production.
• In the long-run, only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally.
• Aggregate supply is usually inadequate to supply ample opportunity. Often, this is fixed capital equipment. The AS curve is drawn given some nominal variable, such as the nominal wage rate.
• In the long run, the nominal wage rate varies with economic conditions (high unemployment leads to falling nominal wages — and vice-versa).
• The equation used to calculate the long-run aggregate supply is: $\mathrm{Y = Y^*}$. In the equation, Y is the level of economic production and Y* is the natural level of production.
• When capital increases, the aggregate supply curve will shift to the right, prices will drop, and the quantity of the good or service will increase.
• The short-run aggregate supply curve is an upward slope. The short-run is when all production occurs in real time.
• The long-run curve is perfectly vertical, which reflects economists’ belief that changes in aggregate demand only temporarily change an economy’s total output. The long-run is a planning and implementation stage.
• Aggregate supply moves from short-run to long-run by considering some equilibrium that is the same for both short and long-run when analyzing supply and demand. That state of equilibrium is then compared to the new short-run and long-run equilibrium state from a change that disturbs equilibrium.
• In the short-run, the aggregate supply curve is upward sloping because some nominal input prices are fixed and as the output rises, more production processes experience bottlenecks.
• At low levels of demand, production can be increased without diminishing returns and the average price level does not rise.
• When the demand is high, few production processes have unemployed fixed inputs. Any increase in demand and production increases the prices.
• Any event that results in a change of production costs shifts the short-run supply curve outwards or inwards if the production costs are decreased or increased.
Key Terms
• factor of production: A resource employed to produce goods and services, such as labor, land, and capital.
• output: Production; quantity produced, created, or completed.
• supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
• long-run: The conceptual time period in which there are no fixed factors of production.
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
• short-run: When one or more factors are fixed.
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Macroeconomic Equilibrium
In economics, the macroeconomic equilibrium is a state where aggregate supply equals aggregate demand.
learning objectives
• Analyze aggregate demand and supply in the long run
Economic Equilibrium
In economics, equilibrium is a state where economic forces (supply and demand) are balanced. Without any external influences, price and quantity will remain at the equilibrium value.
Equilibrium: Similar to microeconomic equilibrium, the macroeconomic equilibrium is the point at which the aggregate supply intersects the aggregate demand.
Supply and Demand
Determining the supply and demand for a good or services provides a model of price determination in a market. In a competitive market, the unit price for a good will vary until it settles at a point where the quantity demanded equals the quantity supplied. The result is the economic equilibrium for that good or service.
There are four basic laws of supply and demand. The laws impact both supply and demand in the long-run.
1. If quantity demand increases and supply remains unchanged, a shortage occurs, leading to a higher price until the quantity demanded is pushed back to equilibrium.
2. If quantity demand decreases and supply remains unchanged, a surplus occurs, leading to a lower price until the quantity demanded is pushed back to equilibrium.
3. If quantity demand remains unchanged and supply increases, a surplus occurs, leading to a lower price until the quantity supplied is pushed back to equilibrium.
4. If quantity demand remains unchanged and supply decreases, a shortage occurs, leading to a higher price until the quantity supplied is pushed back to equilibrium.
Aggregate Supply and Aggregate Demand
Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a specific price level in an economy.
Aggregate supply: This graph shows the three stages of aggregate supply. It is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. Changes in aggregate supply cause shifts along the supply curve.
Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It is the demand for the gross domestic product (GDP) of a country.
Aggregate Supply-Aggregate Demand Model
Equilibrium is the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented on the AS-AD model where the demand and supply curves intersect. In the long-run, increases in aggregate demand cause the price of a good or service to increase. When the demand increases the aggregate demand curve shifts to the right. In the long-run, the aggregate supply is affected only by capital, labor, and technology. Examples of events that would increase aggregate supply include an increase in population, increased physical capital stock, and technological progress. The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.
When the aggregate supply and aggregate demand shift, so does the point of equilibrium. The aggregate demand curve shifts and the equilibrium point moves horizontally along the aggregate supply curve until it reaches the new aggregate demand point.
Reasons for and Consequences of Shift in Aggregate Demand
A short-run shift in aggregate demand can change the equilibrium price and output level.
learning objectives
• Explain the causes of economic fluctuations using aggregate demand curves
Aggregate Demand
In economics, aggregate demand is the total demand for final goods and services at a given time and price level. It gives the amounts of goods and services that will be demanded at all possible price levels, which, unless there are shortages, is equivalent to GDP. Aggregate demand equals the sum of consumption (C), investment (I), government spending (G), and net export (X -M). This is often written as an equation, which is given by:
$\mathrm{AD = C + I + G + (X – M)}$
Shifts in the Aggregate Supply-Aggregate Demand Model
The aggregate supply-aggregate demand model uses the theory of supply and demand in order to find a macroeconomic equilibrium. The shape of the aggregate supply curve helps to determine the extent to which increases in aggregate demand lead to increases in real output or increases in prices. An increase in any of the components of aggregate demand shifts the AD curve to the right. When the AD curve shifts to the right it increases the level of production and the average price level. When an economy gets close to potential output, the price will increase more than the output as the AD rises.
AS-AD Model: The Aggregate Supply-Aggregate Demand Model shows how equilibrium is determined by supply and demand. It shows how increases and decreases in output and prices impact the economy in the short-run and long-run. The model is also used to show real and potential output.
When price increase dominates an economy, this means that the economy is near its potential output.
Reasons for Aggregate Demand Shift
The slope of the aggregate demand curve shows the extent to which the real balances change the equilibrium level of spending. The aggregate demand curve shifts to the right as a result of monetary expansion. In an economy, when the nominal money stock in increased, it leads to higher real money stock at each level of prices. The interest rates decrease which causes the public to hold higher real balances. This stimulates aggregate demand, which increases the equilibrium level of income and spending. Likewise, if the monetary supply decreases, the demand curve will shift to the left.
Reasons for and Consequences of Shift in Aggregate Supply
In economics, the aggregate supply shifts and shows how much output is supplied by firms at different price levels.
learning objectives
• Explain shifts in aggregate supply and their impact on the economy
Aggregate Supply
In economics, aggregate supply is defined as the total supply of goods and services that firms in a national economy produce during a specific period of time. It is the total amount of goods and services that firms are willing to sell at a specific price level in the economy.
Shift in Aggregate Supply
The aggregate supply curve may shift labor market disequilibrium or labor market equilibrium. If labor or another input suddenly becomes cheaper, there would be a supply shock such that supply curve may shift outward, causing the equilibrium price in to drop and the equilibrium quantity to increase.
Supply Shift: A supply shock could be caused by changing regulations or a sudden change in the price of an input, among other reasons.
During the short-run, there is one fixed factor of production, usually capital. However, the fixed factor does not stop the curve’s ability to shift outward. When the curve shifts to the right, it causes an increase in the output and a decrease in the GDP at a given price. Examples of events that cause the curve to shift to the right in the short-run include a decrease in the wage rate, an increase in physical capital stock, and technological progress.
In the long-run only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long run curve is often seen as static because it shift the slowest. The long-run aggregate supply curve is vertical which shows economist’s belief that changes in aggregate demand only have a temporary change on the economy’s total output. Examples of events that shift the long-run curve to the right include an increase in population, an increase in physical capital stock, and technological progress.
Reasons for Shifts
The short-run aggregate supply curve is affected by production costs including taxes, subsidies, price of labor (wages), and the price of raw materials. All of these factors will cause the short-run curve to shift. When there are changes in the quality and quantity of labor and capital the changes affect both the short-run and long-run supply curves. The long-run aggregate supply curve is affected by events that change the potential output of the economy.
Changes in short-run aggregate supply cause the price level of the good or service to drop while the real GDP increases. In the long-run the prices stabilize and the price level of the good or service increase in response to the changes.
Key Points
• Equilibrium is the price -quantity pair where the quantity demanded is equal to the quantity supplied.
• In the long-run, increases in aggregate demand cause the output and price of a good or service to increase.
• In the long-run, the aggregate supply is affected only by capital, labor, and technology.
• The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.
• The aggregate supply curve determines the extent to which increases in aggregate demand lead to increases in real output or increases in prices.
• The equation used to calculate aggregate demand is: $\mathrm{AD = C + I + G + (X – M)}$.
• The aggregate demand curve shifts to the right as a result of monetary expansion.
• If the monetary supply decreases, the demand curve will shift to the left.
• The aggregate supply curve shows how much output is supplied by firms at different price levels.
• The short-run aggregate supply curve is affected by production costs including taxes, subsides, price of labor (wages), and the price of raw materials.
• The long-run aggregate supply curve is affected by events that change the potential output of the economy.
Key Terms
• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
• supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
• demand: The desire to purchase goods and services.
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• Supply curve: A graph that illustrates the relationship between the price of a good and the quantity supplied.
• output: Production; quantity produced, created, or completed.
• supply shock: An event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
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Keynesian Theory
Keynesian theory posits that aggregate demand will not always meet the supply produced.
Learning objectives
• Explain the main tenets of Keynesian economics
Historical Background
John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics. It was an interesting time for economic speculation considering the dramatic adverse effect of the Great Depression. Keynes’s concepts played a role in public economic policy under Roosevelt as well as during World War II, becoming the dominant perspective in Europe following the war.
John Maynard Keynes: John Maynard Keynes came to fame after publishing his economic theories during the Great Depression.
At the time, the primary school of economic thought was that of the classical economists (which is still a popular school of thought today). The central tenet of the classical argument says that supply can always create demand, and that surpluses will result in price reductions to the point of consumption. Put simply, people have infinite needs and the market will self-correct to the aggregate demands and available resources. This implies a hands-of public policy where markets are capable of taking care of themselves.
Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct. Keynes theorized that natural inefficiencies in the market will see goods that are not met with demand. This wasted capital can result in market losses, unemployment, and market inefficiency (this was called ‘general glut’ in the classical model, when aggregate demand does not meet supply). Keynes insisted that markets do need moderate governmental intervention through fiscal policy (government investment in infrastructure) and monetary policy ( interest rates ).
Main Tenets
With this overview in mind, Keynesian Theory generally observes the following concepts:
• Unemployment: Under the classical model, unemployment is often attributed to high and rigid real wages. Keynes argues there is more complexity than that, specifically that societies are highly resistant to wage cuts and furthermore that reducing wages would pose a great threat to an economy. Specifically, cutting wages reduces spending and may result in a downwards spiral.
• Excessive Saving: Keynes’s concept here is somewhat complicated, but in short Keynes notes excessive saving as a threat and prospective cause of economic decline. This is because excessive saving leads to reduced investment and reduced spending, which drives down demand and the potential for consumption. This can be another spiraling issue, as money not being exchanged is actively reducing prospective employment, revenues, and future investments.
• Fiscal Policy: The key concept in fiscal policy for Keynes is ‘counter-cyclical’ fiscal policy, which is the expectation that governments can reduce the negative effects of the natural business cycle. This is, generally, achieved through deficit spending in recessions and suppression of inflation during boom times. Simply put, the government should try to curb the extremes of economic fluctuation through informed fiscal policy.
• The Multiplier Effect: This idea has in many ways already been implied in the atom, but inversely. Consider the unemployment and excessive savings problems, and how they stand to lead to spiraling decline. The other side of that coin is that positive economic situations can spiral upwards. Take for example a government investment in transportation, putting money in the pockets of various individuals who build trains and tracks. These individuals will spend that extra capital, putting money in the hands of other business (and this will continue). This is called the multiplier effect.
• IS-LM: While the IS-LM Model is a complicated byproduct of Keynesian economics, it can be summarized as the relationship between interest rates (y-axis) and the real economic output (x-axis). This is done through analyzing the invest-saving relationship (IS) in contrast to the liquidity preference and money supply relationship (LM), generating an equilibrium where certain interest rates and outputs will be generated.
While Keynesian Theory has been expounded upon significantly over the years, the important takeaway here is that aggregate demand (and thus the amount of supply consumed) is not a perfect system. Instead, demand is affected by various external forces that can create an inefficient market which will in turn affect employment, production, and inflation.
IS-LM Model: In this figure, the IS (Interest – Saving) curve is shifted outward in a way that raises both interest rates (i) and the ‘real’ economy (Y). The implication is that interest rates affect investment levels, and that these investment levels in turn affect the overall economy.
Monetarist
Monetarism focuses on the macroeconomic effects of the supply of money and the role of central banking on an economic system.
Learning objectives
• Explain the main tenets of Monetarism
Background
In the rise of monetarism as an ideology, two specific economists were critical contributors. Clark Warburton, in 1945, has been identified as the first thinker to draft an empirically sound argument in favor of monetarism. This was taken more mainstream by Milton Friedman in 1956 in a restatement of the quantity theory of money. The basic premise these two economists were putting forward is that the supply of money and the role of central banking play a critical role in macroeconomics.
The generation of this theory takes into account a combination of Keynesian monetary perspectives and Friedman’s pursuit of price stability. Keynes postulated a demand-driven model for currency; a perspective on printed money that was not beholden to the ‘ gold standard ‘ (or basing economic value off of rare metal). Instead, the amount of money in a given environment should be determined by monetary rules. Friedman originally put forward the idea of a ‘k-percent rule,’ which weighed a variety of economic indicators to determine the appropriate money supply.
Evidence
Theoretically, the idea is actually quite straight-forward. When the money supply is expanded, individuals will be induced to higher spending. In turn, when the money supply retracted, individuals would limit their budgetary spending accordingly. This would theoretically provide some control over aggregate demand (which is one of the primary areas of disagreement between Keynesian and classical economists).
Monetarism began to deviate more from Keynesian economics however in the 70’s and 80’s, as active implementation and historical reflection began to generate more evidence for the monetarist view. In 1979 for example, Jimmy Carter appointed Paul Volcker as Chief of the Federal Reserve, who in turn utilized the monetarist perspective to control inflation. He eventually created a price stability, providing evidence that the theory was sound. In addition, Milton Friedman and Ann Schwartz analyzed the Great Depression in the context of monetarism as well, identifying a shortage of the money supply as a critical component of the recession.
The 1980s were an interesting transitional period for this perspective, as early in the decade (1980-1983) monetary policies controlling capital were attributed to substantial reductions in inflation (14% to 3%)(see ). However, unemployment and the rise of the use of credit are quoted as two alternatives to money supply control being the primary influence of the boom that followed 1983.
U.S. Inflation Rates: The inflation rates over time in the U.S. represent some of the evidence put forward by monetarist economists, stating that governmental control of the money supply allows for some control over inflation.
Counter Arguments
As these counter arguments in the 1980s began to arise, critics of monetarism became more mainstream. Of the current monetarism critics, the Austrian school of thought is likely the most well-known. The Austrian school of economic thought perceives monetarism as somewhat narrow-minded, not effectively taking into account the subjectivity involved in valuing capital. That is to say that monetarism seems to assume an objective value of capital in an economy, and the subsequent implications on the supply and demand.
Other criticisms revolve around international investment, trade liberalization, and central bank policy. This can be summarized as the effects of globalization, and the interdependence of markets (and consequently currencies). To manipulate money supply there will inherently be effects on other currencies as a result of relativity. This is particularly important in regards to the U.S. currency, which is considered a standard in international markets. Controlling supply and altering value may have effects on a variety of internal economic variables, but it will also have unintended consequences on external variables.
Austrian
Austrian economic thought is about methodological individualism, or the idea that people will act in meaningful ways which can be analyzed.
Learning objectives
• Explain the main tenets of Austrian economics
Background
The Austrian school of economics originated in the 19th century in Vienna, Austria. While there were a variety of famous economists attributed to the early foundations and later expansions of the Austrian economic perspective, Carl Menger, Friedrich von Weiser, and Eugen von Bohm-Bawerk are widely recognized as critical early pioneers. The general perspective of Austrian economic thought is methodological individualism, or the recognition that people will act in meaningful ways which can be analyzed for trends.
Central Tenets
The Austrian school of thought provided enormous value to the economic climate, both as a foundation for future economics and as a deliberate counterpoint to more quantitative analysis. Of the most important ideologies, the following central tenets are:
• Opportunity Cost: This is a concept you are likely already familiar with, and one of the most important ideas in all of business and economics. Essentially, the price of a good must also incorporate the value sacrificed of the next best alternative. Basically each choice a consumer or business makes intrinsically has the cost of not being able to make an alternative choice.
• Capital and Interest: Largely in response to Karl Marx’s labor theories, Austrian economist Bohm-Bawerk identified the building blocks of interest rates and profit are supply and demand alongside time preference. In short, present consumption is more valuable than future consumption (the time value of money).
• Inflation: The idea that prices and wages must rise as a result of increased money supply is inflation (note: this is different that price inflation). Simply put, more money in the system without a higher demand for that money will drive down the relative value of each dollar.
• Business Cycles: The Austrian business cycle theory (ABCT) is the simple observation that the issuance of credit (by banks) creates economic fluctuations that tend to be cyclical (see ). In simple terms, banks will lend out money at rates lower than the risk in which that money will be used. So when businesses fail more often than they succeed, thus losing interest as opposed to accruing it, will struggle to repay their debts. When the banks call in those debts the business cannot pay, creating negative business cycles.
• The Organizing Power of Markets: The idea of this concept is that no one person knows what the appropriate price of a good should be. Instead, markets naturally generate incentives to identify optimal price points. This negates the ideas of socialism common at the time, as communist systems will be unable to identify the appropriate exchange value of each good.
As you can see from the above points, this school of economics is largely about making qualitative observations of the markets. These observations are absolutely critical in understanding the theoretical landscape, but difficult to enact in practice.
Criticisms
Austrian economists are often criticized for ignoring arithmetic or statistical ways to measure and analyze economics. Indeed, Austrian economists do not often place much weight on concepts such as econometrics, experimental economics, and aggregate macroeconomic analysis. In this sense, the Austrian school of thought is something of an outsider relative to other perspectives (i.e. classical, Keynesian, etc.).
Paul Krugman criticized Austrian economics as lacking explicit models of analysis, or essentially a lack of clarity in their approach. This results in inadvertent blind spots. This is a sensible criticism in many ways, as the fundamental idea behind this economic theory is that it is driven by individuals and individuals are not always rational (indeed, they are quite often irrational). As a result of this, Austrian economics often rests on the integration of social sciences (psychology, sociology, etc.) to explain preferences and consumer behavior, which is often counter-intuitive. As a result, it is very difficult to accurately measure and provide tangible proof of the efficacy of Austrian models.
Alternative Views
Neoclassical and neo-Keynesian ideas can be coupled and referred to as the neoclassical synthesis, combining alternative views in economics.
Learning objectives
• Summarize neoclassical and Neo-Keynesian economics
Background
The history of different economic schools of thought have consistently generated evolving theories of economics as new data and new perspectives are taken into consideration. The two most well-known schools, classical economics and Keynesian economics, have been adapting to incorporate new information and ideas from one another as well as lesser known schools of economics (Chicago, Austrian, etc.). These different perspectives have motivated economists to generate the neoclassical and neo-Keynesian perspectives. The neoclassical perspective, in conjunction with Keynesian ideas, is referred to as the neoclassical synthesis, which is largely considered the ‘mainstream’ economic perspective.
Neoclassical
In approaching Neoclassical economics, it is most important to keep in mind the following three principles:
1. People have rational preferences in the context of options or outcomes that can be identified and associated with a given value (usually monetary). In short, people make smart choices regarding how they spend their money.
2. Individuals maximize utility and firms maximize profit. People will try to get the most from their money while corporations will try to invest their time and assets to capture the highest margin.
3. People act independently based upon comprehensive and relevant information. People are influenced by rational forces (mostly information and logic), and will make the best personal purchasing decisions based upon this.
A brief timeline of classical to neoclassical perspectives would begin with thought processes put forward by Adam Smith and David Ricardo (alongside many others). The basic idea is that aggregate demand will adjust to supply, and that value theory and distribution will reflect this rational, cost of production model. The next phase was the observation that consumer goods demonstrated a relative value based on utility, which could deviate from consumer to consumer. The final phase, and most central to the advent of the neoclassical perspective, is the introduction of marginalism. Marginalism notes that economic participants make decisions based on marginal utility or margins. For example, a company hiring a new employee will not think of the fixed value of that employee, but instead the marginal value of adding that employee (usually in regards to profitability).
Neo-Keynesian
Neo-Keynesian economics is often confused with ‘New Keynesian’ economics (which attempts to provide microeconomic foundation to Keynesian views, particularly in light of stagflation in the 1970s). Neo-Keynesian economics is actually the formalization and coordination of Keynes’s writings by a number of other economists (most notably John Hicks, Franco Modigliani, and Paul Samuelson). Much of the conceptual value is captured in the previous atoms on Keynesian views, but the substantial value of a few neo-Keynesian ideas is worth reiterating:
• IS/LM Model: This model was put forward by John Hicks in order to capture the inherent relationship between investment and savings (IS) relative to liquidity and the overall money supply (LM) (see ). The implications of this graph pertain to the static representation of monetary policy and the effects on an economic system.
• Phillips Curve: Another important model following Keynes’s publications is the Phillips Curve, put forward by William Phillips in 1958. The idea here was also largely Keynesian, revolving around the relationship between inflation and unemployment (see ).This implies a trade off between inflation rates and the creation of employment, which governments could consider in policy making. Stagflation (economic stagnation and inflation simultaneously) created issues with this however, necessitating New Keynesian ideas (as discussed briefly above).
Synthesis
When learning about these economic perspectives, it is important to understand the value they add to one another and the overall efficacy of all economic theory. Economists are often the product of multiple schools of thought, and don’t fit neatly into one school or another.
Key Points
• John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics.
• Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct.
• Keynes believed that wage reductions in recessions and excessive savings were potential threats to an economy.
• Keynesian theory expects fiscal policy to offset business cycles (employ counter-cyclical strategies).
• Clark Warburton, in 1945, has been identified as the first thinker to draft an empirically sound argument in favor of monetarism. This was taken more mainstream by Milton Friedman in 1956.
• More money in the system results in higher spending and vice verse. This would theoretically provide some control over aggregate demand.
• Historical implementation of monetarism demonstrated some correlation with control over inflation rates and increased economic performance. This could have been a result of other factors however.
• The Austrian school of economic thought perceives monetarism as somewhat narrow-minded, not effectively taking into account the subjectivity involved in valuing capital.
• Due to the globalization of the economy, monetarism may have a negative impact on external economies. This is particularly true of the U.S., whose capital is an international standard.
• The Austrian school of economics is one of the oldest economic perspectives, originating in the 19th century in Vienna.
• Austrian economics is attributed for the identification of opportunity cost, capital and interest, inflation, business cycles and the organizing power of markets.
• Austrian economists do not often place much weight on concepts such as econometrics, experimental economics, and aggregate macroeconomic analysis. In this sense, the Austrian school of thought is something of an outsider relative to other perspectives (i.e. classical, Keynesian, etc. ).
• Paul Krugman criticized Austrian economics as lacking explicit models of analysis, or essentially a lack of clarity in their approach. This results in inadvertent blind spots.
• The history of different economic schools of thought have consistently generated evolving theories of economics as new data and new perspectives are taken into consideration.
• The neoclassical perspective in conjunction with Keynesian ideas is referred to as the neoclassical synthesis, which is largely considered the ‘mainstream’ economic perspective.
• A critical difference between classical and neoclassical perspectives is the introduction of marginalism. Marginalism notes that economic participants make decisions based on marginal utility or margins.
• Neo- Keynesian economics is the formalization and coordination of Keynes’s writings by a number of other economists (most notably John Hicks, Franco Modigliani and Paul Samuelson).
• The important to understand that these economic perspectives add value to one another and the overall efficacy of all economic theory.
Key Terms
• fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
• monetary policy: The process of controlling the supply of money in an economy, often conducted by central banks.
• Keynesian: Of or pertaining to an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest, and Money.
• Monetarism: The doctrine that economic systems are controlled by variations in the supply of money.
• gold standard: A monetary system where the value of circulating money is linked to the value of gold.
• Opportunity cost: The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
• time value of money: The time value of money is the principle that a certain currency amount of money today has a different buying power (value) than the same currency amount of money in the future.
• stagflation: Inflation accompanied by stagnant growth, unemployment or recession.
• static: Unchanging; that cannot or does not change.
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Defining Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy.
learning objectives
• Define Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy. Governments use fiscal policy to influence the level of aggregate demand in the economy in an effort to achieve the economic objectives of price stability, full employment, and economic growth.
The government has two levers when setting fiscal policy:
1. Change the level and composition of taxation, and/or
2. Change the level of spending in various sectors of the economy.
There are three main types of fiscal policy:
1. Neutral: This type of policy is usually undertaken when an economy is in equilibrium. In this instance, government spending is fully funded by tax revenue, which has a neutral effect on the level of economic activity.
2. Expansionary: This type of policy is usually undertaken during recessions to increase the level of economic activity. In this instance, the government spends more money than it collects in taxes.
3. Contractionary: This type of policy is undertaken to pay down government debt and to cap inflation. In this case, government spending is lower than tax revenue.
In times of recession, Keynesian economics suggests that increasing government spending and decreasing tax rates is the best way to stimulate aggregate demand. Keynesians argue that this approach should be used in times of recession or low economic activity as an essential tool for building the foundation for strong economic growth and working towards full employment. In theory, the resulting deficit would be paid for by an expanded economy during the boom that would follow.
Times of Recession: In times of recession, the government uses expansionary fiscal policy to increase the level of economic activity and increase employment.
In times of economic boom, Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices when inflation is too high.
How Fiscal Policy Relates to the AD-AS Model
Expansionary policy shifts the aggregate demand curve to the right, while contractionary policy shifts it to the left.
learning objectives
• Examine the effect of government fiscal policy on aggregate demand
When setting fiscal policy, the government can take an active role in changing its spending or the level of taxation. These actions lead to an increase or decrease in aggregate demand, which is reflected in the shift of the aggregate demand (AD) curve to the right or left respectively.
Expansionary and Contractionary Fiscal Policy: Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left.
It is helpful to keep in mind that aggregate demand for an economy is divided into four components: consumption, investment, government spending, and net exports. Changes in any of these components will cause the aggregate demand curve to shift.
Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two. Since government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right. A reduction in taxes will leave more disposable income and cause consumption and savings to increase, also shifting the aggregate demand curve to the right. An increase in government spending combined with a reduction in taxes will, unsurprisingly, also shift the AD curve to the right. The extent of the shift in the AD curve due to government spending depends on the size of the spending multiplier, while the shift in the AD curve in response to tax cuts depends on the size of the tax multiplier. If government spending exceeds tax revenues, expansionary policy will lead to a budget deficit.
A contractionary fiscal policy is implemented when there is demand-pull inflation. It can also be used to pay off unwanted debt. In pursuing contractionary fiscal policy the government can decrease its spending, raise taxes, or pursue a combination of the two. Contractionary fiscal policy shifts the AD curve to the left. If tax revenues exceed government spending, this type of policy will lead to a budget surplus.
Expansionary Versus Contractionary Fiscal Policy
When the economy is producing less than potential output, expansionary fiscal policy can be used to employ idle resources and boost output.
learning objectives
• Assess the mechanics and outcomes of fiscal policy
Counter-cyclical Fiscal Policies: Keynesian economists advocate counter-cyclical fiscal policies. This means increased spending and lower taxes during recessions and lower spending and higher taxes during economic boom times.
According to Keynesian economics, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Increased government spending will result in increased aggregate demand, which then increases the real GDP, resulting in an rise in prices. This is known as expansionary fiscal policy. Conversely, in times of economic expansion, the government can adopt a contractionary policy, decreasing spending, which decreases aggregate demand and the real GDP, resulting in a decrease in prices.
Highway Construction: The government can implement expansionary fiscal policy through increased spending, such as paying for the construction of new highways.
In instances of recession, government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. The government could stimulate a great deal of new production with a modest expenditure increase if the people who receive this money consume most of it. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in spending, and so on in a virtuous circle.
In addition to changes in spending, the government can also close recessionary gaps by decreasing income taxes, which increases aggregate demand and real GDP, which in turn increases prices. Conversely, to close an expansionary gap, the government would increase income taxes, which decreases aggregate demand, the real GDP, and then prices.
The effects of fiscal policy can be limited by crowding out. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment.
Fiscal Levers: Spending and Taxation
Tax cuts have a smaller affect on aggregate demand than increased government spending.
learning objectives
• Analyze the use of changes in the tax rate as a form of fiscal policy
Spending and taxation are the two levers available to the government for setting fiscal policy. In expansionary fiscal policy, the government increases its spending, cuts taxes, or a combination of both. The increase in spending and tax cuts will increase aggregate demand, but the extent of the increase depends on the spending and tax multipliers.
The government spending multiplier is a number that indicates how much change in aggregate demand would result from a given change in spending. The government spending multiplier effect is evident when an incremental increase in spending leads to an rise in income and consumption. The tax multiplier is the magnification effect of a change in taxes on aggregate demand. The decrease in taxes has a similar effect on income and consumption as an increase in government spending.
However, the tax multiplier is smaller than the spending multiplier. This is because when the government spends money, it directly purchases something, causing the full amount of the change in expenditure to be applied to the aggregate demand. When the government cuts taxes instead, there is an increase in disposable income. Part of the disposable income will be spent, but part of it will be saved. The money that is saved does not contribute to the multiplier effect.
Spending and Saving: The tax multiplier is smaller than the government expenditure multiplier because some of the increase in disposable income that results from lower taxes is not just consumed, but saved.
The multipliers are calculated as follows:
• $\mathrm{Government \; expenditure \; multiplier=\frac{1}{(1−MPC)} \; or \; \frac{1}{MPS}}$
• $\mathrm{Tax \; multiplier=\frac{−MPC}{(1−MPC)} \; or \; \frac{−MPC}{MPS}}$
where MPC is the marginal propensity to consume (the change in consumption divided by the change in disposable income), and MPS is the marginal propensity to save (the change in savings divided by the change in disposable income).
The government spending multiplier is always positive. In contrast, the tax multiplier is always negative. This is because there is an inverse relationship between taxes and aggregate demand. When taxes decrease, aggregate demand increases.
The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume, as well as the crowding out effect. The crowding out effect occurs when higher income leads to an increased demand for money, causing interest rates to rise. This leads to a reduction in investment spending, one of the four components of aggregate demand, which mitigates the increase in aggregate demand otherwise caused by lower taxes.
How Fiscal Policy Can Impact GDP
Fiscal policy impacts GDP through the fiscal multiplier.
learning objectives
• Discuss the mechanisms that allow the fiscal policy to affect GDP
Expansionary fiscal policy can impact the gross domestic product (GDP) through the fiscal multiplier. The fiscal multiplier (which is not to be confused with the monetary multiplier) is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.
The multiplier effect arises when an initial incremental amount of government spending leads to increased income and consumption, increasing income further, and hence further increasing consumption, and so on, resulting in an overall increase in national income that is greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.
For example, suppose the government spends $1 million to build a plant. The money does not disappear, but rather becomes wages to builders, revenue to suppliers, etc. The builders then will have more disposable income, and consumption may rise, so that aggregate demand will also rise. Suppose further that recipients of the new spending by the builder in turn spend their new income, raising demand and possibly consumption further, and so on. The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives$1 million and pays out $800,000 to sub contractors, he has a net income of$200,000 and a corresponding increase in disposable income (the amount remaining after taxes). This process proceeds down the line through subcontractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available.
Fiscal Multiplier Example: The money spent on construction of a plant becomes wages to builders. The builders will have more disposable income, increasing their consumption and the aggregate demand.
In certain cases multiplier values of less than one have been empirically measured, suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place.
Fiscal Policy and the Multiplier
Fiscal policy can have a multiplier effect on the economy.
learning objectives
• Describe the effects of the multiplier beyond its relevance to fiscal policy
Fiscal policy can have a multiplier effect on the economy. For example, if a $100 increase in government spending causes the GDP to increase by$150, then the spending multiplier is 1.5. In addition to the spending multiplier, other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes. The size of the multiplier effect depends upon the fiscal policy.
Expansionary fiscal policy can lead to an increase in real GDP that is larger than the initial rise in aggregate spending caused by the policy. Conversely, contractionary fiscal policy can lead to a fall in real GDP that is larger than the initial reduction in aggregate spending caused by the policy.
Multiplier Effect: The multiplier effect determines the extent to which fiscal policy shifts the aggregate demand curve and impacts output.
The size of the shift of the aggregate demand curve and the change in output depend on the type of fiscal policy. The multiplier on changes in government purchases, 1/(1 – MPC), is larger than the multiplier on changes in taxes, MPC/(1 – MPC), because part of any change in taxes or transfers is absorbed by savings. In both of these equations, recall that MPC is the marginal propensity to consume.
For example, the government hands out $50 billion in the form of tax cuts. There is no direct effect on aggregate demand by government purchases of goods and services. Instead, GDP goes up only because households spend some of that$50 billion. But how much will they spend? Households will spend $\mathrm{MPC \times 50 \; billion}$ (where MPC is the marginal propensity to consume). If MPC is equal to 0.6, the first-round increase in consumer spending will be $\mathrm{30 \; billion (0.6 \times 50 \; billion = 30 \; billion)}$. The initial rise in consumer spending will lead to a series of subsequent rounds in which the real GDP, disposable income, and consumer spending rise further.
Key Points
• The government has two levers when setting fiscal policy: it can change the levels of taxation and/or it can change its level of spending.
• There are three types of fiscal policy: neutral policy, expansionary policy,and contractionary policy.
• In expansionary fiscal policy, the government spends more money than it collects through taxes. This type of policy is used during recessions to build a foundation for strong economic growth and nudge the economy toward full employment.
• In contractionary fiscal policy, the government collects more money through taxes than it spends. This policy works best in times of economic booms. It slows the pace of strong economic growth and puts a check on inflation.
• Aggregate demand is made up of consumption, investment, government spending, and net exports. The aggregate demand curve will shift as a result of changes in any of these components.
• Expansionary policy involves an increase in government spending, a reduction in taxes, or a combination of the two. It leads to a right-ward shift in the aggregate demand curve.
• Contractionary policy involves a decrease in government spending, an increase in taxes, or a combination of the two. It leads to a left-ward shift in the aggregate demand curve.
• Keynes advocated counter-cyclical fiscal policies –implementing an expansionary fiscal policy during a recession and a contractionary policy during times of rapid economic expansion.
• In pursuing either expansionary or contractionary fiscal policy, the government has two levers – government spending and taxation levels.
• The effects of fiscal policy can be limited by crowding out.
• In expansionary policy, the extent to which government spending and tax cuts increase aggregate demand depends on spending and tax multipliers.
• The tax multiplier is smaller than the spending multiplier. This is because the entire government spending increase goes towards increasing aggregate demand, but only a portion of the increased disposable income (resulting for lower taxes) is consumed.
• The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume, as well as the crowding out effect.
• The fiscal multiplier is the ratio of change in national income to the change in governments spending that causes it.
• The multiplier effect occurs when an initial incremental amount of spending leads to an increase in income and consumption, which further increases income, which further increases consumption, and so on in a virtuous circle, resulting in an overall increase in the GDP.
• The multiplier effect is evident when the multiplier is greater or less than one.
• In certain cases, multiplier values of less than one have been empirically measured, suggesting that government spending can crowd out private investment or consumer spending.
• The size of the increase in GDP depends on the type of fiscal policy.
• The multiplier on changes in government spending is larger than the multiplier on changes in taxation levels.
• The taxation multiplier is smaller than the spending multiplier because part of any change in taxes is absorbed by savings.
Key Terms
• fiscal policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
• multiplier: A ratio used to estimate total economic effect for a variety of economic activities.
• Tax multiplier: The change in aggregate demand caused by a change in taxation levels.
• fiscal multiplier: The ratio of a change in national income to the change in government spending that causes it.
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Automatic Stabilizers
Automatic stabilizers are modern government budget policies that act to dampen fluctuations in real GDP.
learning objectives
• Explain the role of automatic stabilizers in regulating economic fluctuations
In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.
Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.
Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country’s GDP.
Fiscal Multiplier Effect
What makes automatic stabilizers so effective in dampening economic fluctuations is the fiscal multiplier effect. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.
The multiplier effect occurs as a chain reaction. The increased funds received from the government by citizens allows them to increase their consumption. As a result, producers must increase their production, which requires firms to hire more workers. Because of the increased purchases and lower unemployment, people have more money to spend and increase their consumption. This consumption-production-consumption cycle leads to the multiplier effect, resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
Tax Form 1040: Taxes are a part of the automatic stabilizers a country uses to minimize fluctuations in their real GDP. During boom times when the economy is doing well, people earn more income and this translates to higher tax revenues for the government, lowering the budget deficit.
Automatic Stabilizers Versus Discretionary Policy
Automatic stabilizers and discretionary policy differ in terms of timing of implementation and what each approach sets out to achieve.
learning objectives
• Describe the differences between automatic stabilizers and discretionary policy
In fiscal policy, there are two different approaches to stabilizing the economy: automatic stabilizers and discretionary policy. Both approaches focus on minimizing fluctuations in real GDP but have different means of doing so.
Discretionary Policy
Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; rather, they use subjective judgment to treat each situation in unique manner. In practice, most policy changes are discretionary in nature. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.
WPA: The Works Progress Administration (WPA) was part of the New Deal. The WPA is an example of a Depression-era discretionary policy meant to reduce unemployment by providing jobs for the unemployed.
Discretionary policies are generally laws enacted by Congress, which requires that any policy go through the same vetting and marking up process as any other law.
Automatic Stabilizers and Discretionary Policy
The key difference between these two types of financial policy approaches is timing of implementation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, Congress must first determine that there is an issue and that action needs to be taken. Then Congress needs to design and implement a policy response. Then the law needs to be passed and the relevant agencies need to adjust and alter any necessary procedures so they can carry out the law. It is due to these significant lags that economists like Milton Friedman believed that discretionary fiscal policy could be destabilizing.
On the other hand, automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy. Discretionary policies can address failings of the economy that are not strictly tied to aggregate demand. For example, if an economy is going through a recession because its workers lack a certain set of skills, automatic stabilizers cannot address that problem. Government programs, such as retraining, can address this problem.
Finally, automatic stabilizers, such as the tax code and social service agencies, exist prior to an economic fluctuation. Discretionary policies are made in response to a fluctuation and only come into existence once a fluctuation starts to occur.
Of course, it is not possible to create an automatic stabilizer for every potential economic issue, so discretionary policy allows policymakers flexibility.
The Role of the Federal Budget
The federal budget dictates how much money the government plans to raise and how it plans to spend it in the upcoming year.
learning objectives
• Describe how the federal budget is created and its economic role
The Federal Budget is the roadmap for how the national government plans to spend its money of the course of the upcoming year. It dictates which programs will receive funding and how much money the government will spend on each.
How the Federal Budget is Created
The Budget of the United States Government often begins as the president’s proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. However, Congress is the body required by law to pass a budget annually and to submit the budget passed by both houses to the president for signature. To help Congress pass the best budget possible, several government agencies provide data and analysis. These include the Government Accountability Office (GAO), Congressional Budget Office (CBO), the Office of Management and Budget (OMB), and the U.S. Treasury Department.
Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.
If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures. After Congress approves an appropriations bill, it is sent to the president, who may sign it into law, or may veto it (as he would a budget when passed by the Congress). A vetoed bill is sent back to Congress, which can pass it into law with a two-thirds majority in each chamber. Congress may also combine all or some appropriations bills into an omnibus reconciliation bill. In addition, the president may request and the Congress may pass supplemental appropriations bills or emergency supplemental appropriations bills.
Economic Role of the Federal Budget
The federal budget is meant to provide the larger American economy with a sense of direction regarding where the Federal government is going to go and what they are going to do. The Federal budget discloses how much the government plans to tax and how it plans to spend its money. Individuals and businesses can then adjust their actions to accommodate what they’ll have to pay in taxes and what resources will be available to them in the government.
The federal budget also is one mechanism for conducting fiscal policy. The government can choose to expand or contract the budget to conduct expansionary or fiscal policy.
The specific items in the budget also have important policy implications: social welfare, social insurance, and government intervention in markets may all be reflected in the budget.
Congress: The U.S. Congress is responsible for passing the Federal Budget. If it cannot pass a Federal Budget, it must pass appropriation bills as a “stop gap. “
Arguments for and Against Balancing the Budget
Balanced budgets, and the associated topic of budget deficits, are a contentious point within both academic economics and politics.
learning objectives
• Describe arguments against maintaining a balanced budget in the United States
A balanced budget, particularly a government budget, is a budget with revenues equal to expenditures. There is neither a budget deficit nor a budget surplus; in other words, “the accounts balance. ” More generally, it refers to a budget with no deficit, but possibly with a surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time.
John Maynard Keynes: John Maynard Keynes founded the Keynesian school, which promotes balanced governmental budgets over the course of the business cycle as opposed to annual balanced budgets.
Balanced budgets, and the associated topic of budget deficits, are a contentious point within academic economics and within politics.
Arguments for a Balanced Budget
Most economists agree that a balanced budget would:
• decrease interest rates, making it easier for businesses and individuals to invest;
• increase savings and investment, which would provide security to individuals;
• shrink trade deficits; and
• help the economy grow faster over a longer period of time.
In the US, every state other than Vermont has a version of a balanced budget amendment, which prohibits some deficits. The federal government does not have such an amendment.
Arguments Against a Balanced Budget
The mainstream economic view is that having a balanced budget in every year is not desirable. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful. If balanced budgets were required and if the budget was in deficit during a recession, critics argue that the required cuts would make the economy even worse off.
Keynesian economists argue that government budgets should be balanced over the business cycles. During recessions governments should run deficits. Keynesians argue that increasing government spending and decreasing taxes can minimize the painful effects of a recession. Once an economy moves into a growth cycle, Keynesians believe the government should shift its perspective and try to run a budget surplus by decreasing spending and increasing taxes. By balancing deficits in recessions and surpluses in growth, Keynesians believe that the government can obtain the benefits of a balanced budget without facing the risks of making recessions worse due to spending and revenue limitations.
Long-Run Implications of Fiscal Policy
Expansionary fiscal policy can lead to decreased private investment, decreased net imports, and increased inflation.
learning objectives
• Identify the long-run consequences of fiscal policy
Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors.
It is important to underline that fiscal policy is heavily debated, and that expected outcomes are not achieved with complete certainty. That being said, these changes in fiscal policy can affect the following macroeconomic variables in an economy:
• Aggregate demand and the level of economic activity;
• The distribution of income;
• The pattern of resource allocation within the government sector and relative to the private sector.
Decreased Private Investment
Economists still debate the effectiveness of fiscal policy to influence the economy, particularly when it comes to using expansionary fiscal policy to stimulate the economy. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
Decreased Net Exports
Some also believe that expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.
Increased Inflation
Other possible problems with fiscal stimulus include inflationary effects driven by increased demand. Simply put, increasing the capital in a given system will eventually devalue the currency itself if there is an increase in money supply in circulation. Similarly, if stimulus capital is invested in creating jobs, the overall spending in a given economy will increase (that is, if jobs are actually created). This spending increase will shift demand to potentially increase price points. Whenever fiscal policy decisions are made, modeling the likelihood of inflation is a critical consideration.
WIN: If a country pursues and expansionary fiscal policy, high inflation becomes a concern.
Problems of Long-Run Government Debt
Government debt limits future government actions and can be hard to pay off because Congressmen are unwilling to do what is necessary to pay down the debt.
learning objectives
• Evaluate the consequences of imbalances in the government budget
Deficit spending during times of recession widely seen as a beneficial policy that can mitigate the effects of an economic downturn. However, even Keynesians that support deficit spending during recessions advise that governments balance this deficit spending with surpluses during the eventual economic boom. This means generating a government surplus by cutting expenses and raising taxes. This is known as a cyclically balanced budget; the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.
Paying Down Debt
During periods of expansionary fiscal policy, the government will often fund programs by issuing debt. The problem with debt is that it must be paid off with future revenues.
Government debt: Publicly issued debt is one means governments use to fund expansionary fiscal policy. The problem with debt is that it needs to be paid off with future revenues, which curtails future government spending.
To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions. On the other hand, if the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.
Cutting Expenses and Raising Taxes
To offset the budgetary deficits and raise the necessary funds to pay down debt, governments will ultimately have to lower costs and raise taxes. In any democracy, especially in the U.S., doing those two things are incredibly difficult because both options are unpopular with voters. Since Congress is responsible for making budgetary, spending and taxation decisions, and because these elected officials may be disinclined to do anything that would hurt their chances to be re-elected, taking the necessary steps to balance out the periods of deficit spending during economic boom is difficult.
Credit Rating
A credit rating is an evaluation of the creditworthiness of a government, but not individual consumers. The evaluation is made by a credit rating agency of the country’s ability to pay back the debt and the likelihood of default. A sovereign credit rating is the credit rating of a sovereign entity (i.e., a national government). The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account, as well as the amount of debt the country has outstanding.
If a country has a bad credit rating, it generally must have a higher interest rate on the debt it issues. This means it will be more expensive for that country to raise funds by issuing debt.
Limits of Fiscal Policy
Two key limits of fiscal policy are coordination with the nation’s monetary policy and differing political viewpoints.
learning objectives
• Identify the political and economic limits of fiscal policy
While fiscal policy can be a powerful tool for influencing the economy, there are limits in how effective these policies are.
Coordination with Monetary Policy
Fiscal policy and monetary policy are the two primary tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to influence the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. Fiscal policies have an impact on the goods market and monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates – the policies interact while influencing the output or the interest rates.
There is controversy regarding whether these two policies are complementary or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker’s expansionary (contractionary) policies are countered by another policy maker’s contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other.
The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.
Political Conflict
Fiscal policy is also a source of significant political conflict along party lines. Conservatives are more likely to reject Keynesianism and are more likely to argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt), and that deficit spending is always bad policy.
American political divide: There are two different approaches to fiscal policy in the US. Broadly, Democrats tend to be more Keynesian than Republicans.
Fiscal conservatism has academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all but one state of the United States (Vermont is the exception) having a balanced budget amendment to its state constitution. Fiscal conservatism was the dominant position until the Great Depression.
Liberals are more likely to be Keynesian and Post-Keynesians than Republican. They are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: one cannot collect fiat money in taxes before one has issued it and spent it, and the amount of fiat money in circulation is exactly the government debt – money spent but not collected in taxes.
Fiscal Multiplier
The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.
How effective fiscal policy is depends on the multiplier. The greater the multiplier, the more effective the policy. If for some reason outside of the control of the government the multiplier remains low, the effectiveness of fiscal policy will remain limited at best.
Difficulty in Getting the Timing Right
Discretionary fiscal policy relies on getting the timing right, but this can be difficult to determine at the time decisions must be made.
learning objectives
• Explain the effect of timing on the use of fiscal policy tools
A nation can respond to economic fluctuations through automatic stabilizers or through discretionary policy. With regards to automatic stabilizers, timing is not an issue. Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action.
With discretionary fiscal policy, timing plays a very significant role. Discretionary policy often requires that a set of laws must be passed through a legislature. This means that the problem has to be identified first, which means collecting macroeconomic data.
Good economic data are a precondition to effective macroeconomic management. With the complexity of modern economies and the lags inherent in macroeconomic policy instruments, a country must have the capacity to promptly identify any adverse trends in its economy and to apply the appropriate corrective measure. This cannot be done without economic data that is complete, accurate and timely. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.
Once the problem has been established, Congress must then arrive at a plan and hold debates. Any legislation must pass through committees in both chambers, and both chambers must approve. Then, it must be presented to the President for his signature. This entire process would take weeks at least, but would more likely take months.
President Coolidge Signing a Bill into Law: It can take many months before Congress can pass a bill that would address current economic fluctuations.
Once the discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.
Crowding-Out Effect
Usually the term “crowding out” refers to the government using up financial and other resources that would otherwise be used by private enterprise.
learning objectives
• Explain the crowding out effect
Usually when economists use the term crowding out they are referring to the government using up financial and other resources that would otherwise be used by private enterprise. However, some commentators and other economists use crowding out to refer to government providing a service or good that would otherwise be a business opportunity for private industry.
The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has crowded out investment.
Crowding out Chart: When crowding-out occurs, the Investment-Savings (IS) curve moves to the right, causing higher interest rates (i) and expansion in the “real” economy (real GDP, or Y). LM stands for Liquidity Preference – Money Supply.
Borrowing and Crowding Out
In economics, crowding-out occurs when increased government borrowing reduces investment spending. The increased borrowing crowds out private investing.
If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.
Crowding-Out and Stimulus Programs
The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Therefore, the effect of the stimulus is offset by the effect of crowding out.
Evaluating the Recent United States Stimulus Package
The American Recovery and Reinvestment Act of 2009 (ARRA) was drafted in response to the Great Recession, primarily in order to create jobs.
learning objectives
• Summarize the effects of the use of stimulus in the wake of the Great Recession
The American Recovery and Reinvestment Act of 2009 (ARRA), otherwise known as the Stimulus or The Recovery Act, was an economic stimulus package was signed into law on February 17, 2009.
The ARRA was drafted in response to the Great Recession. The primary objective for ARRA was to save and create jobs almost immediately. Secondary objectives were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.
Composition of Stimulus: Tax incentives — includes \$15 B for Infrastructure and Science, \$61 B for Protecting the Vulnerable, \$25 B for Education and Training and \$22 B for Energy, so total funds are \$126 B for Infrastructure and Science, \$142 B for Protecting the Vulnerable, \$78 B for Education and Training, and \$65 B for Energy.State and Local Fiscal Relief — Prevents state and local cuts to health and education programs and state and local tax increases.
The approximate cost of the economic stimulus package was estimated to be \$787 billion at the time of passage, later revised to \$831 billion between 2009 and 2019. The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions. The rationale for ARRA came from Keynesian macroeconomic theory, which argues that during recessions, the government should offset the decrease in private spending with an increase in public spending in order to save jobs and stop further economic deterioration.
The Stimulus’s Impact on Unemployment
The primary justification for the stimulus package was to minimize unemployment. The Obama administration and Democratic proponents presented a graph in January 2009 showing the projected unemployment rate with and without the ARRA. The graph showed that if ARRA was not enacted the unemployment rate would exceed 9%; but if ARRA was enacted it would never exceed 8%. After ARRA became law, the actual unemployment rate exceeded 8% in February 2009, exceeded 9% in May 2009, and exceeded 10% in October 2009. The actual unemployment rate was 9.2% in June 2011 when it was projected to be below 7% with the ARRA. However, supporters of ARRA claim that this can be accounted for by noting that the actual recession was subsequently revealed to be much worse than any projections at the time when the ARRA was drawn up.
One year after the stimulus, several independent firms, including Moody’s and IHS Global Insight, estimated that the stimulus saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed. The Congressional Budget Office considered these estimates conservative. The CBO estimated that, according to its model, 2.1 million jobs were saved in the last quarter of 2009, boosting the country’s GDP by up to 3.5% and lowering the unemployment rate by up to 2.1%.
In 2013, the Reason Foundation conducted a study of the results of the ARRA. Only 23% of 8,381 sampled companies hired new workers and kept all of them when the project was completed. Only 41% of sampled companies hired workers at all. 30% of sampled companies laid off all workers once the government money stopped funding. These results cast doubt on previously stated estimates of job creation numbers, which do not take into account those companies that did not retain their workers.
Shovel-Ready Projects
One of the primary purposes and promises of the Act was to launch a large number projects to stimulate the economy. However, a sizable number of these projects, many of which pertained to infrastructure, took longer to implement than they had expected by most. Just because the money was there for the projects did not mean that the projects were “shovel-ready”: there was a delay between when the funding became available and when the project could actually begin. Since the stimulus only is impactful when the money is actually spent, delays could have reduced the overall effectiveness of the stimulus.
Key Points
• During recessions, government spending automatically increases, which raises aggregate demand and offsets decreases in consumer demand. Government revenue automatically decreases.
• During economic booms, government spending automatically decreases, which prevents bubbles and the economy from overheating. Government revenue automatically increases.
• The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. An initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
• Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.
• When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag before action can be taken.
• Automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy.
• Automatic stabilizers exist prior to economic booms and busts. Discretionary policies are enacted in response to changes in the economy.
• Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.
• If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures.
• The budget is a method of conducting fiscal policy and reflect government intervention in markets.
• A balanced budget is a budget where revenues equal expenditures. A balanced budget can also refer to a budget where revenues are greater than expenditures.
• Most economists have also agreed that a balanced budget would decrease interest rates, increase savings and investment, shrink trade deficits and help the economy grow faster over a longer period of time.
• Keynesians argue for balanced budgets over the course of the business cycle. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful.
• Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.
• When government borrowing increases interest rates, it can attract foreign capital from foreign investors, which can increases demand for that country’s currency and raise it’s value. This increase in the currency’s value increases export the price of exports.
• When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services.
• In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle.
• To raise the necessary funds to pay down debt, governments will ultimately have to lower costs and/or raise taxes. Because cutting spending and raising taxes is unpopular, Congressmen may be hesitant to take those actions because it might prevent them from being re-elected.
• To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions.
• If the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.
• Conservatives are more likely to reject Keynesianism and argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt) than Democrats.
• Liberals are more likely to be Keynesian and Post-Keynesians than Republicans; they are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
• There is a dilemma as to whether these monetary and fiscal policies are complementary, or act as substitutes to each other for achieving macroeconomic goals.
• Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action; timing is not an issue.
• Good economic data are a precondition to effective macroeconomic management. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.
• Once a discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.
• Some commentators and other economists use ” crowding out ” to refer to government providing a service or good that would otherwise be a business opportunity for private industry.
• An increase in the demand for loanable funds by the government shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing investment and consumption.
• If the economy is at capacity or full employment, the government suddenly implementing a stimulus program could create competition with the private sector for scarce funds available for investment, resulting in reduced private investment.
• Secondary objectives of the ARRA were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.
• Reports on the effectiveness of the ARRA’s ability to create jobs were mixed. One conservative estimate said that the ARRA saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed.
• A sizeable number of projects funded by the stimulus could not be started right away, diminishing its immediate impact.
Key Terms
• fiscal multiplier: The ratio of a change in national income to the change in government spending that causes it.
• automatic stabilizer: A budget policy that automatically changes to stabilize fluctuations in GDP.
• discretionary policy: Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.
• appropriations bill: A legislative motion that authorizes the government to spend money.
• balanced budget: A (usually government) budget in which income and expenditure are equal over a set period of time.
• inflation: An increase in the general level of prices or in the cost of living.
• cyclically balanced budget: Occurs when the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• discretionary fiscal policy: A fiscal policy achieved through government intervention, as opposed to automatic stabilizers.
• interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
• infrastructure: The basic facilities, services and installations needed for the functioning of a community or society
• quarter: Related to a three-month term, a quarter of a year.
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Money is any object that is generally accepted as payment for goods and services and the repayment of debt.
learning objectives
• Distinguish between the three main functions of money: a medium of exchange, a unit of account, and a store of value
Money is any object that is generally accepted as payment for goods and services and repayment of debts in a given socioeconomic context or country. Money comes in three forms: commodity money, fiat money, and fiduciary money.
Many items have been historically used as commodity money, including naturally scarce precious metals, conch shells, barley beads, and other things that were considered to have value. The value of commodity money comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity.
Commodity Money: Conch shells have been used as commodity money in the past. The value of commodity money is derived from the commodity out of which it is made. (CC BY-SA 3.0; ChildofMidnight.
Fiat money is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts. Paper money is an example of fiat money.
Fiduciary money includes demand deposits (such as checking accounts) of banks. Fiduciary money is accepted on the basis of the trust its issuer (the bank) commands.
Most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins.
Functions of Money
Money has three primary functions. It is a medium of exchange, a unit of account, and a store of value:
1. Medium of Exchange: When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange.
2. Unit of Account: It is a standard numerical unit of measurement of market value of goods, services, and other transactions. It is a standard of relative worth and deferred payment, and as such is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a unit of account, money must be divisible into smaller units without loss of value, fungible (one unit or piece must be perceived as equivalent to any other), and a specific weight or size to be verifiably countable.
3. Store of Value: To act as a store of value, money must be reliably saved, stored, and retrieved. It must be predictably usable as a medium of exchange when it is retrieved. Additionally, the value of money must remain stable over time.
Economists sometimes note additional functions of money, such as that of a standard of deferred payment and that of a measure of value. A “standard of deferred payment” is an acceptable way to settle a debt–a unit in which debts are denominated. The status of money as legal tender means that money can be used for the discharge of debts. Money can also act a as a standard measure and common denomination of trade. It is thus a basis for quoting and bargaining prices. Its most important usage is as a method for comparing the values of dissimilar objects.
The Functions of Money
The monetary economy is a significant improvement over the barter system, in which goods were exchanged directly for other goods.
learning objectives
• Analyze how the characteristics of money make it an effective medium of exchange
Barter is a system of exchange in which goods or services are directly exchanged for other goods or services without using a medium of exchange, such as money. The reciprocal exchange is immediate and not delayed in time. It is usually bilateral, though it can be multilateral, and usually exists parallel to monetary systems in most developed countries, though to a very limited extent. The barter system has a number of limitations which make transactions very inefficient, including:
Barter: In a barter system, individuals possessing something of value could exchange it for something else of similar or greater value.
• Double coincidence of wants: The needs of a seller of a commodity must match the needs of a buyer. If they do not, the transaction will not occur.
• Absence of common measure of value: In a monetary economy, money plays the role of a measure of value of all goods, making it possible to measure the values of goods against each other. This is not possible in a barter economy.
• Indivisibility of certain goods: If a person wants to buy a certain amount of another’s goods, but only has payment of one indivisible good which is worth more than what the person wants to obtain, a barter transaction cannot occur.
• Difficulty of deferred payments: It is impossible to make payments in installments and difficult to make payments at a later point in time.
• Difficulty storing wealth: If society relies exclusively on perishable goods, storing wealth for the future may be impractical.
Despite the long list of limitations, the barter system has some advantages. It can replace money as the method of exchange in times of monetary crisis, such as when a the currency is either unstable (e.g. hyperinflation or deflationary spiral) or simply unavailable for conducting commerce. It can also be useful when there is little information about the credit worthiness of trade partners or when there is a lack of trust.
The money system is a significant improvement over the barter system. It provides a way to quantify the value of goods and communicate it to others. Money has several defining characteristics. It is:
• Durable.
• Divisible.
• Portable.
• Liquid.
• A unit of account.
• Legal tender.
• Resistant to counterfeiting.
Money serves four primary purposes. It is:
• A medium of exchange: an object that is generally accepted as a form of payment.
• A unit of account: a means of keeping track of how much something is worth.
• A store of value: it can be held and exchanged later for goods and services at an approximate value.
• A standard of deferred payments (this is not considered a defining purpose of money by all economists).
The use of money as a medium of exchange has removed the major difficulty of double coincidence of wants in the barter system. It separates the act of sale and purchase of goods and services and helps both parties in obtaining maximum satisfaction and profits independently.
Measuring the Money Supply: M1
M1 captures the most liquid components of the money supply, including currency held by the public and checkable deposits in banks.
learning objectives
• Define M1
The Federal Reserve measures the money supply using three main monetary aggregates: M1, M2, and M3.
M1 is the narrowest measure of the money supply, including only money that can be spent directly. More specifically, M1 includes currency and all checkable deposits. Currency refers to the coins and paper money in the hands of the public. Checkable deposits refer to all spendable deposits in commercial banks and thrifts.
M1: The M1 measure includes currency in the hands of the public and checkable deposits in commercial banks.
A broader measure of money than M1 includes not only all of the spendable balances in M1, but certain additional assets termed “near monies”. Near monies cannot be spent as readily as currency or checking account money, but they can be turned into spendable balances with very little effort or cost. Near monies include what is in savings accounts and money-market mutual funds. The broader category of money that embraces all of these assets is called M2. M3 encompassed M2 plus relatively less liquid near monies. In practice, the measure of M3 is no longer used by the Federal Reserve.
Imagine that Laura deposits \$900 in her checking account in a world with no other money (M1=\$900). The bank sets 10% of the amount aside for required reserves, while the remaining \$810 can be lent out by the bank as credit. The M1 money supply increases by \$810 when the loan is made (M1=\$1,710). In the meantime, Laura writes a check for \$400. The total M1 money supply didn’t change; it includes the \$400 check and the \$500 left in the checking account (M1=\$1,710). Laura’s check is accidentally destroyed in the laundry. M1 and her checking account do not change, because the check is never cashed (M1=\$1,710). Meanwhile, the bank lends Mandy the \$810 credit that it has created. Mandy deposits the money in a checking account at another bank. The bank must keep 10% as reserves and has \$729 available for loans. This creates promise-to-pay money from a previous promise-to-pay, inflating the M1 money supply (M1=\$2,439). Mandy’s bank now lends the money to someone else who deposits it in a checking account at another bank, and the process repeats itself.
Measuring the Money Supply: M2
M2 is a broader measure of the money supply than M1, including all M1 monies and those that could be quickly converted to liquid forms.
learning objectives
• Define M2
There is no single “correct” measure of the money supply. Instead there are several measures, classified along a continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (for example, currency and checkable deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.). The continuum corresponds to the way that different types of money are more or less controlled by monetary policy. Narrow measures include those more directly affected and controlled by monetary policy, whereas broader measures are less closely related to monetary policy actions.
The different types of money are typically classified as “M”s. Around the world, they range from M0 (the narrowest) to M3 (broadest), but which of the measures is actually the focus of policy formulation depends on a country’s central bank.
M2 is one of the aggregates by which the Federal Reserve measures the money supply. It is a broader classification of money than M1 and a key economic indicator used to forecast inflation. M2 consists of all the liquid components of M1 plus near-monies. Near monies are relatively liquid financial assets that may be readily converted into M1 money. More specifically, near monies include savings deposits, small time deposits (less than \$100,000) that become readily available at maturity, and money market mutual funds.
Federal Reserve: Historically, the Federal Reserve has measured the money supply using the aggregates of M1, M2, and M3. The M2 aggregate includes M1 plus near-monies.
Imagine that Laura writes a check for \$1,000 and brings it to the bank to start a money market account. This would cause M1 to decrease by \$1,000, but M2 to stay the same. This is because M2 includes the money market account in addition to all the money counted in M1.
Other Measurements of the Money Supply
In addition to the commonly used M1 and M2 aggregates, several other measures of the money supply are used as well.
learning objectives
• Explain how the money supply is measured
In addition to the commonly used M1 and M2 aggregates, there are several other measurements of the money supply that are used as well. More specifically:
Euro Money Supply: The measures of the money supply are all related, but the use of different measures may lead economists to different conclusions.
• M0: The total of all physical currency including coinage. M0 = Federal Reserve Notes + US Notes + Coins.
• MB: Stands for “monetary base,” referring to the base from which all other forms of money are created. MB is the total of all physical currency plus Federal Reserve Deposits (special deposits that only banks can have at the Fed). MB = Coins + US Notes + Federal Reserve Notes + Federal Reserve Deposits.
• M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits.
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under \$100,000).
• M3: M2 + all other certificates of deposit (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
• M4-: M3 + commercial paper.
• M4: M4- + treasury bills (or M3 + commercial paper + T-bills)
• MZM: “Money Zero Maturity” is one of the most popular aggregates in use by the Fed because its velocity has historically been the most accurate predictor of inflation. It is M2 – time deposits + money market funds.
• L: The broadest measure of liquidity that the Federal Reserve no longer tracks. M4 + Bankers’ Acceptance.
The different forms of money in the government money supply statistics arise from the practice of fractional-reserve banking. Fractional-reserve banking is the practice whereby a bank retains only a portion of its customers’ deposits as readily available reserves from which to satisfy demands for withdrawals. Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created. This new type of money is what makes up the non-M0 components in the M1-M3 statistics.
Key Points
• Money comes in three forms: commodity money, fiat money, and fiduciary money. Most modern monetary systems are based on fiat money.
• Commodity money derives its value from the commodity of which it is made, while fiat money has value only by the order of the government.
• Money functions as a medium of exchange, a unit of account, and a store of value
• The barter system has a number of limitations, including the double coincidence of wants, the absence of a common measure of value, indivisibility of certain goods, difficulty of deferred payments, and difficulty of storing wealth.
• Despite the numerous limitations, the barter system works well when currency is unstable or unavailable for conducting commerce.
• Money is durable, divisible, portable, liquid, and resistant to counterfeiting.
• Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.
• The Federal Reserve measures the money supply using three monetary aggregates: M1, M2, and M3.
• M1 is the narrowest measure of the money supply, including only money that can be spent directly.
• M2 is a broader measure, encompassing M1 and near monies.
• M3 includes M2 plus relatively less liquid near monies. However, this measure is no longer used in practice.
• M0 is a measure of all the physical currency and coinage in circulation in an economy.
• MB is a measure that captures all physical currency, coinage, and Federal Reserve deposits (special deposits that only banks can have at the Fed).
• The different forms of money in the government money supply statistics arise from the practice of fractional-reserve banking. Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created, which makes up the non-M0 components in the M1 -M3 statistics.
Key Terms
• Fiat money: Money that is given value because those who use it believe it has value; the value is not derived from any inherent characteristic.
• barter: An exchange goods or services without involving money.
• M1: The amount of cash in circulation plus the amount in bank checking accounts.
• M0: The amount of coin and banknotes in circulation.
• MB: The portion of the commercial banks’ reserves that is maintained in accounts with their central bank plus the total currency circulating in the public.
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Introduction to Monetary Policy
Monetary policy is the process by which a monetary authority controls the money supply, often to produce stable prices and low unemployment.
learning objectives
• Justify expansionary and contractionary monetary policy.
Monetary policy is the process by which the monetary authority of a country, which could be a government agency or a central bank, controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment.
Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by easing credit to entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values, or to cool an overheating economy. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.
Expansionary Monetary Policy
A monetary authority will typically pursue expansionary monetary policy when there is an output gap – that is, a country is producing output at a lower level than its potential output. Without a policy intervention the output gap may correct itself, if falling wages and prices shift the short-run aggregate supply curve to the right until the economy returns to the long-run equilibrium. Alternatively, the monetary authority could intervene in order to increase aggregate demand and close the output gap. Expansionary monetary policy consists of the tools that a central bank uses to achieve this increase in aggregate demand.
In practice, this means that a monetary authority will use the tools at its disposal in order to increase the money supply and decrease interest rates. Since interest rates represent the price of money, lower interest rates will cause the quantity of money demanded to increase, stimulating investment and spending. In addition, lower interest rates make a currency worth less in the currency exchange market. This reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate (in foreign currency per dollar). A lower exchange rate makes a country’s goods relatively more affordable for the rest of the world, stimulating exports and further increasing output.
Contractionary Monetary Policy
By contrast, a monetary authority will pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that high short-run aggregate demand creates an equilibrium in which prices are higher than in the long-run equilibrium. This will cause high levels of inflation. In response, the monetary authority may reduce the money supply and thereby raise the interest rate. Investment falls as the interest rate rises. The higher interest rate also increases the demand for dollars as foreign investors shift their investments to the United States. Likewise, the supply of dollars declines. Consumers in the United States purchase domestic interest-bearing assets rather than purchasing assets abroad, taking advantage of the higher domestic interest rate. Increased demand and decreased supply cause an increase in the exchange rate, which boots imports while reducing exports. Thus, contractionary monetary policy causes aggregate demand to fall, thereby reducing the rate of inflation..
Money Supply and Inflation: The graph shows the relationship between the money supply and the inflation rate. By controlling the money supply, monetary authorities hope to influence the rate of inflation.
The Creation of the Federal Reserve
The Federal Reserve was created to promote financial stability, provide regulation and banking services, and conduct monetary policy.
learning objectives
• Explain monetary policy as the main function of a central bank
The Federal Reserve Act of 1913
Until 1913, the United States did not have a true central bank. The US suffered through a number of financial crises that eventually drove Congress to create the US central bank, the Federal Reserve (the Fed), through the Federal Reserve Act of 1913.
The Act established three key objectives for monetary policy: maximum employment, stable prices, and moderate long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate and are the most emphasized of the three.
Over the years, the Fed has expanded its duties to include conducting monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system, and providing financial services.
How the Fed Conducts Monetary Policy
The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.
Reserve Requirements
Commercial banks are required to hold a certain proportion of their deposits in reserves and not lend them out. This proportion is called the reserve requirement and is controlled by the Fed. By changing the reserve requirement, the Fed can impact the amount of money available for lending, and by extension, spending and investment.
Discount Window
Commercial banks are required to have a certain amount of reserves on hand at the end of each day. If they are going to come up short, they must borrow from other banks or the Fed. The Fed extends these loans through the discount window and charges what is called the discount rate. The discount rate is set by the Fed, and is important because it radiates throughout the economy: if it becomes more expensive to borrow at the discount window, interest rates will rise and borrowing will become more expensive economy-wide. In this way, the Fed can use the discount window to affect interest rates and the money supply.
Increasing the Money Supply: The diagram shows how the central bank can increase the money supply by lending money through the discount window or purchasing bonds (open market operations).
Open-Market Operations
The government borrows by issuing bonds. Recall that the interest rate that the government pays is determined by the price of the bond: the higher the price of the bond, the lower the interest rate. The Fed can affect the interest rate by conducting open-market operations (OMOs) in which it buys or sells bonds. Buying or selling bonds changes the demand or supply of the bonds, and therefore their price. By extension, OMOs change the interest rate, hopefully to achieve one of the Fed’s monetary goals.
Structure of the Federal Reserve
The Federal Reserve System (The Fed) was designed in order to maintain the central bank’s independence and promote decentralized power.
learning objectives
• Recall the structure of the Federal Reserve System of the United States
The Federal Reserve (the Fed) was designed to be independent of the Congress and the government. The idea justification for independence is that it allows the Fed to operate without being put under political pressure to take actions that may not be in the best long-term economic interest of the country.
The Federal Reserve System is composed of five parts:
Structure of the Federal Reserve: The diagram shows the relationship between the different organizations that compose the Federal Reserve System
1. The presidentially appointed Board of Governors (or Federal Reserve Board), an independent federal government agency located in Washington, D.C. Each governor serves a 14 year term. As of February 2014, the Chair of the Board of Governors is Janet Yellen, who succeeded Ben Bernanke.
2. The Federal Open Market Committee (FOMC), composed of the seven members of the Federal Reserve Board and five of the 12 Federal Reserve Bank presidents, which oversees open market operations, the principal tool of U.S. monetary policy.
3. Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts. The Federal Reserve Banks act as fiscal agents for the U.S. Treasury, and each has its own nine-member board of directors.
4. Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
5. Various advisory councils.
The Fed can be thought of as having both private and public organization characteristics, though it considers itself to be private. On one hand, the Fed works toward achieving public goals such as moderate inflation and low unemployment. It does not exist to make money. On the other hand, it is, by design, separate from the government. It operates independently, and is not subject to political pressures directly as is Congress or the President.
The Federal Open Market Committee and the Role of the Fed
The Federal Open Market Committee is responsible for conducting open market operations in order to achieve a target interest rate.
learning objectives
• Describe the structure and operations of the Federal Open Market Committee (FOMC)
One of the primary tools used by the Federal Reserve (the Fed) to conduct monetary policy is open market operations: the buying and selling of federal government bonds in order to influence the money supply and interest rate. These operations are the primary responsibility of the Federal Open Market Committee (FOMC). The FOMC is a twelve-person committee composed of the seven members of the Board of Governors, plus a rotating combination of five presidents of the Federal Reserve Regional Banks. The president of the New York regional bank is always a member of the FOMC; the other four seats are filled by four of the other eleven bank presidents.
When conducting monetary policy the Fed sets a target for the federal funds rate, which it attempts to achieve using open market operations. To lower the federal funds rate, for example, the Fed buys securities on the open market, increasing the money supply. In order to raise the federal funds rate, on the other hand, the Fed sells securities and thereby reduces the money supply.
Open Market Operations
As mentioned previously, the aim of open market operations is to manipulate the short term interest rate and the total money supply. This involves meeting the demand for money at the target interest rate by buying and selling government securities or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
Imagine the Fed is targeting a federal funds rate of 3%. If there is an increased demand for money and the Fed takes no action, interest rates will rise. This may produce unintended contractionary effects in the economy. Instead, the FOMC responds to an increase in the demand for money by going to the open market to buy a financial asset, such as government bonds, foreign currency, or gold. To pay for these assets, the Fed transfers bank reserves to the seller’s bank and the seller’s account is credited. Since the bank now has more reserves than it had before, it can lend out more money and the money supply increases. Thus, the increase in demand for money is met with an increase in supply, and the interest rate remains unchanged.
Conversely, if the central bank sells its financial assets on the open market, reserves are transferred from the buyer’s bank back to the Fed. This reduces the amount of money that a bank may loan out and the total money supply falls. The process works because the central bank has the authority to bring money in and out of existence. They are the only point in the whole system with the unlimited ability to produce money.
FOMC Meeting: The members of the FOMC meet eight times a year in order to vote on current monetary policies.
The Federal Reserve and the Financial Crisis of 2008
The Fed responded to the financial crisis with conventional open market operations and unconventional credit facilities and bailouts.
learning objectives
• Summarize the monetary policy tools used by the Federal Reserve in response to the financial crisis of 2008.
In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s. It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis caused the failure of businesses, huge declines in consumer wealth, and a downturn in economic activity that lead to the 2008-2012 global recession.
The Federal Reserve ‘s response to the 2008 crisis saw the use of both conventional and new monetary tools in order to stabilize the economy, support market liquidity, and encourage economic activity. Conventional monetary policy suggests that in an economic downturn, a central bank should conduct open market operations in order to increase the money supply and lower interest rates. Lower interest rates stimulate loans, spending, and investment and help an economy escape from recession. Further, this type of financial crisis meant that banks’ assets were suddenly worth far less; open market operations can ensure that these banks have the liquidity they need to carry out their financial activities.
Conventional Monetary Tools
The Federal Reserve (the Fed) did engage in these types of conventional operations in 2007 and 2008, cutting the target federal funds rate and the discount rate seven times. Normally, a low federal funds rate would encourage banks to borrow money in order to lend it out to firms and individuals, stimulating the economy, but in the aftermath of the financial crisis the Fed was unable to lower interest rates enough to successfully induce banks to make loans. One reason why traditional monetary policies failed is due to the zero lower bound and the low levels of inflation that accompanied the crisis.
The zero lower bound refers to the fact that the central bank cannot push nominal interest rates below 0%. This is because any creditor can do better by keeping their money in cash than by loaning it out at an interest rate below 0%. When inflation is high, however, central banks may be able to push the real interest rate below 0%. Recall that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. If the nominal interest rate is 1% and inflation is 3%, the real interest rate is -2%. However, following the crisis, the U.S. experienced very low levels of inflation, and cutting the federal funds rate failed to provide enough economic stimulus to get the country out of the recession.
Unconventional Monetary Tools
Unable to create interest rates low enough to encourage banks to resume lending money, the Fed turned to other, untried policy tools to encourage economic activity. To deal with the shrinking credit markets, the Fed created a selection of new credit facilities. The Primary Dealer Credit Facility (PDCF) allows the banks that normally handle open market operations on behalf of the Fed to apply for overnight loans. The Term Asset-Backed Securities Loan Facility uses the primary dealers to give companies access to loans based on asset-backed securities, such as those related to credit card or small business debt. These new credit facilities were created based on the hope that increasing liquidity in the market would induce firms and consumers to borrow and spend.
The Fed also provided targeted assistance to bail out large financial institutions that would have otherwise collapsed. During the crisis, housing prices fell and the number of foreclosures increased dramatically. Investors, banks, and other financial institutions came under pressure as their mortgage-based assets lost value. The Fed provided credit to these institutions in an attempt to mitigate the effect of falling asset prices and stem the crisis. This included bailouts of two housing finance firms – Fannie Mae and Freddie Mac – which had been established by the government in order to encourage home ownership and stimulate the housing market.
The Fed also provided billions of dollars of assistance to AIG, an insurance firm that had invested heavily in mortgage loans. Without the assistance the firm would have collapsed, possibly causing a chain reaction of failing financial institutions. The Fed determined that these consequences were too severe to be allowed – that is, that AIG was “too big to fail. ” Many argue that when the Fed provided this type of emergency aid, it encouraged banks to take even more extreme risks, safe in the knowledge that they would be bailed out if their investments failed. Others praise the Fed for avoiding an even deeper financial crisis.
Government Bails Out AIG With \$85 Billion Loan: September 16, 2008: The Federal Reserve says the U.S. government has agreed to provide an \$85 billion emergency loan to rescue the huge insurer AIG. The Fed says the U.S. Treasury Department is in full support of the decision.
The Structure and Function of Other Banks
While central banks share responsibility for monetary policy, their structures, methods, and primary goals differ across countries.
learning objectives
• Summarize the structure of the ECB, the Bank of England, and the People’s Bank of China
The primary function of a central bank is to manage the nation’s money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. However, the structure, tools, and primary goals of these banks differ between countries.
European Central Bank
The European Central Bank (ECB) is the central bank for the euro and administers the monetary policy of the Eurozone, which consists of 17 EU member states and is one of the largest currency areas in the world. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany. In contrast with the Federal Reserve, the ECB has the primary objective of maintaining price stability within the Eurozone, but is not charged with regulating unemployment or economic output.
In the U.S., liquidity is furnished to the economy primarily through the purchase of Treasury bonds by the Federal Reserve (the Fed), but the European system uses a different method. Instead, there are about 1,500 eligible banks that can bid for short term repurchase contracts, or “repos”. The banks borrow cash, and when the repo notes come due the participating banks bid again. Because the loans have a short duration, the ECB can adjust interest rates and money supply by varying the quantity of notes offered at auction.
The ECB has three decision-making bodies: the Executive Board, the Governing Council, and the General Council. The Executive Board is responsible for implementing monetary policy and the day-to-day running of the bank. The Governing Council makes decisions about what monetary policies to implement. The General Council deals with the transitional issues that come about as new countries adopt the euro.
The Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world. It was established to act as the English Government’s banker, and was privately owned from its foundation in 1694 until it was nationalized in 1946. In 1998, it became an independent public organization, owned by the Treasury Solicitor on behalf of the government, with independence in setting monetary policy. The primary goals of the Bank of England are to maintain price stability and support the economic policies of the government.
Bank of England Charter: The illustration shows the sealing of the Bank of England Charter in 1694. The structure and function of the Bank of England served as a model for the central banks formed later.
The Monetary Policy Committee is responsible for formulating monetary policy and for setting interest rates in order to maintain a given inflation target. The recently-established Financial Policy Committee is responsible for regulating the UK’s financial sector in order to maintain financial stability.
The People’s Bank of China
The People’s Bank of China (PBC) is the central bank of the People’s Republic of China with the power to control monetary policy and regulate financial institutions in mainland China. The People’s Bank of China has the most financial assets of any single public finance institution. It is responsible for making and implementing monetary policy for safeguarding the overall financial stability and provision of financial services.
The PBC has nine regional branches, as well as many sub-branches and six overseas representative offices. It is divided into 18 functional departments that oversee such issues as monetary policy, financial stability, anti-money laundering, and legal affairs. The top management of the PBC is composed of the governor and a certain number of deputy governors. The PBC adopts a governor responsibility system under which the governor supervises the overall work of the PBC while the deputy governors provide assistance to the governor to fulfill his or her responsibility.
Key Points
• Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the money supply more rapidly than usual, and contractionary policy expands the money supply more slowly than usual.
• Expansionary policy is traditionally used to try to combat unemployment by lowering interest rates. A monetary authority will typically pursue expansionary monetary policy when there is an output gap.
• Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.
• The Federal Reserve (the Fed) was originally created in response to a series of bank panics. While its policy goals were originally unclear, today the Fed has a dual mandate: to achieve maximum employment and stable prices.
• The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.
• The Fed sets the required ratio of reserves that banks must hold relative to their deposit liabilities.
• The discount rate is the interest rate charged by the Fed when it lends reserves to banks.
• The buying and selling of federal government bonds by the Fed are called open-market operations.
• The Fed is a system of 12 regional banks, each of which has its own board of directors and rotating representative to the Federal Open Market Committee (FOMC).
• The Fed is run by a Board of Governors, the head of which is the Chairperson.
• The Federal Open Market Committee (FOMC) consists of the seven members of the Board of Governors and five rotating regional bank presidents. It is primarily responsible for buying and selling federal government bonds in order to conduct monetary policy.
• Open market operations are the buying and selling of federal government bonds in order to influence the money supply and interest rate.
• The Fed sets targets for the federal funds rate and then conducts operations to maintain that rate. To achieve a lower federal funds rate, for example, the Fed goes into the open market to buy securities and thus increase the money supply.
• The FOMC decides on a target federal funds rate by looking at monetary targets such as inflation, interest rates, or exchange rates.
• In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s.
• The Fed cut the target federal funds rate and the discount lending rate seven times. Normally, a low federal funds rate would encourage banks to make loans, stimulating the economy, but this failed to work following the crisis.
• Unable to rely on conventional tools, the Fed created a variety of credit facilities to provide liquidity to the economy.
• The Fed also provided emergency funds to support financial institutions deemed “too big to fail”.
• The European Central Bank controls interest rates through auctions rather than the bond market, and is responsible for maintaining price stability over all other goals.
• The Bank of England is the second-oldest central bank in the world. Monetary policy is dictated by the Monetary Policy Committee, and recently the Financial Policy Committee was formed in order to regulate the UK’s financial sector.
• The People’s Bank of China conducts monetary policy and is the largest central bank in the world.
Key Terms
• output gap: The difference between an economy’s actual GDP and its long-run potential GDP
• inflation: An increase in the general level of prices or in the cost of living.
• central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.
• reserve requirement: The minimum amount of deposits each commercial bank must hold (rather than lend out).
• open market operations: An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• federal funds rate: The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.
• reserve: Banks’ holdings of deposits in accounts with their central bank.
• discount rate: An interest rate that a central bank charges to depository institutions that borrow reserves from it.
• liquidity: The degree to which an asset can be easily converted into cash.
• Eurozone: Those European Union member states whose official currency is the euro.
• price stability: A state of economy characterized by low inflation, and thus a stable value of money.
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The Fractional Reserve System
A fractional reserve system is one in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.
learning objectives
• Examine the impact of fractional reserve banking on the money supply
Banks operate by taking in deposits and making loans to lenders. They are able to do this because not every depositor needs her money on the same day. Thus, banks can lend out some of their depositors’ money, while keeping some on hand to satisfy daily withdrawals by depositors. This is called the fractional-reserve banking system: banks only hold a fraction of total deposits as cash on hand.
Reserve Ratio
The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Federal Reserve. If, for example, the reserve requirement is 1%, then a bank must hold reserves equal to 1% of their total customer deposits. These assets are typically held in the form of physical cash stored in a bank vault and in reserves deposited with the central bank.
Banks can also choose to hold reserves in excess of the required level. Any reserves beyond the required reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. In general, since banks make less money from holding excess reserves than they would lending them out, economists assume that banks seek to hold no excess reserves.
Money Creation
Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money. To understand this, imagine that you deposit $100 at your bank. The bank is required to keep$10 as reserves but may lend out $90 to another individual or business. This loan is new money; the bank created it when it issued the loan. In fact, the vast majority of money in the economy today comes from these loans created by banks. Likewise when a loan is repaid, that money disappears from the economy until the bank issues another loan. Money Creation in a Fractional Reserve System: The diagram shows the process through which commercial banks create money by issuing loans. Thus, there are two ways that a central bank can use this process to increase or decrease the money supply. First, it can adjust the reserve ratio. A lower reserve ratio means that banks can issue more loans, increasing the money supply. Second, it can create or destroy reserves. Creating reserves means that commercial banks have more reserves with which they can satisfy the reserve ratio requirement, leading to more loans and an increase in the money supply. Why Have Reserve Requirements? Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. However, banks also have an incentive to loan out as much money as possible and keep only a minimum buffer of reserves, since they earn more on these loans than they do on the reserves. Mandating a reserve requirement helps to ensure that banks have the ability to meet their obligations. Example Transactions Showing How a Bank Can Create Money The amount of money created by banks depends on the size of the deposit and the money multiplier. learning objectives • Calculate the change in money supply given the money multiplier, an initial deposit and the reserve ratio To understand the process of money creation, let us create a hypothetical system of banks. We will focus on two banks in this system: Anderson Bank and Brentwood Bank. Assume that all banks are required to hold reserves equal to 10% of their customer deposits. When a bank’s excess reserves equal zero, it is loaned up. Anderson and Brentwood both operate in a financial system with a 10% reserve requirement. Each has$10,000 in deposits and no excess reserves, so each has $9,000 in loans outstanding, and$10,000 in deposit balances held by customers.
Suppose a customer now deposits $1,000 in Anderson Bank. Anderson will loan out the maximum amount (90%) and hold the required 10% as reserves. There are now$11,000 in deposits in Anderson with $9,900 in loans outstanding. The debtor takes her$900 loan and deposits it in Brentwood bank. Brentwood’s deposits now total $10,900. Thus, you can see that total deposits were$20,000 before the initial $1,000 deposit, and are now$21,900 after. Even though only $1,000 were added to the system, the amount of money in the system increased by$1,900. The $900 in checkable deposits is new money; Anderson created it when it issued the$900 loan.
Mathematically, the relationship between reserve requirements ($rr$), deposits, and money creation is given by the deposit multiplier (m). The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves. When banks in the economy have made the maximum legal amount of loans (zero excess reserves), the deposit multiplier is equal to the reciprocal of the required reserve ratio ($m=1/rr$).
In the above example the deposit multiplier is 1/0.1, or 10. Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to$10.
Key Points
• The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected.
• The fraction of deposits that a bank keeps in cash or as a deposit with the central bank, rather than loaning out to the public, is called the reserve ratio.
• A minimum reserve ratio (or reserve requirement ) is mandated by the Fed in order to ensure that banks are able to meet their obligations.
• Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money.
• A lower reserve requirement allows banks to issue more loans and increase the money supply, while a higher reserve requirement does the opposite.
• When a deposit is made at a bank, that bank must keep a portion the form of reserves. The proportion is called the required reserve ratio.
• Loans out a portion of its reserves to individuals or firms who will then deposit the money in other bank accounts.
• Theoretically, this process will until repeat until there are no excess reserves left.
• The total amount of money created with a new bank deposit can be found using the deposit multiplier, which is the reciprocal of the reserve requirement ratio. Multiplying the deposit multiplier by the amount of the new deposit gives the total amount of money that may be created.
• The total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio (the money multiplier ).
• When banks have no excess reserves, the supply of total money is equal to reserves times the money multiplier. Theoretically, banks will never have excess reserves.
• According to the theory, a central bank can change the money supply in an economy by changing the reserve requirements.
• Some banks may choose to hold excess reserves, leading to a money supply that is less than that predicted by the money multiplier.
• Customers may withdraw cash, removing a source of reserves against which banks can create money.
• Individuals and businesses may not spend the entire proceeds of their loans, removing the multiplier effect on money creation.
Key Terms
• deposit: Money placed in an account.
• reserves: Banks’ holdings of deposits in accounts with their central bank, plus currency that is physically held in the bank’s vault.
• deposit multiplier: The maximum amount of commercial bank money that can be created by a given unit of reserves.
• currency: Paper money.
• central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.
• money multiplier: The maximum amount of commercial bank money that can be created by a given unit of central bank money.
• commercial bank: A type of financial institution that provides services such as accepting deposits, making business loans, and offering basic investment products to the public.
• reserve requirement: The minimum amount of deposits each commercial bank must hold (rather than lend out).
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The Demand for Money
In economics, the demand for money is the desired holding of financial assets in the form of money (cash or bank deposits).
learning objectives
• Relate the level of the interest rate to the demand for money
The Demand for Money
In economics, the demand for money is generally equated with cash or bank demand deposits. Generally, the nominal demand for money increases with the level of nominal output and decreases with the nominal interest rate.
The equation for the demand for money is: $\mathrm{M_d= P \times L(R,Y)}$. This is the equivalent of stating that the nominal amount of money demanded (Md) equals the price level (P) times the liquidity preference function L(R,Y)–the amount of money held in easily convertible sources (cash, bank demand deposits). Specific to the liquidity function, L(R,Y), R is the nominal interest rate and Y is the real output.
Money is necessary in order to carry out transactions. However inherent to the holding of money is the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.
When the demand for money is stable, monetary policy can help to stabilize an economy. However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations.
Impact of the Interest Rate
The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). It is viewed as a “cost” of borrowing money. Interest-rate targets are a tool of monetary policy. The quantity of money demanded varies inversely with the interest rate. Central banks in countries tend to reduce the interest rate when they want to increase investment and consumption in the economy. However, low interest rates can create an economic bubble where large amounts of investments are made, but result in large unpaid debts and economic crisis. The interest rate is adjusted to keep inflation, the demand for money, and the health of the economy in a certain range. Capping or adjusting the interest rate parallel with economic growth protects the momentum of the economy.
Control of the Money Supply
While the demand of money involves the desired holding of financial assets, the money supply is the total amount of monetary assets available in an economy at a specific time. Data regarding money supply is recorded and published because it affects the price level, inflation, the exchange rate, and the business cycle.
Monetary policy also impacts the money supply. Expansionary policy increases the total supply of money in the economy more rapidly than usual and contractionary policy expands the supply of money more slowly than normal. Expansionary policy is used to combat unemployment, while contractionary is used to slow inflation.
In the United States, the Federal Reserve System controls the money supply. The reserves of money are kept in Federal Reserve accounts and U.S. banks. Reserves come from any source including the federal funds market, deposits by the public, and borrowing from the Fed itself. The Fed can attempt to change the money supply by affecting the reserve requirement and through other monetary policy tools.
Federal Funds Rate: This graph shows the fluctuations in the federal funds rate from 1954-2009. The Federal Reserve implements monetary policy through the federal funds rate.
Shifts in the Money Demand Curve
A shift in the money demand curve occurs when there is a change in any non-price determinant of demand, resulting in a new demand curve.
learning objectives
• Explain factors that cause shifts in the money demand curve, Explain the implications of shifts in the money demand curve
Demand for Money
In economics, the demand for money is the desired holding of financial assets in the form of money. The nominal demand for money generally increases with the level of nominal output (the price level multiplied by real output). The interest rate is the price of money. The quantity of money demanded increases and decreases with the fluctuation of the interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. A demand curve is used to graph and analyze the demand for money.
Factors that Cause Demand to Shift
A demand curve has the price on the vertical axis (y) and the quantity on the horizontal axis (x). The shift of the money demand curve occurs when there is a change in any non-price determinant of demand, resulting in a new demand curve. Non-price determinants are changes cause demand to change even if prices remain the same. Factors that influence prices include:
• Changes in disposable income
• Changes in tastes and preferences
• Changes in expectations
• Changes in price of related goods
• Population size
Factors that change the demand include:
• Decrease in the price of a substitute
• Increase in the price of a complement
• Decrease in consumer income if the good is a normal good
• Increase in consumer income if the good is an inferior good
The demand for money shifts out when the nominal level of output increases. It shifts in with the nominal interest rate.
Shift of the Demand Curve: The graph shows both the supply and demand curve, with quantity of money on the x-axis (Q) and the price of money as interest rates on the y-axis (P). When the quantity of money demanded increase, the price of money (interest rates) also increases, and causes the demand curve to increase and shift to the right. A decrease in demand would shift the curve to the left.
Implications of Demand Curve Shift
The demand for money is a result of the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money determines how a person’s wealth should be held. When the demand curve shifts to the right and increases, the demand for money increases and individuals are more likely to hold on to money. The level of nominal output has increased and there is a liquidity advantage in holding on to money. Likewise, when the demand curve shifts to the left, it shows a decrease in the demand for money. The nominal interest rate declines and there is a greater interest advantage in holding other assets instead of money.
The Equilibrium Interest Rate
In an economy, equilibrium is reached when the supply of money is equal to the demand for money.
learning objectives
• Use the concept of market equilibrium to explain changes in the interest rate and money supply
Interest Rate
The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). Equilibrium is reached when the supply of money is equal to the demand for money. Interest rates can be affected by monetary and fiscal policy, but also by changes in the broader economy and the money supply.
Factors that Influence the Interest Rate
Interest rates fluctuate over time in the short-run and long-run. Within an economy, there are numerous factors that contribute to the level of the interest rate:
Fluctuation in Interest Rates: This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. Interest rates fluctuate over time as the result of numerous factors. In Germany, the interest rates dropped from 14% in 1967 to almost 2% in 2003. This graph illustrates the fluctuations that can occur in the short-run and long-run. Interest rates fluctuate based on certain economic factors.
• Political gain: both monetary and fiscal policies can affect the money supply and demand for money.
• Consumption: the level of consumption (and changes in that level) affect the demand for money.
• Inflation expectations: inflation expectations affect a the willingness of lenders and borrowers to transact at a given interest rate. Changes in expectations will therefore affect the equilibrium interest rate.
• Taxes: changes in the tax code affect the willingness of actors to invest or consume, which can therefore change the demand for money.
Market Equilibrium
In economics, equilibrium is a state where economic forces such as supply and demand are balanced and without external influences, the equilibrium will stay the same. Market equilibrium refers to a condition where a market price is established through competition where the amount of goods and services sought by buyers is equal to the amount of goods and services produced by the sellers. In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced. The money supply is the total amount of monetary assets available in an economy at a specific time. Without external influences, the interest rate and the money supply will stay in balance.
Key Points
• Money provides liquidity which creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.
• The quantity of money demanded varies inversely with the interest rate.
• While the demand of money involves the desired holding of financial assets, the money supply is the total amount of monetary assets available in an economy at a specific time.
• In the United States, the Federal Reserve System controls the money supply. The Fed has the ability to increase the money supply by decreasing the reserve requirement.
• The real demand for money is defined as the nominal amount of money demanded divided by the price level.
• The nominal demand for money generally increases with the level of nominal output (the price level multiplied by real output).
• The demand for money shifts out when the nominal level of output increases.
• The demand for money is a result of the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.
• The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor).
• Factors that contribute to the interest rate include: political gains, consumption, inflation expectations, investments and risks, liquidity, and taxes.
• In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced.
• The real interest rate measures the purchasing power of interest receipts. It is calculated by adjusting the nominal rate charge to take inflation into account.
Key Terms
• money supply: The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.
• asset: Something or someone of any value; any portion of one’s property or effects so considered.
• nominal interest rate: The rate of interest before adjustment for inflation.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
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The Reserve Ratio
The reserve ratio is the percentage of deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned.
learning objectives
• Identify the effects of reserve requirements on monetary policy
Banks assume responsibility for consumer deposits and make money by loaning out deposited finds. Therefore, banks with relatively higher deposits are able to supply a larger amount of loanable funds. The supply of loanable funds directly impacts growth and interest rates in an economy. Typically, an increase in the supply of loanable funds is associated with a decrease in interest rates. The greater the accessibility of loanable funds, as conferred by access and cost, the greater opportunity for businesses and consumers to make investment purchases and increase production and labor supply, respectively.
However, in economic downturns the amount of outstanding loans may be counter to a bank’s longevity, as depositors may seek to cash-out holdings. In order to reduce the risk of a panic or “run on bank” from the perception that a bank may not have adequate liquidity to meet depositor access to cash deposits, central banks have adopted policies to ensure that banks use prudent judgement when assessing the amount of deposits to loan.
Reserve Ratio
The reserve ratio is a central bank regulatory tool employed by most, but not all, of the world’s central banks. The ratio is a set percentage of customer deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned. Required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impact the amount of loanable funds available.
Federal Reserve-US Central Bank: The Federal Reserve is charged with maintaining sustainable economic growth. To carry out its responsibilities, the “Fed” uses policies including the reserve ratio to adjust the money supply to either incentivize growth or slow down growth, as needed.
Monetary policy tool
Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio. For example, a reserve ratio of 20% will result in 80% of any given initial deposit being loaned out and if the process of loaning is assumed to continue, the maximum increase in money expansion specific to an initial deposit at a 20% reserve ratio will be equal to the reserve multiplier $\mathrm{\frac{1}{(reserve \; ratio)} \times the \; initial \; deposit}$.
For example, with the reserve ratio (RR) of 20 percent, the money multiplier, mm, will be calculated as:
$\mathrm{m=\dfrac{1}{RR}}$
$\mathrm{m=\dfrac{1}{0.20}=5}$
This then signifies that any initial deposit will contribute to an expansion in money supply up to 5 times its original value.
The conventional view in economic theory is that a reserve requirement can act as a tool of monetary policy. The higher the reserve requirement is set, the theory supposes, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.
The Discount Rate
The rate that member banks charge each other is the federal funds rate and the rate the Fed charges is referred to as the discount rate.
learning objectives
• Illustrate the effects of the discount rate on monetary policy
The central bank of the United States is the Federal Reserve (the Fed). The Fed employs monetary policy through direct controls on the money supply through open market operations to achieve economic stability and growth.
Open market operations entail Fed intervention in the buying and selling of government bonds to achieve a change in the money supply and the corresponding change in the interest rate. The Fed sells bonds to reduce the money supply and increase the prevailing interest rate and buys bonds to increase the money supply and reduce the prevailing interest rate. The interest rate is an active target and is set as a target rate range by the Fed; it is conveyed to the public by the Federal Reserve Open Market Committee (FOMC) as the fed funds target rate (short for the Federal Funds rate).
Coincident with the Fed’s open market operations is the Fed’s selection of a reserve requirement which corresponds to a required percentage of deposits (reserves) that banks must keep on site or at the Fed on a daily basis. Given their daily activities, banks may fall short of their required daily reserve requirement. When this occurs, banks may either turn to the Fed or Fed member banks for overnight or short-term loans to satisfy their liquidity short-fall. The rate that member banks charge each other is referred to as the federal funds rate and the rate the Fed charges banks is referred to as the discount rate.
This distinction is particularly important. The discount rate is the rate that the central bank actual controls. It is the rate the central bank charges its member banks to borrow overnight. However, the rate that the central bank actually cares about is the fed funds rate. That is the rate banks charge each other, and is influenced by the discount rate.
The Fed targets the rate for federal funds via its open market operations and seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate.
Historical discount and fed fund target rates: The discount rate is higher than the fed funds target rate and the variance serves as a disincentive for banks to seek funds or short-term borrowings from the Fed.
For example, the difference or spread of the primary credit rate (rate to member banks in solid financial standing) over the FOMC’s target federal funds rate was initially 1 percent. During the financial crisis, this spread was reduced to one-half of one percent on August 17, 2007, and was further reduced, to a quarter of 1 percent, on March 16, 2008.
Typically, the discount rate along with the fed funds target rate are mechanisms that the Fed uses to discourage banks from excess lending, as part of a contractionary or restrictive policy scheme. Given that lending has an expansionary effect, to the extent that the fed funds target rate and discount rate diminish the profitability of excess loaning, these parameters place limits to the expansion of the money supply via the loanable funds market. However, as noted in the aforementioned historical example, the discount rate, in conjunction with the fed funds target rate, may be purposely maintained at a lower interest level to encourage borrowing and increase growth when the economy is showing signs of either slowing or contracting. In this manner, the discount rate in tandem with the fed funds target rate are part of an expansionary policy mechanism.
The Federal Funds Rate
The Federal Funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve.
learning objectives
• Discuss the importance of the Federal Funds Rate as a monetary policy tool
The Federal Funds rate (or fed funds rate) is the interest rate at which depository institutions (primarily banks) actively trade balances held at the Federal Reserve. In the US, banks are obligated to maintain certain levels of reserves, either in the form of reserves with the Fed or as vault cash. Each day, banks receive deposits, which contribute to a bank’s reserves, and issue loans, which are liabilities against the bank. These daily activities change their ratio of reserves to liabilities. If, by the end of the day, the bank’s reserve ratio has dropped below the legally required minimum, it must add to its reserves in order to remain compliant with the law. Banks do this by borrowing reserves from other banks with excess reserves, and the weighted average of these interest rates paid by borrowing banks determines the federal funds rate.
The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates and still make a profit. On the other hand, if the Federal Funds rate is high, banks will not borrow reserves in order to issue low-interest loans to the public. In fact, many mortgages and credit card interest rates are indexed to the Federal Funds rate – a homeowner might pay an adjustable interest rate that is set at the level of the Federal Funds rate plus four percent, for example. A high Federal Funds rate, therefore, has a contractionary effect on economic activity, while a low Federal Funds rate has an expansionary effect.
The Fed doesn’t control the Federal Funds rate directly – it is negotiated between borrowing and lending banks – but it does set a target interest rate and uses open market operations in order to achieve that rate. The target Federal Funds rate is decided by the governors at the Federal Open Market Committee (FOMC) meetings, who will either increase, decrease, or leave the target rate unchanged based on the economic conditions within the country. Influencing the Federal Funds rate is the primary monetary policy tool that the Fed uses to achieve its dual mandate of stable prices and low unemployment.
Federal Funds Rate 1954-2009: The graph shows the federal funds rate for the past fifty years. The peak in the 1980s reflects the contractionary monetary policy the Fed instituted to combat high levels of inflation due to oil shocks, and the low rate in the late 2000s reflects expansionary monetary policy meant to combat the effects of recession.
Open Market Operations
Open market operations (OMOs) are the purchase and sale of securities in the open market by a central bank.
learning objectives
• Discuss the use of open market operations to implement monetary policy
The Federal Reserve has several tools at its disposal to reach its monetary policy objectives. These include the discount rate, the fed funds target rate, and the reserve requirement, and open market operations (OMOs). OMOs are considered to be the most flexible option for the Federal Reserve out of all of these.
On a general level, OMO are the purchase and sale of securities in the open market by a central bank, as a means of controlling the money supply and the related prevailing interest rate.
US Treasury Bill Yields: By buying and selling US Treasury bills on the open market, the Federal Reserve hopes to change their yields, which will then affect the interest rates in the broader market.
In the United States, the Federal Reserve Bank of New York conducts open market operations. They are under the oversight of the Federal Reserve Open Market Committee (FOMC). The FOMC makes a plan for open market operations over the short term, and publicly announce it after their regularly scheduled meetings.
Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.
OMO Mechanism
OMOs are typically either expansionary or contractionary in nature. In an expansionary platform, the OMO will seek to increase the money supply and reduce interest rates in order to promote economic growth. In a contractionary scheme, the OMO will seek to reduce the money supply and increase interest rates in an effort to deter economic growth. Therefore, the implementation of contractionary policy will result in the selling of bonds (cash in exchange for debt holding) and an expansionary policy (buy bonds in exchange for cash) will result in an increase in the money supply at a lower interest rate as a means to enhance growth opportunities and revitalize the economy.
The interest rate targeted through the OMO manipulation of the money supply is the fed funds target rate or the rate that member Fed banks charge one another for overnight loans. The target rate is important monetary tool from the perspective that the higher the fed funds rate relative to the return on loanable funds, the greater the incentive for banks to meet their reserve requirement (the bank will lose money) thereby placing limits on the growth of the money supply through the loanable funds market. In addition to this direct interest rate channel, the fed funds rate influences many other interest rates in the economy and by so doing contributed to either incentivizing borrowing for growth or disincentivizing the same.
Setting and Achieving the Interest Rate Target
The Federal Reserve (Fed) has an ability to directly influence economic growth and stability through the use of monetary policy.
learning objectives
• Describe the way in which the Federal Reserve targets the interest rate
The Federal Reserve (Fed) has an ability to directly influence economic growth and stability through the use of monetary policy. Though the central bank can directly influence the money supply the majority of its activities center around interest rates, the outcome of changes to the money supply.
Interest Rate Mechanism
The Fed can set a reserve ratio, which is in effect the required reserves (percentage of deposits ) that a bank must hold either on site or at the Fed. The requirement must be satisfied on a daily basis. However, given daily bank dynamics of withdrawals, deposits and loan of funds some banks may fall short of their daily reserve requirement. For banks in need of reserve funds, the overnight or short-term bank loan market is available.
Banks can seek to borrow from other banks holding funds at the Fed. The rate that Fed member banks charge one another is referred to as the Federal Funds rate, or Fed Funds rate for short (rate for funds held at the Fed). The rate is indirectly influenced and targeted by the Fed via a direct channel of open market operations and is communicated to the public as a Fed Funds target range as a standard part of the Fed Open Market Committee communications. It is important to note that the Fed does not set the fed funds target rate, it only issues a range that it targets through active management of the money supply.
Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it. Adding to the money supply will typically lead to lower interest rates, while reducing the money supply will increase interest rates. The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the Fed Funds rate. The fed funds rate will be within the range of the target; if not the Fed will adjust its open market operations (buying and selling of bonds) to achieve the range.
Historical effective federal funds target rate: The graphic depicts the movement in the effective federal funds target rate. The target rate has historically been set in terms of a range; the current range as depicted in the graph is 0.00 to 0.25 percent.
Executing Expansionary Monetary Policy
Central banks initiate expansionary policy during periods of economic slowing, increasing the money supply and reducing interest rates.
learning objectives
• Explain common expansionary monetary policy tools
Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is essentially the price of money. The two variables have an inverse relationship. As a result, as the money supply in an economy is increased, the interest rate will generally decrease and if the money supply is contracted, interest rates will generally increase.
Relationship between money supply and interest rates: As money supply increases, the interest rate decreases, as depicted in the graph above.
The money supply is a monetary policy mechanism available to a central bank as part of its mandate to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls the demand for funds increases, thereby expanding consumer and investment spending and promoting economic growth.
Expansionary policy
An active expansionary policy increases the size of the money supply, decreasing the interest rate. Central banks can increase the money supply through open market operations and changes in the reserve requirement.
Bank reserves
Banks and other depository institutions are required to keep a certain amount of funds in reserve in order to maintain enough liquidity to meet unexpected demand for deposits. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve (the Fed). By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.
In an expansionary policy regime, the Fed would reduce the reserve requirement. Banks would be able to issue more loans with the same reserves, thereby increasing the supply of money and the level of economic activity and investment.
Federal Funds market
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the ” fed funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.
Expansionary monetary policy will seek to reduce the fed funds target rate (a range). The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.
Open market operations
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
In an expansionary policy regime, the Fed purchases government securities from a bank in exchange for cash. Payment for the bonds increases the bank’s reserves. As a result, the bank may have more reserves than required. The bank can lend these unneeded reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.
Executing Restrictive Monetary Policy
The central bank may initiate a contractionary or restrictive monetary policy to slow growth.
learning objectives
• Explain common restrictive monetary policy tools
Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is the price of money. The interest rate, therefore, has an inverse relationship with the money supply. As a result, as the money supply in an economy is decreased, the interest rate is assumed to increase and if the money supply is increased, interest rates are typically assumed to decrease.
Contractionary monetary policy: Contractionary monetary policy results in a reduction in the money supply, depicted as a leftward shift, which results in an increase in interest rates as well as a decrease in the quantity of loanable funds.
The money supply is a monetary policy mechanism available to a central bank as part of its initiatives to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls, economic theory assumes that the demand for funds will increase, thereby expanding consumer and investment spending and promoting economic growth. During periods where the economy is showing signs of growing too quickly or operating above full employment, the central bank may initiate a contractionary or restrictive monetary policy by reducing the money supply and allowing interest rates to increase and economic growth to slow.
Restrictive policy
An active contractionary policy restricts the size of the money supply, increasing the interest rate. Central banks can decrease the money supply through open market operations and changes in the reserve requirement.
Bank reserves
Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.
In a contractionary policy regime, the Fed would increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.
Federal funds market
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the “funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is lower than the demand, then the funds rate increases.
At higher fed funds rates, banks are more likely to limit borrowing and their provision of loanable funds, thereby decreasing access to loanable funds and reducing economic growth.
Restrictive monetary policy will seek to increase the fed funds target rate. The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.
Open market operations
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
In a contractionary policy regime, the Fed sells government securities from a bank in exchange for cash. Payment for the bonds decreases the bank’s reserves, reducing the supply of funds that the bank has for loans. The Fed’s open market purchase decreases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) increases. In net, this reduces the financial resources available to stimulate growth and leads to a contraction in the economy.
The Taylor Rule
Taylor’s rule was designed to provide monetary policy guidance for how a central bank should set short-term interest rates.
learning objectives
• Explain the Taylor Rule and its use by central banks
The Taylor rule is a formula developed by Stanford economist John Taylor. It was designed to provide monetary policy guidance for the Federal Reserve. The formula suggests short-term interest rates depending on changing economic conditions, in order to keep the economy stable in the short term, and minimize inflation over the long term.
Professor John Taylor: Stanford University Professor John Taylor is the creator of the Taylor Rule, a monetary policy instrument developed to promote stable economic growth and limit short-run economic disruption related to inflation.
The rule stipulates how much a central bank should change the nominal interest rate (real rate plus inflation) in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.
The factors that the Taylor rule suggests taking into account when setting inflation-adjusted short-term interest rates are:
1. the level of actual inflation relative to the target,
2. how far economic activity is above or below its “full employment” level, and
3. what the level of the short-term interest rate is that would be consistent with full employment.
The Taylor rule advocates setting interest rates relatively high (contractionary policy) when inflation is high or when the employment rate exceeds the economy’s full employment level. Expansionary policies with low interest rates are recommended by the Taylor rule in times when the economy is slow (i.e. unemployment is high, or inflation is low).
The Taylor rule doesn’t always provide an easy answer. For example, in times of stagflation, inflation may be high while unemployment is also high. However, the Taylor rule can still provide a handy “rule of thumb” to policy makers on how to balance these conflicting issues when setting the interest rates.
The Taylor rule fairly accurately demonstrates how monetary policy has been conducted under recent leaders of the Federal Reserve, such as Volker and Greenspan. However, the Federal Reserve does not follow the Taylor rule as an explicit policy.
Key Points
• The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impacts the amount of loanable funds available.
• Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio.
• The higher the reserve requirement is set, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.
• The Fed targets the rate for federal funds via its open market operations.
• The Fed seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate.
• The discount rate difference over the fed funds rate can be varied by the Fed based on bank liquidity needs.
• Banks may borrow reserves from one another overnight in order to maintain their required reserve ratio. The rate of interest negotiated between banks for these loans is the Federal Funds rate.
• The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates. Thus, a high Federal Funds rate is contractionary, while a low federal funds rate is expansionary.
• The Federal Reserve doesn’t control the Federal Funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.
• The Fed doesn’t control the federal funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.
• In the United States, the Federal Reserve Bank of New York uses open market operations to implement monetary policy.
• This occurs under the oversight of the Federal Reserve Open Market Committee (FOMC).
• The short-term objective for open market operations is specified by the FOMC and is publicly communicated following the FOMC meeting.
• Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.
• Though the Fed can directly influence the money supply through open market operations, the majority of the Fed’s activities seek to target interest rates, the outcome of changes in money supply.
• Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it.
• The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the fed funds rate.
• In an expansionary policy regime, the Fed would reduce the reserve requirement, thereby effectively increasing the amount of loans that a bank can issue.
• Expansionary monetary policy will seek to reduce the fed funds target rate (a range).
• In an expansionary policy regime, the Fed purchases government securities via open market operations from a bank in exchange for cash; the Fed’s purchase increases the supply of reserves (money) to the banking system, and the federal funds rate ( interest rate ) falls.
• In a contractionary policy regime, the Fed may increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.
• Restrictive monetary policy will seek to increase the fed funds rate, which is the interest banks charge on loans to other banks.
• In a contractionary policy regime, the Fed uses open market operations to sell government securities from a bank in exchange for cash and thereby reduce the money supply and increase interest rates.
• The rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation ) should be determined according to three factors.
• The rule recommends a relatively high interest rate (contractionary monetary policy ) when inflation is above its target or when the economy is above its full employment level.
• The rule recommends a relatively low interest rate (expansionary monetary policy) when inflation is below its target or when the economy is below its full employment level.
Key Terms
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• money supply: The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.
• loanable funds: Money available to be issued as debt.
• open market operations: An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.
• discount rate: An interest rate that a central bank charges to depository institutions that borrow reserves from it.
• fed funds rate: Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.
• reserve: Banks’ holdings of deposits in accounts with their central bank.
• federal funds rate: The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.
• fed funds target rate: The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.
• open market operations: An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.
• reserve ratio: A central bank regulation employed by most, but not all, of the world’s central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).
• reserve requirement: The minimum amount of deposits each commercial bank must hold (rather than lend out).
• full employment: A state when an economy has no cyclical or deficient-demand unemployment.
• Taylor Rule: A way of determining the appropriate change in interest rates for a given change in inflation.
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The Impact of Monetary Policy on Aggregate Demand, Prices, and Real GDP
Changes in a country’s money supply shifts the country’s aggregate demand curve.
learning objectives
• Recognize the impact of monetary policy on aggregate demand
Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the combination of consumer spending, investments, government spending, and net exports within a given economic system (often written out as $\mathrm{AD = C + I + G + nX}$). As a result of this, increases in overall capital within an economy impacts the aggregate spending and/or investment. This creates a relationship between monetary policy and aggregate demand.
This brings us to the aggregate demand curve. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is also referred to as the effective demand.
The aggregate demand curve illustrates the relationship between two factors – the quantity of output that is demanded and the aggregated price level. Another way of defining aggregate demand is as the sum of consumer spending, government spending, investment, and net exports. The aggregate demand curve assumes that money supply is fixed. Altering the money supply impacts where the aggregate demand curve is plotted.
Contractionary Monetary Policy
Contractionary monetary policy decreases the money supply in an economy. The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP). In addition, the decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the aggregate demand curve to the left. This reduction in money supply reduces price levels and real output, as there is less capital available in the economic system.
Aggregate Demand Graph: This graph shows the effect of expansionary monetary policy, which shifts aggregate demand (AD) to the right.
Expansionary Monetary Policy
Expansionary monetary policy increases the money supply in an economy. The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. This increase will shift the aggregate demand curve to the right.
In addition, the increase in money supply would lead to movement up along the aggregate supply curve. This would lead to a higher prices and more potential real output.
The Effect of Expansionary Monetary Policy
An expansionary monetary policy is used to increase economic growth, and generally decreases unemployment and increases inflation.
learning objectives
• Analyze the effects of expansionary monetary policy
Monetary policy is referred to as either being expansionary or contractionary. Expansionary policy seeks to accelerate economic growth, while contractionary policy seeks to restrict it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. This is done by increasing the money supply available in the economy.
Expansionary policy attempts to promote aggregate demand growth. As you may remember, aggregate demand is the sum of private consumption, investment, government spending and imports. Monetary policy focuses on the first two elements. By increasing the amount of money in the economy, the central bank encourages private consumption. Increasing the money supply also decreases the interest rate, which encourages lending and investment. The increase in consumption and investment leads to a higher aggregate demand.
It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to growing the economy, the agents will anticipate future prices to be higher than they would be otherwise. The private agents will then adjust their long-term plans accordingly, such as by taking out loans to invest in their business. But if the agents believe that the central bank’s actions are short-term, they will not alter their actions and the effect of the expansionary policy will be minimized.
The Basic Mechanics of Expansionary Monetary Policy
A central bank can enact an expansionary monetary policy several ways. The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. Commonly, the central bank will purchase government bonds, which puts downward pressure on interest rates. The purchases not only increase the money supply, but also, through their effect on interest rates, promote investment.
Because the banks and institutions that sold the central bank the debt have more cash, it is easier for them to make loans to its customers. As a result, the interest rate for loans decrease. Businesses then, presumably, use the money it borrowed to expand its operations. This leads to an increase in jobs to build the new facilities and to staff the new positions.
The increase in the money supply is inflationary, though it is important to note that, in practice, different monetary policy tools have different effects on the level of inflation.
Other Methods of Enacting Expansionary Monetary Policy
Another way to enact an expansionary monetary policy is to increase the amount of discount window lending. The discount window allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. Decreasing the rate charged at the discount window, the discount rate, will not only encourage more discount window lending, but will put downward pressure on other interest rates. Low interest rates encourage investment.
Bank of England Interest Rates: The Bank of England (the central bank in England) undertook expansionary monetary policy and lowered interest rates, promoting investment.
Another method of enacting a expansionary monetary policy is by decreasing the reserve requirement. All banks are required to have a certain amount of cash on hand to cover withdrawals and other liquidity demands. By decreasing the reserve requirement, more money is made available to the economy at large.
The Effect of Restrictive Monetary Policy
A restrictive monetary policy will generally increase unemployment and decrease inflation.
learning objectives
• Analyze the effects of restrictive monetary policy
Monetary policy is can be classified as expansionary or restrictive (also called contractionary). Restrictive monetary policy expands the money supply more slowly than usual or even shrinks it, while and expansionary policy increases the money supply. It is intended to slow economic growth and/or inflation in order to avoid the resulting distortions and deterioration of asset values
Business cycle: Restrictive monetary policy is used during expansion and boom periods in the business cycle to prevent the overheating of the economy.
Contractionary policy attempts to slow aggregate demand growth. As you may remember, aggregate demand is the sum of private consumption, investment, government spending and imports. Monetary policy focuses on the first two elements. By decreasing the amount of money in the economy, the central bank discourages private consumption. Increasing the money supply also increase the interest rate, which discourages lending and investment. The higher interest rate also promotes saving, which further discourages private consumption. The decrease in consumption and investment leads to a decrease in growth in aggregate demand.
It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to limiting inflation through restrictive monetary policy, the agents will anticipate future prices to be lower than they would be otherwise. The private agents will then adjust their long-term strategies accordingly, such as by putting plans to expand their operations on hold. But if the agents believe that the central bank’s actions will soon be reversed, they may not alter their actions and the effect of the contractionary policy will be minimized.
The Basic Mechanics of Expansionary Monetary Policy
A central bank can enact a contractionary monetary policy several ways. The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. The central bank can issue debt in exchange for cash. This results in less cash being in the economy.
Because the banks and institutions that purchased the debt from the central bank have less cash, it is harder for them to make loans to its customers. As a result, the interest rate for loans increase. Businesses then, presumably, have less money to use to expand its operations or even maintain its current levels. This could lead to an increase in unemployment.
The higher interest rates also can slow inflation. Consumption and investment are discouraged, and market actors will choose to save instead of circulating their money in the economy. Effectively, the money supply is smaller, and there is reduced upward pressure on prices since demand for consumption goods and services has dropped.
Other Methods of Enacting Restrictive Monetary Policy
Another way to enact a contractionary monetary policy is to decrease the amount of discount window lending. The discount window allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions
A final method of enacting a contractionary monetary policy is by increasing the reserve requirement. All banks are required to have a certain amount of cash on hand to cover withdrawals and other liquidity demands. By increasing the reserve requirement, less money is made available to the economy at large.
Limitations of Monetary Policy
Limitations of monetary policy include liquidity traps, deflation, and being canceled out by other factors.
learning objectives
• Describe obstacles to the Federal Reserve’s monetary policy objectives
Monetary policy is the process by which the monetary authority of a country controls the supply of money with the purpose of promoting stable employment, prices, and economic growth. Monetary policy can influence an economy but it cannot control it directly. There are limits as to what monetary policy can accomplish. Below are some of the factors that can make monetary policy less effective.
Multiple Factors Influencing Economy
While monetary policy can influence the elements listed above, it is not the only thing that does. Fiscal policy can also directly influence employment and economic growth. If these two policies do not work in concert, they can cancel each other out. This is an especially significant problem when fiscal policy and monetary policy are controlled by two different parties. One party might believe that the economy is teetering on recession and may pursue an expansionary policy. The other group may believe the economy is booming and pursue a contractionary policy. The result is that the two would cancel each other, so that neither would influence the direction of the economy.
Liquidity Trap
A liquidity trap is a situation where injections of cash into the private banking system by a central bank fail to lower interest rates and therefore fail to stimulate economic growth. Usually central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little to no interest, which makes them nearly equivalent to cash. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.
Liquidity Trap: Sometimes, when the money supply is increased, as shown by the Liquidity Preference-Money Supply (LM) curve shift, it has no impact on output (GDP or Y) or on interest rates. This is a liquidity trap.
A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.
Deflation
Deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0%. This should not be confused with disinflation, a slowdown in the inflation rate. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money. This allows one to buy more goods with the same amount of money over time.
From a monetary policy perspective, deflation occurs when there is a reduction in the velocity of money and/or the amount of money supply per person. The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.
Deflation is a problem in a modern economy because it increases the real value of debt and may aggravate recessions and lead to a deflationary spiral. If monetary policy is too contractionary for too long, deflation could set in.
Using Monetary Policy to Target Inflation
Inflation targeting occurs when a central bank attempts to steer inflation towards a set number using monetary tools.
learning objectives
• Assess the use of inflation targets and goals in monetary policy
Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or “target”, inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.
Fed Reserve Seal: The United States Federal Reserve uses a form of inflation targeting when coordinating its monetary policy.
Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples include:
• if inflation appears to be above the target, the bank is likely to raise interest rates. This usually has the effect over time of cooling the economy and bringing down inflation;
• if inflation appears to be below the target, the bank is likely to lower interest rates. This usually has the effect over time of accelerating the economy and raising inflation.
Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.
The United States Federal Reserve, the country’s central bank, practices a version of inflation targeting. Instead of setting a specific number, the Fed sets a target range.
Criticisms of Inflation Targeting
Increases in inflation, measured by changes in the consumer price index (CPI), are not necessarily coupled to any factor internal to country’s economy. Strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.
It has been argued that focusing on inflation may inhibit stable employment and exchange rates. Supporters of a nominal income target also criticize the tendency of inflation targeting to ignore output shocks by focusing solely on the price level. They argue that a nominal income target is a better goal.
Key Points
• Aggregate demand (AD) is the sum of consumer spending, government spending, investment, and net exports.
• The AD curve assumes that money supply is fixed.
• The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product ( GDP ).
• The decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the AD curve to the left.
• The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP).
• The increase in the money supply will lead to an increase in consumer spending. This increase will shift the AD curve to the right.
• Increased money supply causes reduction in interest rates and further spending and therefore an increase in AD.
• The primary means a central bank uses to implement an expansionary monetary policy is through purchasing government bonds on the open market.
• Another way to enact an expansionary monetary policy is to increase the amount of discount window lending.
• A third method of enacting a expansionary monetary policy is by decreasing the reserve requirement.
• Another way to enact a restrictive monetary policy is to decrease the amount of discount window lending.
• A final method of enacting a restrictive monetary policy is by increasing the reserve requirement.
• The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. The central bank can issue or resell its debt in exchange for cash. It can also sell off some of its reserves in gold or foreign currencies.
• A liquidity trap is a situation where injections of cash into the private banking system by a central bank fail to lower interest rates and therefore fail to stimulate economic growth.
• Deflation is a decrease in the general price level of goods and services. Deflation is a problem in a modern economy because it increases the real value of debt and may aggravate recessions and lead to a deflationary spiral.
• Fiscal policy can also directly influence employment and economic growth. If these two policies do not work in concert, they can cancel each other out.
• Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.
• If inflation appears to be above the target, the bank is likely to raise interest rates; if inflation appears to be below the target, the bank is likely to lower interest rates.
• Increases in inflation, measured by the consumer price index (CPI), are not necessarily coupled to any factor internal to country’s economy and strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.
Key Terms
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• expansionary monetary policy: Traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.
• unemployment: The state of being jobless and looking for work.
• contractionary monetary policy: Central bank actions designed to slow economic growth.
• deflation: A decrease in the general price level, that is, in the nominal cost of goods and services.
• consumer price index: A statistical estimate of the level of prices of goods and services bought for consumption purposes by households.
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Volcker Disinflation
Paul Volcker, the 12th Chairman of the Federal Reserve, became known for lowering the inflation rate and achieving price stability.
learning objectives
• Evaluate the benefits and consequences of Paul Volcker’s actions as chairman of the Federal Reserve Board of Governors
Paul Volcker
Paul Volcker is an American economist who was appointed by President Carter in 1979 to be the 12th Chairman of the Federal Reserve of the United States (the Fed). He was reappointed by President Reagan and served as chairman until August of 1987. During his time as the Chairman of the Fed, Volcker is credited with ending the high levels of inflation that the United States experienced during the 1970s and early 1980s. Volcker was also appointed as the chairman of the Economic Recovery Advisory Board under President Obama from 2009 to 2011.
Paul Volcker: Paul Volcker was the 12th Chairman of the Federal Reserves. He became known for decreasing inflation during the early 1980s.
Benefits During Volcker’s Tenure
During his time as chairman, Paul Volcker led the Federal Reserve board and helped to end the stagflation crisis of the 1970s. The inflation rate had remained high throughout the 1970s, while the growth rate was slow and the unemployment was high. When he became chairman in 1979, inflation was high and peaked in 1981 at 13.5%. However, due to the work of Volcker and the rest of the board, the inflation rate dropped to 3.2% by 1983.
Volcker raised the federal funds target rate from 11.2% in 1979 to 20% in June of 1981. The unemployment rate became higher than 10% during this time as well. The economy was restored by 1982 as a result of the tight-money policy put in place by the Fed. Volcker chose to enact a policy of preemptive restraint during the economic upturn which increased the real interest rates. Volcker’s policy also pushed the President and Congress to adopt a plan to balance the budget. Volcker’s tenure as the chairman of the Federal Reserve resulted in sound monetary and fiscal integrity that achieved the goal of price stability.
Consequences From Volcker’s Tenure
Despite his level of success in certain areas, Volcker’s Federal Reserve board drew some of the strongest political attacks and protests in the history of the Federal Reserve. The protests were a result of the negative effects that the high interest rates had on the construction and farming industries. Nobel laureate Joseph Stiglitz explained “Paul Volcker, the previous Fed Chairman known for keeping inflation under control, was fired because the Reagan Administration didn’t believe he was an adequate deregulator. ”
Despite the protests, Paul Volcker was respected for the work that he did while he was the chairman of the Federal Reserve. Congressman Ron Paul was a harsh critic of the Fed, but he commented about Volcker by saying, “If I had to name a Federal Reserve chairman that did a little bit of good, that would be Paul Volcker. ” Volcker received the U.S. Senator John Heinz Award for Greatest Public Service by an elected or Appointed Official in 1983.
Greenspan Era
Alan Greenspan was Chairman of the Federal Reserve from 1987 to 2006.
learning objectives
• Summarize the actions taken during Alan Greenspan’s tenure as chairman of the Federal Reserve Board of Governors
Alan Greenspan
Alan Greenspan is an American economist who served as the Chairman of the Federal Reserve of the United States from 1987 to 2006. He had the second longest tenure in the position. He was appointed by Ronald Reagan in 1987 and reappointed in four-year intervals, finally retiring on January 31, 2006.
Alan Greenspan: Alan Greenspan was the 13th Chairman of the Federal Reserve. He held the position from 1987 until 2006. His tenure as the chairman was marked by low interest rates which eventually were blamed for the 2007 mortgage crisis in the United States.
Chairman of the Federal Reserve
The stock market crashed in 1987 shortly after Greenspan became Chairman of the Federal Reserve (the Fed). He stated the the Fed was ready “to serve as a source of liquidity to support the economic and financial system. ” Throughout his early years as chairman, Greenspan impacted all the presidencies in various ways. President George H.W. Bush blamed federal policy when he was not reappointed for a second term.
During President Clinton’s terms in office, Greenspan was consulted regarding economic affairs and assisted in the 1993 deficit reduction program. As a whole, the 1990s saw healthy economic growth.
The most notable actions taken during Greenspan’s tenure as chairman began in 2000. He raised interest rates several times in 2000 which was likely this cause of the bursting of the dot-com bubble. In 2001, Greenspan and the Fed initiated a series of interest cuts that brought the Federal Funds rate down to 3% following the September 11, 2001 terror attacks. The Federal Funds rate continued to drop until it was 1% in 2004. Greenspan believed that a group in rates would lead to a surge in home sales and refinancing. In February of 2004, Greenspan suggested that homeowners should consider taking out adjustable-rate mortgages (ARMS) where the interest rate adjusts to the current interest rate in the market. A few months later, Greenspan began raising the interest rates. Interest rate funds increased to 5.25% about two years later.
The Housing Bubble
In 2007, only months after Greenspan retired, the subprime mortgage crisis occurred in the United States. It is suggested that Greenspan’s easy-money policies were the leading cause of the mortgage crisis. When homeowners took out subprime ARMS in 2004, the interest rates were set much higher than what the homeowners paid the first few years of the mortgages. In 2009, Robert Reich explained that the lower interest rates in 2004 allowed banks to borrow money for free. As a result, the banks borrowed large amounts of money, lent it out to borrowers, and earned substantial profits. Without government oversight for lending institutions, banks lent money to unfit borrowers. Greenspan did not think the oversight was necessary. He trusted that the market would weed out bad credit risks, but it did not. In 2008, Greenspan admitted during Congressional testimony that he had put too much faith in the self-correcting power of free markets. He had not anticipated the self-destructive power of irresponsible mortgage lending. Greenspan did not accept responsibility for creating the housing bubble that led to the mortgage crisis. He simply stated that he did not believe in deregulation as strongly following the crisis.
Bernanke Era
The Bernanke Era has included challenges faced by the Federal Reserve such as the financial crisis, strengthening federal policy, and reducing the deficit.
learning objectives
• Review the challenges faced by Ben Bernanke during his time as chairman of the Federal Reserve Board of Governors
Ben Bernanke
Ben Bernanke is an American economist and chairman of the Federal Reserve (the Fed) through January 2014. He was appointed chairman by President Bush and reappointed by President Obama. During his tenure as chairman, Bernanke has been responsible for overseeing the Federal Reserve’s response to the financial crisis.
Ben Bernanke: Ben Bernanke (right) was appointed chairman of the Federal Reserve by President Bush and he was reappointed by President Obama. Throughout his time as chairman, Bernanke has influenced the financial crisis, the Wall Street bailout, and the economic stimulus.
The Great Moderation
Ben Bernanke was one of the first individuals to discuss “the Great Moderation” which is the theory that traditional business cycles have declined in volatility in recent decades because of structural changes that have occurred in the international economy. The primary structural changes include increases in the economic stability of developing nations and the diminished influence of monetary and fiscal policy.
The Great Moderation is important because while Bernanke was chairman of the Federal Reserve, it is speculated the the economic and financial crisis in the later-2000s brought the period of the Great Moderation to an end. The period was known for predictable policy, low inflation, and modest business cycles.
The Bernanke Doctrine
Ben Bernanke gave a speech in 2002, before he became chairman of the Federal Reserve. He emphasized that Congress gave the Fed responsibility for preserving price stability – avoiding inflation and deflation. He also identified seven specific measures for the Fed to reduced deflation. These seven measures were:
1. Increase the money supply
2. Ensure liquidity makes its way into the financial system
3. Lower interest rates all the way down to 0%
4. Control the yield on corporate bonds and other privately issued securities
5. Depreciate the U.S. dollar
6. Execute a de facto depreciation
7. Buy industries throughout the U.S. economy with “newly created money”
Chairman of the Federal Reserve
As Chairman of the Federal Reserve, Bernanke sits on the Financial Stability Oversight Board and is also Chairman of the Federal Open Market Committee, the Fed’s principal monetary policy making body. One of Bernanke’s first main challenges was balancing his comments and how they were influenced by the media. As an advocate for more transparent federal policy, Bernanke stated clearer inflation goals, but his public statements negatively impacted the stock market. As a result, he did not continue to make public statements about the direction of the Federal Reserve.
The main controversies surrounding Bernanke’s terms as chairman include how he handled the financial crisis, particularly failing to see the crisis, for bailing out Wall Street, and for injecting \$600 billion into the banking system to give the slow economic recovery a boost.
Two areas that received prominent attention include:
• The Merrill Lynch merger with Bank of America: New York state Attorney General Andrew Cuomo wrote a letter to Congress in 2009 accusing Bernanke and the treasury secretary of fraud concerning the acquisition of Merrill Lynch by Bank of America. Cuomo stated that the extent of Merrill Lynch’s losses were not disclosed to Bank of America by Bernanke or the treasury secretary. Bernanke was questioned in Congressional hearings as to whether he bullied individuals when the merger was invoked. Bernanke stated that the Fed did nothing illegal when they tried to convince Bank of America to not end the merger.
• AIG bailout: It was stated that Bernanke had overruled recommendations from his staff regarding the AIG bailout. The question arose as to whether it had been necessary to bailout AIG. Senators from both parties supported Bernanke and said that the AIG bailout averted worse problems. They stated that act of averting worse problems outweighed any responsibility that he had for the financial crisis.
In 2010, Bernanke also expressed his views regarding deficit reduction and reforming Social Security / Medicare. He favored reducing the U.S. budget deficit. He stated that reforming Social Security and Medicare entitlement programs would help reduce the deficit. He believed that a credible plan needed to be developed in order to address the funding crisis that is pending. He explained that without reform, the U.S. will not have financial stability or healthy economic growth. His comments were directed at Congress and the President since reform in fiscal exercise is not in the power of the Federal Reserve. He emphasized that deficit reduction would need to consist of raising taxes, cutting entitlement payments, and reducing government spending.
Key Points
• During his time as the chairman of the Fed, Volcker is credited with ending the high levels of inflation that the United States experienced during the 1970s and early 1980s.
• When he became chairman in 1979, inflation was high and peaked in 1981 at 13.5%. However, due to the work of Volcker and the rest of the board, the inflation rate dropped to 3.2% by 1983.
• Volcker raised the federal funds rate from 11.2% in 1979 to 20% in June of 1981. The unemployment rate became higher than 10% during this time as well.
• Volcker chose to enact a policy of preemptive restraint during the economic upturn which increased the real interest rates.
• Despite his level of success, Volcker’s Federal Reserve board drew some of the strongest political attacks and protests in the history of the Federal Reserve. The protests were a result of the negative effects that the high interest rates had on the construction and farming industries.
• In 1987, Greenspan stated that the Fed was ready “to serve as a source of liquidity to support the economic and financial system” following the stock market crash.
• Greenspan influenced each presidency during his tenure as chairman. He provided economic consultation for President Clinton and assisted in the deficit reduction program in 1993.
• He raised interest rates several times in 2000 which was likely this cause of the bursting of the dot-com bubble. In 2001, Greenspan began to lower interest rates. By 2004, the Federal Funds rate was 1%.
• In 2004, Greenspan urged homeowners to take out ARMS. Over the next two years, the interest rates increased to 5.25% which contributed to the mortgage crisis in 2007.
• During his tenure as chairman, Bernanke has been responsible for overseeing the Federal Reserve ‘s response to the financial crisis.
• Ben Bernanke was one of the first individuals to discuss “the Great Moderation” which is the theory that traditional business cycles have declined in volatility in recent decades because of structural changes that have occurred in the international economy.
• The financial crisis in the later-2000s brought the period of the Great Moderation to an end.
• The main controversies surrounding Bernanke’s terms as chairman include how he handled the financial crisis, particularly failing to see the crisis, for bailing out Wall Street, and for injecting \$600 billion into the banking system to give the slow economic recovery a boost.
• Bernanke also focused on the importance of reducing the deficit and reforming entitlement programs in order to achieve financial stability and economic growth.
Key Terms
• stagflation: Inflation accompanied by stagnant growth, unemployment, or recession.
• inflation: An increase in the general level of prices or in the cost of living.
• interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
• financial crisis: A period of serious economic slowdown characterized by devaluing of financial institutions often due to reckless and unsustainable money lending.
• deflation: A decrease in the general price level, that is, in the nominal cost of goods and services.
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Institutions, Markets, and Intermediaries
A financial intermediary is an institution that facilitates the flow of funds between individuals or other economic entities.
learning objectives
• Review the purpose and types of financial intermediaries
A financial intermediary is an institution that facilitates the flow of funds between individuals or other economic entities having a surplus of funds (savers) to those running a deficit of funds (borrowers). Banks are a classic example of financial institutions.
Banks provide a safe and accessible environment for individuals and economic entities to deposit excess funds Additionally, banks also provide a service by packaging deposits into loans that are made available to economic agents (individuals and entities) in need of funds.
Banks are the most common financial intermediaries: Banks convert deposits to loans and thereby increase access to capital by serving as a financial intermediary between savers and borrowers.
Though, perhaps the most well-known of financial intermediaries, banks represent only one intermediary within a larger group. Other financial intermediaries include: credit unions, private equity, venture capital funds, leasing companies, insurance and pension funds, and micro-credit providers.
Major functions of financial intermediaries
As noted, financial intermediaries provide access to capital. However, in conjunction with increasing access to funds, through their ability to aggregate funds, intermediaries also reduce the transaction and search costs between lenders and borrowers.
By repurposing funds from savers to borrowers financial intermediaries are able to promote economic growth by providing access to capital. Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles and through creating loans of varying lengths from investor monies or demand deposits, these intermediaries are able to convert short-term liabilities to assets of varying maturities.
Returning to the example of a bank used above, banks convert short-term liabilities (demand deposits) into long-term assets by providing loans; thereby transforming maturities. Additionally, through diversified lending practices, banks are able to lend monies to high-risk entities and by pooling with low-risk loans are able to gain in yield while implementing risk management.
Role in Matching Savings and Investment Spending
Savings are income after-consumption and investment is what is facilitated by saving.
learning objectives
• Explain the connection between savers and investors
A popular national income accounting framework for discussing the economy is the GDP expenditure equation:
$Y=C+I+G+(X−M),$ where $C$ refers to consumption spending, II references investment spending, $G$ is government spending, and $X−M$ is net imports ($X$, exports;$M$, imports). Savings is defined as income that is not consumed. $C$ is consumption. Investment, $I$, is made into capital (plant and machinery, also ‘ human capital ‘ – training and education), with intent to increase productivity, efficiency and output of goods and services. $I$ can be generally defined as purchases of good that will be used to produce more goods and services in the future. In national accounting terms, stocks, bonds, mutual funds, and other cash equivalents, are not classified as investments but rather are classified as savings. Savings from this perspective facilitates capital purchase which are included in investments
Saving is what households (participants in the consumption account) do. The level of saving in the economy depends on a number of factors:
• A higher real interest rates increases returns to saving.
• Poor expectations for future economic growth, increase households’ savings as a precaution.
• More disposable income after fixed expenditures (such as mortgage, heating bill, basic goods purchases) have been made increases saving.
• Perceived likelihood of reduced return through regulation or taxation on savings will make saving less attractive.
Marginal propensity to save
The factors as stated affect the marginal propensity to save (MPS), the percentage of after-tax income that an economic agent will choose to save. The greater the MPS, the more saving households will do as a proportion of each additional increment of income. Stocks and bonds are considered to be important intermediary forms of savings as these get transformed into a capital investment that produces value.
Bonds are a type of savings: Savings are used to fund investments, where investments are defined as expenditures on factory plants, equipment and homes.
Savings and Investment
Assuming a closed economy, one where there is no export or impart activity to interfere with the domestic savings level, on an aggregate basis individual savings creates the supply of loanable funds available for investment purposes. The amount of savings available in the economy is equal to the amount of funding available for investment activity. The higher the level of savings, typically the lower the relative interest rate, ceteris paribus. On a macroeconomic theory basis, a higher the savings rate promotes business activity my lessening the cost of money and increasing risk taking activities to facilitate growth or production of goods and services.
Financial intermediaries can assist with increasing the incentive to save through developing financial products that offer ease of liquidation but provide a higher return than a savings account. In this manner, financial intermediaries are a significant component to the transformation of savings into investment. Mutual funds, pension obligations, insurance annuities, and other forms of savings marketed by financial intermediaries all consist of stocks, bonds, and cash balances, which in turn pay for the investment capital that increases productivity, efficiency and output of goods and services.
Role in Providing a Market for Loanable Funds
The loanable funds market is a conceptual market where savers (suppliers) and borrowers (demanders) are able to establish a market clearing.
learning objectives
• Summarize the mechanics of the loanable funds market.
In economics, the loanable funds market is a conceptual market where savers (suppliers) and borrowers (demanders) are able to establish a market clearing quantity and price (interest rate). In the loanable funds market, market clearing is defined as the interest rate/loanable funds quantity where savings equal investment (the amount of capital needed for property, plant, and equipment based investments). Loanable funds are typically cash, but can also include other financial assets to serve as an intermediary.
Equilibrium in the loanable funds market: When the supply and demand for loanable funds are equal, savings is equal to investment and the loanable funds market is in equilibrium at the prevailing interest rate.
For instance, buying bonds will transfer savers’ money to the institution issuing the bond, which can be a firm or government. In return, the borrower’s (institution issuing the bond) demand for loanable funds is satisfied when the institution receives cash in exchange for the bond.
Loanable funds are often used to invest in new capital goods. Therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds.
Interest rate
The interest rate is the cost of borrowing or demanding loanable funds and is the amount of money paid for the use of a dollar for a year. The interest rate can also describe the rate of return from supplying or lending loanable funds.
As an example, consider this: a firm that borrows $10,000 in funds for one year, at an annual interest rate of 10%, will have to pay the lender$11,000 at the end of the year. This amount includes the original $10,000 borrowed plus$1,000 in interest; in mathematical terms, this can be written as $\10,000 \times 1.10 = \ 11,000$.
Key Points
• Financial intermediaries provide access to capital.
• Banks convert short-term liabilities ( demand deposits ) into long-term assets by providing loans; thereby transforming maturities.
• Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles.
• The marginal propensity to save (MPS), the percentage of after-tax income that an economic agent will choose to save.
• Savings marketed by financial intermediaries, all consist of stocks, bonds, and cash balances, which in turn pay for the investment capital that increases productivity, efficiency and output of goods and services.
• Financial intermediaries are a significant component to the transformation of savings into investment.
• In the loanable funds market, market clearing is defined as the interest rate /loanable funds quantity where savings equal investment (the amount of capital needed for property, plant, and equipment based investments).
• The interest rate is the cost of borrowing or demanding loanable funds and is the amount of money paid for the use of a dollar for a year.
• Loanable funds are often used to invest in new capital goods. Therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds.
Key Terms
• pooling: grouping together of various resources or assets
• financial intermediary: A financial institution that connects surplus and deficit agents.
• real interest rates: The rate of interest an investor expects to receive after allowing for inflation.
• loanable funds: Money available to be issued as debt.
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