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TABLE OF CONTENTS
1: Principles of Economics
1.1: The Study of Economics
1.2: Individual Decision Making
1.3: Interaction of Individuals, Firms, and Societies
1.4: Basic Economic Questions
1.5: Economic Models
1.6: Differences Between Macroeconomics and Microeconomics
2: The Market System

2.1: Introducing the Market System
3: Introducing Supply and Demand

3.1: Demand
3.2: Supply
3.3: Market Equilibrium
3.4: Government Intervention and Disequilibrium
4: Economic Surplus
4.1: Consumer Surplus
4.2: Producer Surplus
5: Consumer Choice and Utility

5.1: The Demand Curve and Utility
5.2: Theory of Consumer Choice
6: Elasticity and its Implications

6.1: Price Elasticity of Demand
6.2: Other Demand Elasticities
6.3: Price Elasticity of Supply
7: Market Failure: Externalities

7.1: Introducing Market Failure
7.2: Externalities in Depth
7.3: Government Policy Options
7.4: Private Solutions
8: Market Failure: Public Goods and Common Resources

8.1: Public Goods
8.2: Common Resources
9: Production
9.1: The Production Function
9.2: Production Cost
1 https://socialsci.libretexts.org/@go/page/186000
9.3: Economic Profit
10: Competitive Markets

10.1: Perfect Competition
10.2: Production Decisions in Perfect Competition
10.3: Long-Run Outcomes
11: Monopoly
11.1: Introduction to Monopoly
11.2: Barriers to Entry: Reasons for Monopolies to Exist
11.3: Monopoly Production and Pricing Decisions and Profit Outcome
11.4: Impacts of Monopoly on Efficiency
11.5: Price Discrimination
11.6: Monopoly in Public Policy
12: Monopolistic Competition

12.1: Monopolistic Competition
13: Oligopoly
13.1: Prerequisites of Oligopoly
13.2: Oligopoly in Practice
14: Inputs to Production: Labor, Natural Resources, and Technology

14.1: Demand for Labor
14.2: Labor Market Equilibrium and Wage Determinants
14.3: Income Distribution
14.4: Capital and Natural Resource Markets
14.5: Capital, Productivity, and Technology
15: Challenges to Efficient Outcomes

15.1: Sources of Inefficiency
16: Taxes and Public Finance

16.1: Introduction to Taxes What Taxes Do
16.2: Deploying and Measuring Taxes
16.3: Progressive, Proportional, and Regressive Taxes
16.4: Taxation in the United States
16.5: Personal, Property, and Sales Taxes
17: Income Inequality and Poverty

17.1: Defining and Measuring Inequality, Mobility, and Poverty
17.2: Policies for Reducing Poverty
18: Introduction to Macroeconomics

18.1: Key Topics in Macroeconomics
19: Measuring Output and Income
19.1: Measuring Output Using GDP
19.2: Other Measures of Output
19.3: Comparing Real and Nominal GDP
19.4: Cost of Living
20: Economic Growth

20.1: Comparing Economies
20.2: Assessing Growth
20.3: Productivity
20.4: Long-Run Growth
20.5: The Impact of Policy on Growth
21: Inflation
21.1: Defining, Measuring, and Assessing Inflation
22.: Unemployment
22.1: Introduction to Unemployment
22.2: Measuring Unemployment
22.3: Understanding Unemployment
23: Inflation and Unemployment

23.1: The Relationship Between Inflation and Unemployment
24: Aggregate Demand and Supply

24.1: Introducing Aggregate Expenditure
24.2: Introducing Aggregate Demand and Aggregate Supply
24.3: Aggregate Demand
24.4: Aggregate Supply
24.5: The Aggregate Demand-Supply Model
25: Major Macroeconomic Theories

25.1: Major Theories in Macroeconomics
26: Fiscal Policy

26.1: Introduction to Fiscal Policy
26.2: Evaluating Fiscal Policy
27: The Monetary System

27.1: Introducing Money
27.2: Introducing the Federal Reserve
27.3: Creating Money
28: Monetary Policy

28.1: Introduction to Monetary Policy
28.2: Monetary Policy Tools
28.3: Impacts of Federal Reserve Policies
28.4: Historical Federal Reserve Policies
29: The Financial System

29.1: Introducing the Financial System
29.2: Tools of Finance
30: Current Topics in Macroeconomics

30.1: Questions for Debate
31: International Trade

31.1: Introduction to International Trade
31.2: Gains from Trade
31.3: The United States in the Global Economy
31.4: Barriers to Trade
31.5: Arguments for and Against Protectionist Policy
32: Open Economy Macroeconomics

32.1: Capital Flows
32.2: Exchange Rates
32.3: Equilibrium
33: Economic Crises

33.1: Fundamentals of Banking Crises
33.2: Economic Crises
34: Interest and Profit

34.1: Interest
35: Health Care Economics

35.1: Introducing Health Care Economics
36: Natural Resource Economics

36.1: Introduction to Natural Resource Economics
37: Agriculture Economics

37.1: Introduction to the Agriculture Economics
38: Immigration Economics

38.1: Introduction to Immigration Economics
Licensing
Index
Glossary
Detailed Licensing
Licensing
A detailed breakdown of this resource's licensing can be found in Back Matter/Detailed Licensing.
CHAPTER OVERVIEW
1: Principles of Economics
This page titled 1: Principles of Economics is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
1
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.
1.1.1 https://socialsci.libretexts.org/@go/page/3428
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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”.
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.
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.
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.
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.
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
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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CHAPTER OVERVIEW
10: Competitive Markets

Topic hierarchy
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1
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.
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.
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 revenue: The additional profit that will be generated by increasing product sales by one unit.
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.
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.
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.
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.
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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CHAPTER OVERVIEW
11: Monopoly
Topic hierarchy
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1
Defining Monopoly
A monopoly is an economic market structure where a specific person or enterprise is the only supplier of a particular good.
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
differentiation: The act of distinguishing a product from the others in the market.
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Boundless. Provided by: Boundless Learning. Located at: www.boundless.com//management...ifferentiation. License: CC
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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.
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.
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.
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.
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.
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.
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.
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) (11.3.1)
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) (11.3.2)
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:
2
c(q) = 2 + 3q + q (11.3.3)
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 (11.3.4)
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 (11.3.5)
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.
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.
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 , that is, it can produce one widget for $2, two widgets for $8, three widgets for
2
$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:
dT R (30 − 2Q)
= (11.3.6)
dQ 2
dT C
= 4Q (11.3.7)
dQ
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.
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.
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.
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.
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
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.
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.
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.
Analyze the use of price discrimination in commerce
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.

The purpose of price discrimination is to capture the market’s consumer surplus and generate the most revenue possible for a good.
Give examples of price discrimination in common industries
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.

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.
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.
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.
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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CHAPTER OVERVIEW
12: Monopolistic Competition

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12.1 https://socialsci.libretexts.org/@go/page/3511
Defining Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one
another.
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.
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.
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.
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.
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.
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.
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.
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
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.
perfect competition: A type of market with many consumers and producers, all of whom are price takers
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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CHAPTER OVERVIEW
13: Oligopoly
Topic hierarchy
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1
Few Sellers
An oligopoly – a market dominated by a few sellers – is often able to maintain market power through increasing returns to scale.
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.
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.
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.
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.
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.
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.
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.
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.
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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CHAPTER OVERVIEW
14: Inputs to Production: Labor, Natural Resources, and Technology

Topic hierarchy
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1
Marginal Product of Labor (Physical)
The marginal product of labor is the change in output that results from employing an added unit of labor.
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.
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:
ΔTR
MRPL =
ΔL
TR
MR =
ΔQ
ΔQ
MPL =
ΔL
ΔTR ΔQ ΔTR
MR × MPL = ( )×( ) =
ΔQ ΔL ΔL
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.
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
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
MPL
PL
=
MPK
PK
.
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.
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.
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.
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.
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.
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.
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
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.
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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How Income is Allocated
Recent growth in overall income inequality has been driven mostly by increasing inequality in wages and salaries.
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.
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.
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.
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.
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.
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.
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.
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
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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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.
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.
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:
α β
Y = AK L (14.5.1)
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.
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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CHAPTER OVERVIEW
15: Challenges to Efficient Outcomes

Topic hierarchy
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Boundless.
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.
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.
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.
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.
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.
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.
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.
Adverse selection. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Adverse_selection. License: CC BY-SA:
Market failure. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Market_failure. License: CC BY-SA:
adverse selection. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/adverse_selection. License: CC BY-SA:
Moral hazard. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Moral_hazard. License: CC BY-SA: Attribution-
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Information asymmetries. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Information_asymmetries. License:
adverse selection. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/adverse_selection. License: CC BY-SA:
moral hazard. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/moral_hazard. License: CC BY-SA:
Japanese car accident blur. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Ja...ident_blur.jpg. License:
Principle agent problem. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Principle_agent_problem. License:
Objective. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/Objective. License: CC BY-SA: Attribution-
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voting system. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/voting_system. License: CC BY-SA:
Public choice. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Public_choice. License: CC BY-SA: Attribution-
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Voting systems. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Voting_systems. License: CC BY-SA:
Condorcet method. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Condorcet_method. License: CC BY-SA:
paradox. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/paradox. License: CC BY-SA: Attribution-
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Behavioral economics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Behavioral_economics. License: CC
behavioral economics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/behavioral%20economics. License: CC
heuristic. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/heuristic. License: CC BY-SA: Attribution-
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Inefficiency. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Inefficiency. License: CC BY-SA: Attribution-
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expenditure. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/expenditure. License: CC BY-SA: Attribution-
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CHAPTER OVERVIEW
16: Taxes and Public Finance

Topic hierarchy
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1
What Taxes Do
On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government.
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.
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.
image
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.
image
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.
another.
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progressive tax. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/progressive%20tax. License: CC BY-SA:
regressive tax. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/regressive%20tax. License: CC BY-SA:
sales tax. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/sales_tax. License: CC BY-SA: Attribution-
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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.
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.
IRS. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/IRS. License: CC BY-SA: Attribution-ShareAlike
US Income Tax/Introduction. Provided by: Wikibooks. Located at: en.wikibooks.org/wiki/US_Income_Tax/Introduction.
Taxation in the United States. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Taxation_in_the_United_States.
United States Congress. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/United_States_Congress. License: CC
Congress. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/Congress. License: CC BY-SA: Attribution-
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Internal Revenue Service. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/Internal_Revenue_Service.
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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.
Calculate the average tax rate and marginal tax rate
Computing Taxes
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.
change in T
= marginal tax rate (16.3.1)
change in P
Types of Taxes
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.
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.
image
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.
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.
image
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.
image
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.
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.
equity: Justice, impartiality or fairness.
Progressive tax. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Progressive_tax. License: CC BY-SA:
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Financing the US Government
Taxes are the primary source of government revenue.
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.
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.
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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.
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.
Payroll tax. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Payroll...3United_States. License: CC BY-SA:
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CHAPTER OVERVIEW
17: Income Inequality and Poverty

Topic hierarchy
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1
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.
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.
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.
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.
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.
purchasing power. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/purchasing_power. License: CC BY-SA:
Measuring poverty. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Measuring_poverty. License: CC BY-SA:
Poverty threshold. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Poverty_threshold. License: CC BY-SA:
Measuring poverty. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Measuring_poverty. License: CC BY-SA:
Poverty in the United States. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Poverty_in_the_United_States.
Multidimensional Poverty Index. Provided by: Wikipedia. Located at:
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Income inequality metrics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Income_inequality_metrics.
Poverty line. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/Poverty+line. License: CC BY-SA: Attribution-
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Income inequality metrics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Income_inequality_metrics.
entropy. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/entropy. License: CC BY-SA: Attribution-ShareAlike
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2008.png. License: CC BY-SA: Attribution-ShareAlike
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economic_mobility_in_the_United_States. 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.
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.
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.
Medicare (United States). Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Medicare_(United_States). License:
Unemployment benefit. Provided by: Wikipedia. Located at:
en.Wikipedia.org/wiki/Unemployment_benefit%23United_States. License: CC BY-SA: Attribution-ShareAlike
Social insurance. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Social_insurance. License: CC BY-SA:
Social Security (United States). Provided by: Wikipedia. Located at:
en.Wikipedia.org/wiki/Social_Security_(United_States). License: CC BY-SA: Attribution-ShareAlike
Retirement Insurance Benefits. Provided by: Wikipedia. Located at:
en.Wikipedia.org/wiki/Retirement_Insurance_Benefits. License: CC BY-SA: Attribution-ShareAlike
Boundless. Provided by: Boundless Learning. Located at: www.boundless.com//economics/...cial-insurance. License: CC
SocialSecurityposter2. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:So...ityposter2.gif. License: Public
public assistance. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/public_assistance. License: CC BY-SA:
Universal healthcare. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Universal_healthcare. License: CC BY-
Unemployment insurance. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Unemployment_insurance. License:
Welfare. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Welfare. License: CC BY-SA: Attribution-ShareAlike
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Voucher. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Voucher. License: CC BY-SA: Attribution-ShareAlike
voucher. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/voucher. License: CC BY-SA: Attribution-
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CHAPTER OVERVIEW
18: Introduction to Macroeconomics

Topic hierarchy
This page titled 18: Introduction to Macroeconomics is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by
Boundless.
Defining Macroeconomics
Macroeconomics is a branch of economics that focuses on the behavior and decision-making of an economy as a whole.
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).
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:
Income – Spending = Net Savings (18.1.1)
Rearranging:
Spending = Income – Net Savings = Income + Net Increase in Debt (18.1.2)
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.
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.
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.
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.
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.
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
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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Boundless.
CHAPTER OVERVIEW
19: Measuring Output and Income

This page titled 19: Measuring Output and Income is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by
Boundless.
1
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).
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.
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: 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.
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): Y = C + I + G + (X– M) .
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):
Y = C + I + G + (X − M) (19.1.1)
Expenditure accounts: Components of the expenditure approach to calculating GDP as presented in the National Income Accounts (U.S.
Bureau of Economic Analysis).
Defining the components

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
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.
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:
GDP = C + I + G + (X − M) (19.1.2)
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:
GDP = National Income (NY) + Indirect Business Taxes (IBT) (19.1.3)
+ Capital Consumption Allowance and Depreciation (CCA)
+ 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.
Net value added = Gross value of output– Value of intermediate consumption. (19.1.4)
Gross value of output = Value of the total sales of goods and services + Value of changes in the inventories. (19.1.5)
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.
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:
GDP = COE + GOS + GMI + TP&M – SP&M (19.1.6)
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 (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.
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: 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
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)) 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.
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 = GDP at market price – depreciation + 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:
NDP at factor cost = compensation of employees + net interest + rental and royalty income + profit of incorporated and
unincorporated 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:
GPD = 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.
Personal Income
Personal income is an individual’s total earnings from wages, investment interest, and other sources.
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.
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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Boundless.
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.
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:
GDP = C + I + G + (X − M) (19.3.1)
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.
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: 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.
gross domestic product. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/gross_domestic_product. License:
Nominal GDP. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Nominal...stments_to_GDP. License: CC BY-
Real GDP. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Real_GDP. License: CC BY-SA: Attribution-
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GDP. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/GDP. License: CC BY-SA: Attribution-ShareAlike
nominal. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/nominal. License: CC BY-SA: Attribution-
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USA states nominal gdp. Provided by: Wikimedia. Located at: commons.wikimedia.org/wiki/Fi...ominal_gdp.PNG.
Real gross domestic product. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Real_gr...mestic_product.
GDP deflator. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/GDP_deflator. License: CC BY-SA: Attribution-
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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.
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.
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:
Current CPI
Current CPI = Current item price × Base year price × (19.4.1)
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.
Market basket at base period prices = 5(6.00) + 2(4.00) + 2(35.00) = 108.00.
Market basket at current period prices = 5(7.00) + 2(6.00) + 2(45.00) = 137.00.
137
CPI for multiple items = × 100 = 127
108
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
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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CHAPTER OVERVIEW
2: The Market System

Topic hierarchy
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Defining a Market System
A market system is a way to match buyers and sellers.
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.
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.
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.
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.
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).
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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CHAPTER OVERVIEW
20: Economic Growth

Topic hierarchy
20.3: Productivity
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1
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. 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.
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.
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.
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.
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: 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
The economy in the United States is the world’s largest single national economy; 2013 GDP estimation was $16.6 trillion.
Describe historical growth in the US
Economic Growth
Economic growth is defined as the increase in the market value of the goods and services produced by an economy over time. It is
measured as the percentage rate of increase in the real gross domestic product (GDP). To determine economic growth, the GDP is
compared to the population, also know as the per capita income. When the per capita income increases it is called intensive growth.
When the GDP growth is only cause by an increase in population or territory it is called extensive growth.
U.S. GDP per capita (1929-2010): This graph shows the GDP per capita in the United States from 1929 to 2010. The GDP per
capita is the ratio of the GDP to the population. This graph shows the intensive growth of the United States during this time period.
U.S. Economy
The economy in the United States is the world’s largest single national economy. In 2013, the estimated GDP was $16.6 trillion,
which is a quarter of the nominal global GDP. Currently, the U.S. has a mixed economy, a stable GDP growth rate, moderate
unemployment, and high levels of research and capital investment.
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.
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.
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.
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.
demographics: The characteristics of human populations for purposes of social studies.
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Economic cycle. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Economic_cycle.svg. License: Public
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US GDP per capita. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:US...per_capita.PNG. License: Public
Gdp versus household income. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Gd...old_income.png.
Global economy. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Global_economy. License: CC BY-SA:
Share of world gdp 2012 imf. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Sh...p_2012_imf.png.
Gdp accumulated change. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/File:Gd...ted_change.png. License:
Development economics. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Development_economics. License:
Trade. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Trade%2...national_trade. License: CC BY-SA:
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20.3: Productivity
The Importance of Productivity
Increasing productivity is a rare win-win, improving the standard of living from a governmental, commercial and consumer
perspective.
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.
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 , X , X , … , X ). In this circumstance ‘Q’ is the quantity of output while each ‘x’ is a factor input.
1 2 3 n
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 + cX + dX + …
1 2 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 Kβ 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 = Min( , )z1
a
z2
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
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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CHAPTER OVERVIEW
21: Inflation
Topic hierarchy
This page titled 21: Inflation is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
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
Basket Costyear 1
CPIyear 1 =( ) × 100 (21.1.1)
Basket Costbase year
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) × 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 × 10 + 8 × 1.5 + 2 × 40 = 142(base period)
4 × 12 + 6 × 2 + 2 × 45 = 150(current period)
150
Price index = ( ) × 100 = 105.6
142
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 × 10 + 8 × 1.5 + 2 × 40 = 142 , and the current period index would be
5 × 12 + 8 × 2 + 2 × 45 = 166 . The Laspeyres price index is (166/142) × 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 × 10 + 6 × 1.5 + 2 × 40 = 129 , and the current period index would be
4 × 12 + 6 × 2 + 2 × 45 = 150 . The Paasche index is (150/129) × 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, Money Supply × Velocity of Money = Price Level × 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.
market basket: A list of items used specifically to track the progress of inflation in an economy or specific market.
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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CHAPTER OVERVIEW
22.: Unemployment
Topic hierarchy
This page titled 22.: Unemployment is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
1
Defining Unemployment
Unemployment, also referred to as joblessness, occurs when people are without work and actively seeking employment.
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.
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.
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.
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.
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.
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
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.
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 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 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.
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 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 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.
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.
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.
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
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CHAPTER OVERVIEW
23: Inflation and Unemployment

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The Phillips Curve
The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation
increases.
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.
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.
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.
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.
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.
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.
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
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.
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CHAPTER OVERVIEW
24: Aggregate Demand and Supply

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1
Defining Aggregate Expenditure: Components and Comparison to GDP
Aggregate expenditure is the current value of all the finished goods and services in the economy.
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:
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.
Identify the assumptions fundamental to classical economics in regards to aggregate expenditure at economic equilibrium
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 .
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: 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 (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.
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 is the current value of all the finished goods and services in the economy. The equation for aggregate
expenditure is: 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.
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 supply: The total supply of goods and services that firms in a national economy plan on selling during a specific
time period.
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.
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 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.
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.
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
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.
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: 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.
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.
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 ( ):The x-axis represents the overall output, while the y-axis represents the
AD
AS
price level. The aggregate quantity demanded (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.
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: Y = Y + α(P − P ) . In the equation, Y is the production of the economy, Y* is the natural level of
∗
e
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: 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.
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: Y = Y + α(P − P ) . In the equation, Y is the production of the
∗
e
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.
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: 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.
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.

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.
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.

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: 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: Y = Y + α(P − P ) . In the equation, Y is the production of the economy, Y* is
∗
e
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: 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: 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.
supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held
constant.
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.
Analyze aggregate demand and supply in the long run
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 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.
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:
AD = C + I + G + (X– M) (24.5.1)
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.
image
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.
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: 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
constant.
Supply curve: A graph that illustrates the relationship between the price of a good and the quantity supplied.
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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CHAPTER OVERVIEW
25: Major Macroeconomic Theories

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Keynesian Theory
Keynesian theory posits that aggregate demand will not always meet the supply produced.
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.
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.
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.
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
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.
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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CHAPTER OVERVIEW
26: Fiscal Policy

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1
Defining Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy.
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.
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.
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.
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:
1 1
Government expenditure multiplier = or
(1−MPC) MPS
−MPC −MPC
Tax multiplier = or
(1−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.
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.
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 MPC × $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 $30 billion(0.6 × $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
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.
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Automatic Stabilizers
Automatic stabilizers are modern government budget policies that act to dampen fluctuations in real GDP.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
cyclically balanced budget: Occurs when the government runs a deficit during recessions and lean years but a surplus during
periods of significant growth.
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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CHAPTER OVERVIEW
27: The Monetary System

Topic hierarchy
This page titled 27: The Monetary System is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
1
Money is any object that is generally accepted as payment for goods and services and the repayment of debt.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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
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.
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.
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.
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.
Money Creation and Reserve Requirements: The graph shows the total amount of money that can be created with the addition of
$100 in reserves, using different reserve requirements as examples.
The Money Multiplier in Theory

The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central
bank money.
Explain how the money multiplier works in theory
In order to understand the money multiplier, it’s important to understand the difference between commercial bank money and
central bank money. When you think of money, what you probably imagine is commercial bank money. This consists of the dollars
in your bank account – the money that you use when you write a check or use a debit or credit card. This money is created when
commercial banks make loans to companies or individuals. Central bank money, on the other hand, is the money created by the
central bank and used within the banking system. It consists of bank reserves held in accounts with the central bank, as well as
physical currency held in bank vaults.
The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central
bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend
(the commercial bank money that they can legally create) is a multiple of reserves; this multiple is the reciprocal of the reserve
ratio. We can derive the money multiplier mathematically, writing M for commercial bank money (loans), R for reserves (central
bank money), and RR for the reserve ratio. We start with the reserve ratio requirement that the the fraction of deposits that a bank
keeps as reserves is at least the reserve ratio:
R
≥ RR (27.3.1)
M
Taking the reciprocal:

M 1
≤ (27.3.2)
R RR
Therefore:
1
M ≤ R×( ) (27.3.3)
RR
The above equation states that the total supply of commercial bank money is, at most, the amount of reserves times the reciprocal
of the reserve ratio (the money multiplier).
Money Creation and the Money Multiplier: The graph shows the theoretical amount of money that can be created with different
reserve requirements.
If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an approximate equality, and
commercial bank money is central bank money times the multiplier. If banks instead lend less than the maximum, accumulating
excess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier. In theory banks
should always lend out the maximum allowed by their reserves, since they can receive a higher interest rate on loans than they can
on money held in reserves.
Theoretically, then, a central bank can change the money supply in an economy by changing the reserve requirements. A 10%
reserve requirement creates a total money supply equal to 10 times the amount of reserves in the economy; a 20% reserve
requirement creates a total money supply equal to five times the amount of reserves in the economy.
The Money Multiplier in Reality

In reality, it is very unlikely that the money supply will be exactly equal to reserves times the money multiplier.
Explain factors that prevent the money multiplier from working empirically as it does theoretically
The money multiplier in theory makes a number of assumptions that do not always necessarily hold in the real world. It assumes
that people deposit all of their money and banks lend out all of the money they can (they hold no excess reserves). It also assumes
that people instantaneously spend all of their loans. In reality, not all of these are true, meaning that the observed money multiplier
rarely conforms to the theoretical money multiplier.
Excess Reserves
First, some banks may choose to hold excess reserves. In the decades prior to the financial crisis of 2007-2008, this was very rare –
banks held next to no excess reserves, lending out the maximum amount possible. During this time, the relationship between
reserves, reserve requirements, and the money supply was relatively close to that predicted by economic theory. After the crisis,
however, banks increased their excess reserves dramatically, climbing above $900 billion in January of 2009 and reaching $2.3
trillion in October of 2013. The presence of these excess reserves suggests that the reserve requirement ratio is not exerting an
influence on the money supply.
U.S. Monetary Base: The monetary base is the sum of currency and reserves held in accounts at the central bank. After the
financial crisis the monetary base increased dramatically: the result of banks starting to hold excess reserves as well as the central
bank increasing the supply of reserves.
Cash
Second, customers may hold their savings in cash rather than in bank deposits. Recall that when cash is stored in a bank vault it is
included in the bank’s supply of reserves. When it is withdrawn from the bank and held by consumers, however, it no longer serves
as reserves and banks cannot use it to issue loans. When people hold more cash, the total supply of reserves available to banks goes
down and the total money supply falls.
Loan Proceeds
Third, some loan proceeds may not be spent. Imagine that the reserve requirement ratio is 10% and a customer deposits $1,000 into
a bank. The bank then uses this deposit to make a $900 loan to another one of its customers. If the customer fails to spend this
money, it will simply sit in the bank account and the full multiplier effect will not apply. In this case, the $1,000 deposit allowed the
bank to create $900 of new money, rather than the $10,000 of new money that would be created if the entire loan proceeds were
spent.
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.
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.
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currency. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/currency. License: CC BY-SA: Attribution-
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CHAPTER OVERVIEW
28: Monetary Policy

Topic hierarchy
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1
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).
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: M = P × L(R, Y) . This is the equivalent of stating that the nominal amount of money
d
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.
image
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.
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.
Use the concept of market equilibrium to explain changes in the interest rate and money supply
Interest Rate
(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:
image
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.
(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
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.
Interest rate. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Interes...t_rate_changes. License: CC BY-SA:
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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.
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
× the initial deposit .
1
(reserve ratio)
For example, with the reserve ratio (RR) of 20 percent, the money multiplier, mm, will be calculated as:
1
m = (28.2.1)
RR
1
m = =5 (28.2.2)
0.20
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.
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.
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.
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.
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.
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.
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.
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
loanable funds: Money available to be issued as debt.
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.
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).
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.
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 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.
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.
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.
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.
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
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.
contractionary monetary policy: Central bank actions designed to slow economic growth.
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.
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.
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.
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
financial crisis: A period of serious economic slowdown characterized by devaluing of financial institutions often due to
reckless and unsustainable money lending.
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CHAPTER OVERVIEW
29: The Financial System

Topic hierarchy
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1
Institutions, Markets, and Intermediaries
A financial intermediary is an institution that facilitates the flow of funds between individuals or other economic entities.
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.
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.
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 × 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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Present Value and the Time Value of Money
The time value of money is the principle that a certain amount of money today has a different buying power (value) than in the
future.
Calculate the present and future value of money
The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same
currency amount of money in the future. The value of money at a future point of time would take account of interest earned or
inflation accrued over a given period of time. This notion exists both because there is an opportunity to earn interest on the money
and because inflation will drive prices up, thus changing the “value” of the money.
For example, assume that an investor has $100 today and can invest this money at a 5% return for one year. A year from now the
original investment will equal $105, (100) × (1.05). The return of $5 represents the time value of money over the one year
interval.
Money: Assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely,
$100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate.
Time value of money:(1 + r) t
x (the value of the initial investment) = future value ; where r is the annual interest rate and t
is the number of years.

Alternatively, if an investment is valued at $125 and this value includes the 7% return generated over a one year time horizon, the
(125)
original value of the investment or its present value is equal to (1.07)
or 117.
(the value of the investment at a future time)
Present value: (1+r)
n
; where r is the annual interest rate and n is the number of years the investment
has occurred.
The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the
impact of interest and assumes, for simplicity, that inflation is neutral.
Measuring and Managing Risk

Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.
Explain the relationship between time, money, and risk
Assets can have varying maturity dates and potential for default, the attribution of time to maturity and timely payments involve an
assessment of risk. Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.
Time and Risk
Time is a component of risk for varying reasons; however, the two most common are related to the increase in general uncertainty
rising with the time horizon and reinvestment risk.
In our everyday lives, we are faced with momentary uncertainties that become increasingly harder to predict as we move from a
five minute horizon to a five day, five month, or even five year period. This same phenomenon is true of financial assets. Though
the attribution of acceptable inflation can be incorporated into an investment return, the actual pricing and resulting purchasing
power of the investment at maturity is unknown and the uncertainty increases with time. Therefore, investment returns compensate
holders for the time to maturity via a risk premium.
Return expectations are based on risk analysis: In finance and economics, as depicted in the graph above of the capital asset
pricing model, risk is evaluated to set the boundary for acceptable return.
Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an
investment. For example, if asset A and asset B both pay a 5% coupon on an annual basis, but asset B matures in 5 years and asset
A matures in 1 year, all else equal (asset quality and issuer solvency), we would expect asset A to trade at a higher price than asset
B. Remembering that yield and price are inversely related, the higher price on A implies that it has a lower yield than B. The
differential in yield can be attributed to a risk premium for time to maturity.
Another aspect of time horizon is reinvestment risk. For some investments, there is a potential for an issuer to call or redeem a
security prior to maturity. Given that at the time that the investment is called prevailing rates may be lower than at the purchase of
the asset, the holder is taking a reinvestment risk at the time of purchase. To compensate investors for taking on this type of risk,
the issuer will provide a risk premium to incentivize the investor to purchase the investment.
The Value of Diversification

The compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.
Explain the rationale for diversification
Each asset class has specific investment objectives; these are typically stated in a prospectus or investment description. However,
all investments have some degree of risk in meeting the stated investment objectives or return.
The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market
participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset. However, the
compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.
The Value of Diversification

Diversification strategies can be as simple as not “placing all your eggs in one basket.” It can also be as complex as a routine
evaluation of investment correlation and risk, and dynamic rebalancing of investment holdings. However, whether a common sense
or a highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return.
By holding varying investments, even if they are within the same company or sector, an investor still has the benefit of reducing
risk inherent from the default of one asset. For example, stock and bonds provide different returns; while a stock may exhibit no
growth for a period of time, the bond may continue to pay its coupon and provide a return. Through diversification, an investor’s
entire portfolio can perform better than its worst-performing asset.
In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit
of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class. In some cases
where the return on investment needs to be met, managers may advocate for the use of hedging instruments to transfer risk of
return objectives being met to another party in lieu of a consistent return.
Hedging strategies can be relatively complex but, in general, they serve the role of insuring that an investor is able to meet
investment performance objectives. Typically, an investor pays a fee and enters into the hedging strategy, which transfer the risk
inherent in an investment for a constant return. The party on the opposite side of the hedge absorbs both the upside and downside
return potential of the asset, along with the fee for taking on the risk of uncertainty, and pays the first party a constant return as part
of the agreement.
Systematic Risk
It’s important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of
any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from market structure or
dynamics which produce shocks or uncertainty faced by all agents in the market. For example, government policy, international
economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how
diversified it is.
The Relationship Between Risk and Return and the Security Market Line
The security market line is useful to determine if an asset being considered for a portfolio offers a reasonable expected return for
risk.
Explain how the security market line relates risk and return
Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non- systematic risk.
Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market.
Non-systematic risk is unique to a specific company and can be reduced through diversification.
Capital Asset Pricing Model (CAPM)

In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account
an asset’s sensitivity to non-diversifiable or systematic risk. Non-diversifiable risk is noted by the variable beta (β), where beta is
greater than one if the asset’s price sensitivity is greater than the market; equal to one when the asset’s sensitivity is equal to the
market; and less than one if the asset exhibits less pricing volatility than the market.
The CAPM is a model for pricing an individual security or portfolio. The expected return of an asset is equal to the risk free rate
plus the excess return of the market above the risk-free rate, adjusted for the asset’s overall sensitivity to market fluctuations or its
beta. Mathematically, the capital asset pricing model can be written as: E(R ) = R + β(E(R )– R ) , where R is the return,
i f m f
E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.
Security Market Line (SML)

For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an
individual security in relation to their security risk class. The SML essentially graphs the results from the capital asset pricing
model formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is
determined from the slope of the SML. The relationship between β and required return is plotted on the SML, which shows
expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market
premium, E(R ) − R .
m f
Security market line: The security market line depicts the the return on a security relative to its own risk.
The SML is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk.
Individual securities are plotted on the SML graph. If the security’s expected return versus risk is plotted above the SML, it is
undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued
since the investor would be accepting a smaller return for the amount of risk assumed.
Key Points
Time value of money: (1 + r) x (the value of the initial investment) = future value ; where r is the annual interest rate
t
and t is the number of years.

The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the
impact of interest and assumes, for simplicity, that inflation is neutral.
The time value of money is the principle that a certain amount of money today has a different buying power (value) than the
same currency amount of money in the future.
Investment returns compensate holders for the time to maturity via a risk premium.
Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an
investment.
To compensate investors for taking on reinvestment risk, issuers will provide a risk premium to incentivize the investor to
purchase the investment.
Diversification strategies can be as simple as not “placing all your eggs in one basket” or be as complex as routine evaluation of
investment correlation and risk and dynamic rebalancing of investment holdings.
Whether a common sense or highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance
consistency of return. A diversified portfolio will earn a return that is always higher than its lowest performing asset.
Most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of
growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class.
Investors may enter into hedging strategies in order to ensure a constant return over market volatility. For a fee, a hedging
strategy offers a constant return on an investment. The party on the other side of the hedge absorbs the volatility of the
investment and pays out a consistent return.
In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset taking into
account an asset’s sensitivity to non-diversifiable risk.
The security market line essentially graphs the results from the capital asset pricing model formula. The intercept of the SML is
the nominal risk-free rate available for the market, while the slope is the market premium.
If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater
return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting less return
for the amount of risk assumed.
Key Terms
time value of money: 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.
present value: The value of an asset in today’s dollars after adjusting for an increase in the asset values as a result of interest
earned during the period.
risk premium: The minimum amount of money by which the expected return on a risky asset must exceed the known return on
a risk-free asset
time horizon: A fixed point of time in the future where certain processes will be evaluated or assumed to end.
prospectus: A document, distributed to prospective members, investors, buyers, or participants, which describes an institution
(such as a university), a publication, or a business and what it has to offer.
asset class: A group of economic resources sharing similar characteristics, such as riskiness and return.
systematic risk: The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as
its beta.
non-systematic risk: Risk that is unique to a specific company; can be reduced through diversification.
capital asset pricing model: Used to determine the required rate of return of an asset taking into account an asset’s sensitivity
to non-diversifiable risk (also known as systematic risk or market risk).
security market line: A line representing the relationship between expected return and systematic risk; thus a graphical
representation of the capital asset pricing model.
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CHAPTER OVERVIEW
3: Introducing Supply and Demand

3.1: Demand
3.2: Supply
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1
3.1: Demand
The Law of Demand
In general, the law of demand states that the quantity demanded and the price of a good or service is inversely related, other things
remaining constant.
Explain the concept of demand and discuss the factors that affect it
In economics, the law of demand states that the quantity demanded and the price of a good or service is inversely related, other
things remaining constant. Therefore, the demand curve will generally be downward sloping, indicating the negative relationship
between the price of a good or service and the quantity demanded.
Movement along the Demand Curve

If the income of the consumer, prices of the related goods, and preferences of the consumer remain unchanged, then the change in
quantity of good demanded by the consumer will be negatively correlated to the change in the price of the good or service. The
change in price will be reflected as a move along the demand curve.
Shift in the Demand Curve

The demand curve will shift, move either inward or outward as a result of non-price factors. A shift in demand can be related to the
following factors (non-exhaustive list):
Consumer preferences
Consumer income
Change in the price of related goods (i.e. compliments)
Change in the number of buyers
Consumer expectations
Law of Demand: A demand curve, shown in red and shifting to the right, demonstrating the inverse relationship between price and
quantity demanded (the curve slopes downwards from left to right; higher prices reduce the quantity demanded).
Though in general terms and specific to normal goods, demand will exhibit a downward slope, there are exceptions: Giffen goods
and Veblen goods
Giffen Goods
A Giffen good describes an extreme case for an inferior good. In theory, a Giffen good would display the characteristic that as price
increases, demand for the product increases. In the real world application, there has not been a true example of a Giffen good,
though a popular albeit historically inaccurate example is the purchase of potatoes (an inferior good) as prices continued to increase
during the Irish potato famine.
Veblen Goods
Some expensive commodities like diamonds, expensive cars, designer clothing and other high-price limited items, are used as
status symbols to display wealth. The more expensive these commodities become, the higher their value as a status symbol and the
greater the demand for them. The amount demanded of these commodities increase with an increase in their price and decrease
with a decrease in their price. These goods are known as a Veblen goods.
Demand Schedules and Demand Curves

A demand curve depicts the price and quantity combinations listed in a demand schedule.
Describe the relationship between demand curves and demand schedules
The demand curve is a graphical representation depicting the relationship between a commodity’s different price levels and
quantities which consumers are willing to buy. The curve can be derived from a demand schedule, which is essentially a table view
of the price and quantity pairings that comprise the demand curve.
Demand Schedule and Curve: The demand curve is the graphical representation of the economic entity’s willingness to pay for a
good or service. It is derived from a demand schedule, which is the table view of the price and quantity pairs that comprise the
demand curve.
Given that in most cases, as the price of a good increases, agents will likely decrease consumption and substitute away to another
good or service, the demand curve embodies a negative price to quantity relationship. The curve typically slopes downward from
left to right; though there are some goods and services that exhibit an upward sloping demand, these goods and services are
characterized as abnormal.
The demand curve of an individual agent can be combined with that of other economic agents to depict a market or aggregate
demand curve. Using a demand schedule, the quantity demanded per each individual can be summed by price, resulting in an
aggregate demand schedule that provides the total demanded specific to a given price level. The plotting of the aggregated quantity
to price pairings is what is referred to as an aggregate demand curve. In this manner, the demand curve for all consumers together
follows from the demand curve of every individual consumer.
The demand curve in combination with the supply curve provides the market clearing or equilibrium price and quantity
relationship. This is found at the intersection or point at which the supply and demand curves cross each other.
Market Demand
Market demand is the summation of the individual quantities that consumers are willing to purchase at a given price.
Examine the relationship between market demand and individual demand
The demand schedule represents the amount of some good that a buyer is willing and able to purchase at various prices. The
relationship between price and quantity demanded reflected in this schedule assumes the following factors remain constant:
Income levels;
Population;Tastes and preferences;
Price of substitute goods; and
Price of complementary goods
The demand schedule is depicted graphically as the demand curve. The demand curve is shaped by the law of demand. In general,
this means that the demand curve is downward-sloping, which means that as the price of a good decreases, consumers will buy
more of that good.
Demand Curve: The demand curve is the graphical depiction of the demand schedule. For most goods and services, the demand
curve exhibits a negative relationship between price and quantity and is as a result downward sloping.
A market demand schedule is a table that lists the quantity of a good all consumers in a market will buy at every different price. A
market demand schedule for a product indicates that there is an inverse relationship between price and quantity demanded. The
graphical representation of a market demand schedule is called the market demand curve.
Market Demand Schedule: A market demand schedule is a table that lists the quantity of a good all consumers in a market will
buy at every different price.
The determinants of demand are:
Income
Tastes and preferences
Prices of related (AKA complimentary) goods and services
Prices of substitutes
Number of potential consumers
The market demand is the summation of the individual quantities that consumers are willing to purchase at a given price.
As noted, both individual demand curves and market demand are typically expressed as downward shaping curves. However,
special cases exist where the preference for the good or service may be perverse. Two different hypothetical types of goods with
upward-sloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods characterized as being more
desirable the higher the price; luxury or status items).
Ceteris Paribus
Ceteris paribus is defined as “all else being equal,” or “holding all else constant”.
Explain the rationale for the assumption of ceteris paribus
Economics seeks to interpret, analyze and or evaluate situations that occur between individuals, firms and other entities. Due to the
potential for multiple agents and other known and unknown external activities to be involved or present but not relevant to an
analysis, economics employs the assumption of “all else constant,” which is the English translation of the Latin phrase “ceteris
paribus”.
When the ceteris paribus assumption is employed in economics, all other variables – with the exception of the variables under
evaluation – are held constant.
A Macroeconomic Example
What would happen to the demand for labor by firms if a minimum wage was imposed at a level above the prevailing wage rate,
ceteris paribus? As depicted in below, the supply and demand curve are held constant, as are labor and leisure preferences for
workers, and output considerations for firms, in addition to all other variables and characteristics embedded within the shape of the
supply and demand curves. Thus, what is being evaluated is the impact of a constraint on market equilibrium.
image
Macroeconomics: Binding price floor: E is the equilibrium wage level when there is no binding minimum wage. When a
minimum wage is imposed, ceteris paribus, suppliers of labor are willing to provide more labor than firms (demand for labor) are
willing to purchase at the binding minimum wage rate. There is no shifting of either curve related to behavior influenced by the
higher wage rate because ceteris paribus is holding labor-leisure trade-off (of workers) and substitution of labor (by firms) constant,
along with other potential influencing variables.
A Microeconomic Example
What would happen for the demand for a normal good when income increases, ceteris paribus? In this case, as depicted in, a
consumer’s preferences for the good and his demand for complements and substitutes are being held constant along with other
attributes that could potentially impact his demand for a good, such as the good’s price. The supply of the good and the market and
firm characteristics implicit in the shape of the supply curve are also held constant. This allows for an analysis of the increase in
income, on the consumer’s demand for the single good alone.
Microeconomics: Income and Demand: A consumer is able to purchase a normal good and has a demand curve, D1, which
provides the relationship between price and quantity given his preferences, income and other consumption attributes. Assuming an
increase in his income, ceteris paribus, his demand curve would shift outward to D2, corresponding to a higher quantity for each
purchase price. The consumer would then move his consumption for the good from Q1 to Q2, increasing his purchase of the good.
Changes in Demand and Shifts in the Demand Curve

Demand is the relationship between the willingness to purchase a quantity of a good or service at a specific price.
Distinguish between shifts in the demand curve and movement along the demand curve
The demand curve is a graphical representation of an economic agent’s willingness to purchase a given quantity of a good or
service at a specific price based on preferences, income, and other prevailing factors at a given point in time. Demand curves in
combination with supply curves, which depict the price to quantity relationship of producers, are a representation of the goods and
services market. Where the two curves intersect is market equilibrium, the price to quantity relationship where demand and supply
are equal.
Movements in demand are specific to either movements along a given demand curve or shifts of the entire demand curve.
Movements along the demand curve are due to a change in the price of a good, holding constant other variables, such as the price
of a substitute. If the price of a good or service changes the consumer will adjust the quantity demanded based on the preferences,
income and prices of other factors embedded within a given curve for the time period under consideration.
Shifts in the demand curve are related to non-price events that include income, preferences and the price of substitutes and
complements. An increase in income will cause an outward shift in demand (to the right) if the good or service assessed is a normal
good or a good that is desirable and is therefore positively correlated with income. Alternatively, an increase in income could result
in an inward shift of demand (to the left) if the good or service assessed is an inferior good or a good that is not desirable but is
acceptable when the consumer is constrained by income.
Demand Curve: A demand curve provides an economic agent’s price to quantity relationship related to a specific good or service.
Movements along a demand curve are related to a change in price, resulting in a change in quantity; shifts is demand (D1 to D2)
are specific to changes in income, preferences, availability of substitutes and other factors.
A change in preferences could result in an increase (outward shift) or decrease (inward shift) in the quantity level desired for a
specific price; while a change in the price of a substitute, could result in an outward shift if the price of the substitute increases and
an inward shift if the substitute’s price decreases. The demand curve for a good will shift in parallel with a shift in the demand for a
complement.
Key Points
The demand curve is downward sloping, indicating the negative relationship between the price of a product and the quantity
demanded.
For normal goods, a change in price will be reflected as a move along the demand curve while a non-price change will result in
a shift of the demand curve.
Two exceptions to the law of demand are Giffen goods and Veblen goods.
Demand curves are a graphical representation of a demand schedule, which is the table view of an economic agents’ price to
quantity relationship.
Demand curves embody preferences, substitution potential and income, as well as other characteristics that influence an
economic agent’s ability to assess willingness to pay at a specific point in time for goods and services.
Demand curves may be linear or curved.
Aggregate demand is the sum of the quantity demanded for a specific price over a group of economic agents.
The graphical representation of a market demand schedule is called the market demand curve.
Following the law of demand, the demand curve is almost always represented as downward-sloping. This means that as price
decreases, consumers will buy more of the good.
Two different hypothetical types of goods with upward-sloping demand curves are Giffen goods and Veblen goods.
When ceteris paribus is employed in economics, all other variables with the exception of the variables under evaluation are held
constant.
An example of the use of ceteris paribus in macroeconomics is: what would happen to the demand for labor by firms if a
minimum wage was imposed at a level above the prevailing wage rate, ceteris paribus.
An example of the use of ceteris paribus in microeconomics is: what would happen for the demand for a normal good when
income increases, ceteris paribus.
A change in price will result in a movement along a demand curve.
A change in a non-price variable will result in a shift in the demand curve.
An outward shift in demand will occur if income increases, in the case of a normal good; however, for an inferior good, the
demand curve will shift inward noting that the consumer only purchases the good as a result of an income constraint on the
purchase of a preferred good.
Key Terms
Giffen good: A good which people consume more of as only the price rises; Having a positive price elasticity of demand.
Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater
price confers greater status.
constant.
Market demand: The summation of the individual quantities that consumers are willing to purchase at a given price.
ceteris paribus: all else equal; holding everything else constant
constant.
inferior good: a good that decreases in demand when consumer income rises; having a negative income elasticity of demand.
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3.2: Supply
The Law of Supply
The law of supply states that there is a positive relationship between the quantity that suppliers are willing to sell and the price
level.
Explain the Law of Supply
The law of supply is a fundamental principle of economic theory. It states that an increase in price will result in an increase in the
quantity supplied, all else held constant.
An upward sloping supply curve, which is also the standard depiction of the supply curve, is the graphical representation of the law
of supply. As the price of a good or service increases, the quantity that suppliers are willing to produce increases and this
relationship is captured as a movement along the supply curve to a higher price and quantity combination.
The Law of Supply: Supply has a positive correlation with price. As the market price of a good increases, suppliers of the good
will typically seek to increase the quantity supplied to the market.
The rationale for the positive correlation between price and quantity supplied is based on the potential increase in profitability that
occurs with an increase in price.
All else held constant, including the costs of production inputs, the supplier will be able to increase his return per unit of a good or
service as the price for the item increases. Therefore, the net return to the supplier increases as the spread or difference between the
price and the cost of the good or service being sold increases.
The law of supply in conjunction with the law of demand forms the basis for market conditions resulting in a price and quantity
relationship at which both the price to quantity relationship of suppliers and demanders (consumers) are equal. This is also referred
to as the equilibrium price and quantity and is depicted graphically at the point at which the demand and supply curve intersect or
cross one another. It is the point where there is no surplus or shortage in the market.
Law of Supply and Law of Demand: Equilibrium: The law of supply and the law of demand form the foundation for the
establishment of an equilibrium–where the price to quantity combination for both suppliers and demanders are the same.
Supply Schedules and Supply Curves

A supply schedule is a tabular depiction of the relationship between price and quantity supplied, represented graphically as a supply
curve.
Explain the price to quantity relationship exhibited in the supply curve
Supply is the amount of some product that producers are willing and able to sell at a given price, all other factors being held
constant. In general, supply depicts a positive relationship between the price of a good or service and the quantity that the producer
is willing to supply: if a supplier believes it can sell the product for more, it will want to make more of the product. As a result, as
the price of a good or service increases, suppliers increase the quantity available for purchase.
A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. The supply curve is
a graphical depiction of the supply schedule that illustrates that relationship between the price of a good and the quantity supplied.
The Supply Schedule and Supply Curve: The supply curve is a graphical depiction of the price to quantity pairings presented in a
supply schedule. The supply schedule is a table view of the relationship between the price suppliers are willing to sell a specific
quantity of a good or service.
The supply curves of individual suppliers can be summed to determine aggregate supply. One can use the supply schedule to do
this: for a given price, find the corresponding quantity supplied for each individual supply schedule and then sum these quantities
to provide a group or aggregate supply. Plotting the summation of individual quantities per each price will produce an aggregate
supply curve.
In theory, in the long run the aggregate supply curve will not be upward sloping but will instead be vertical, consistent with a fixed
supply level. This is due to the underlying assumption that in the long run, supply of a good only depends on the fixed level of
capital, technology, and natural resources available.
The supply curve provides one side of the price-to-quantity relationship that ensures a functional market. The other component is
demand. When the supply and demand curves are graphed together they will intersect at a point that represents the market
equilibrium – the point where supply equals demand and the market clears.
Market Supply
Market supply is the summation of the individual supply curves within a specific market where the market is characterized as being
perfectly competitive.
Identify the market conditions that yield a market supply curve.
A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or
service. As a result, the supply curve is upward sloping. Market supply is the summation of the individual supply curves within a
specific market.
Market Supply: The market supply curve is an upward sloping curve depicting the positive relationship between price and
quantity supplied.
The market supply curve is derived by summing the quantity suppliers are willing to produce when the product can be sold for a
given price. As a result, it depicts the price to quantity combinations available to consumers of the good or service. In combination
with market demand, the market supply curve is requisite for determining the market equilibrium price and quantity.
By its very nature, conceptualizing a supply curve requires the firm to be a perfect competitor, namely requires the firm to have no
influence over the market price. This is true because each point on the supply curve is the answer to the question “If this firm is
faced with this potential price, how much output will it be able to and willing to sell? ” If a firm has market power, its decision of
how much output to provide to the market influences the market price, then the firm is not “faced with” any price, and the question
is meaningless.
The attributes of a competitive market signal that the price is set external to any firm. Therefore, production in the market is a
sliding scale dependent on price. As price increases, quantity increases due to low barriers to entry, and as the price falls, quantity
decreases as some firms may even opt out of the market.
The supply curve can be derived by compiling the price-to-quantity relationship of a seller. A seller could set the price of a good or
service equal to zero and then incrementally increase the price; at each price he could calculate the hypothetical quantity he would
be willing to supply. Following this process the seller would be able to trace out its complete individual supply function. The
market supply curve is simply the sum of every seller’s individual supply curve.
Determinants of Supply
Supply levels are determined by price, which increases or decreases supply along the price curve, and non-price factors, which
shifts the entire curve.
Identify the factors that affect the supply of a good
Supply is the quantity of a good or service that a supplier provides to the market. Innumerable factors and circumstances could
affect a seller’s willingness or ability to produce and sell a good. Some of the more common factors are:
Good’s own price: An increase in price will induce an increase in the quantity supplied.
Prices of related goods: For purposes of supply analysis, related goods refer to goods from which inputs are derived to be used
in the production of the primary good.
Conditions of production: The most significant factor here is the state of technology. If there is a technological advancement
related to the production of the good, the supply increases.
Expectations: Sellers’ expectations concerning future market conditions can directly affect supply.
Price of inputs: If the price of inputs increases the supply curve will shift left as sellers are less willing or able to sell goods at
any given price. Inputs include land, labor, energy and raw materials.
Number of suppliers: As more firms enter the industry the market supply curve will shift out driving down prices. The market
supply curve is the horizontal summation of the individual supply curves.
Government policies and regulations: Government intervention can take many forms including environmental and health
regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. These regulations
can affect a good’s supply.
Suppliers will change their production levels along the supply curve in response to a price change, so that their production level is
equal to demand. However, some factors unrelated to price can shift the production level. For example, a technological
improvement that reduces the input cost of a product will shift the supply curve outward, allowing suppliers to provide a greater
supply at the same price level.
Determinants of Supply: If the price of a good changes, there will be movement along the supply curve. However, the supply
curve itself may shift outward or inward in response to non-price related factors that affect the supply of a good, such as
technological advances or increased cost of materials.
Changes in Supply and Shifts in the Supply Curve
The supply curve depicts the supplier’s positive relationship between price and quantity.
Distinguish between shifts in the supply curve and movement along the supply curve
Price changes and movement along supply curve

If the price of the good or service changes, all else held constant such as price of substitutes, the supplier will adjust the quantity
supplied to the level that is consistent with its willingness to accept the prevailing price. The change in price will result in a
movement along the supply curve, called a change in quantity supplied, but not a shift in the supply curve. Changes in supply are
due to non-price changes.
Non-price changes and shifts of the supply curve

If production costs increase, the supplier will face increasing costs for each quantity level. Holding all else the same, the supply
curve would shift inward (to the left), reflecting the increased cost of production. The supplier will supply less at each quantity
level.
If production costs declined, the opposite would be true. Lower costs would result in an increase in output, shifting the supply
curve outward (to the right) and the supplier will be willing sell a larger quantity at each price level. The supply curve will shift in
relation to technological improvements and expectations of market behavior in very much the same way described for production
costs.
Technological improvements that result in an increase in production for a set amount of inputs would result in an outward shift in
supply.
Supply will shift outward in response to indications of heightened consumer enthusiasm or preference and will respond by shifting
inward if there is an assessment of a negative impact to production costs or demand.
Supply Shifts: A shift in supply from S1 to S2 affects the equilibrium point, and could be caused by shocks such as changes in
consumer preferences or technological improvements.
Key Points
Quantity supplied moves in the same direction as price.
The supply curve is an upward sloping curve.
Producers are willing to increase production at higher prices to increase profit.
The supply curve plots the quantity that is willingly supplied at any given price.
The individual supply curves can be summed by quantity provided at a specific price to achieve an aggregate supply curve.
The supply curve is upward sloping in the short run.
A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or
service.
The supply curve can only be attributed to a depiction of a perfectly competitive market due to the unique attributes of perfect
competition: firms are price takers, no single firm’s actions can influence the market price, and ease of exit and entry.
The market supply curve is derived by summing the quantity for a given price across all market participants (suppliers). It
depicts the price-to-quantity combinations available to consumers of the good or service.
Supply is the quantity of a good or service that a supplier provides to the market.
Suppliers will shift production for non- price changes related to the determinants of supply and will slide production levels
across the supply curve for price related movements.
Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good.
A change in the price of a good or service, holding all else constant, will result in a movement along the supply curve.
A change in the cost of an input will impact the cost of producing a good and will result in a shift in supply; supply will shift
outward if costs decrease and will shift inward if they increase.
A change in the expected demand for a good or service will result in a shift in supply; supply will shift outward if enthusiasm is
expected to increase and will shift inward if there is an expectation for consumers preferences to change in favor of an alternate
good or service.
Key Terms
surplus: That which remains when use or need is satisfied, or when a limit is reached; excess; overplus.
shortage: a lack or deficiency
Supply curve: A graphical representation of the quantity producers are willing to make when the product can be sold at a given
price.
intervention: The action of interfering in some course of events.
Non-price changes: Shocks, either exogenous or endogenous, that affect the positioning of the supply curve.
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Clearing the Market at Equilibrium Price and Quantity
When a market achieves perfect equilibrium there is no excess supply or demand, which theoretically results in a market clearing.
Define market equilibrium
The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the ideal
price and quantity of a given product or service in a marketplace. This equilibrium point is represented by the intersection of a
downward sloping demand line and an upward sloping supply line, with price as the y-axis and quantity as the x-axis. At perfect
equilibrium there is no excess demand (represented by ‘A’ in the figure) or excess supply (represented by ‘B’ in the figure), which
theoretically results in a market clearing.
Equilibrium Pricing: This chart effectively highlights the various basic implications of a simple supply and demand chart. The
equilibrium point is where market clearing will theoretically occur.
Market Clearing Assumptions

A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity
demanded. This definition requires a variety of assumptions which simplify the complexities of real markets to coincide with a
more theoretical framework, most centrally the assumptions of perfect competition and Say’s Law:
Perfect competition is a market where the price determined for a given good or service is not affected by external forces or
competition in a way that allows incumbents (companies) to attain market influence.
Say’s Law hinges on the concept that capital loses value over time, or that money is essentially perishable. The simplest way to
view this law is interest rates. When you invest or owe money, that capital accrues interest due to the fact that there is an
opportunity cost in not investing that money elsewhere. This opportunity cost creates the assumption that money will not go
unused.
Combining these two assumptions, in a perfectly competitive market the amount of a product or service that is supplied at a given
price will equate to the amount demanded, clearing the market of all goods/services at a given equilibrium point.
Theory and Practice

While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. Markets
demonstrate consistent shifts of supply and shifts of demand based on a wide spectrum of externalities. Even in static markets there
is competitive consolidation that allows companies to charge differing price points than that of the equilibrium. The concept of
monopolies provides a good example for this experience, as monopolies (see example) can control price and quantity
simultaneously.
Another classic criticism of market clearing is the way in which the labor market functions. In the 1930’s, during the worst
depression recorded in the United States, the labor market did not clear the way economic theories of market clearing would
assume it would. Instead, there seemed to be what John Maynard-Keynes (father of Keynesian Economics) called ‘stickiness,’
which preventing the market from normalizing. The importance of raising these concerns is the understanding that while the
concept of market clearing, equilibrium and supply/demand charts are highly useful in understanding the basic functioning of
markets, reality does not always conform with these models.
Impacts of Surpluses and Shortages on Market Equilibrium

The existence of surpluses or shortages in supply will result in disequilibrium, or a lack of balance between supply and demand
levels.
Infer the outcomes of departures from equilibrium using the model of supply and demand
In the analysis of market equilibrium, specifically for pricing and volume determinations, a thorough understanding of the supply
and demand inputs is critical to economics. Surpluses and shortages on the supply end can have substantial impacts on both the
pricing of a specific product or service, alongside the overall quantity sold over time. Shifts such as these in the supply availability
results in disequilibrium, or essentially a lack of balance between current supply and demand levels. Surpluses and shortages often
result in market inefficiencies due to a shifting market equilibrium.
Surpluses
Surpluses, or excess supply, indicate that the quantity of a good or service exceeds the demand for that particular good at the price
in which the producers would wish to sell (equilibrium level). This inefficiency is heavily correlated in circumstances where the
price of a good is set too high, resulting in a diminished demand while the quantity available gains excess. There are substantial
business risks inherently built into the concept of surpluses, as the general outcome will be either selling off inventory at sub-par
prices or leftover unsold inventory. In both scenarios businesses will be forced to minimize margins or incorporate losses on that
particular good. Governmental intervention can often create surplus as well, particularly through the utilization of a price floor if it
is set at a price above the market equilibrium.
Price Floor: A price floor ensures a minimum price is charged for a specific good, often higher than that what the previous market
equilibrium determined. This can result in a surplus.
In a perfectly competitive market, particularly pertaining to goods that are not perishable, excess supply is equivalent to the
quantity available in the market beyond the equilibrium point of intersection between supply and demand. In this theoretical
scenario the equilibrium point will transition towards a lower price point due to the increased supply, which will in turn motivate
consumers to purchase a higher quantity as a result. This allows the economic model of the market to correct itself.
Shortages
Inversely, shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the
consumers. This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand
relationship, noting that the price is set too low. It could also indicate that the desired good has a low level of affordability by the
general public, and can be a dangerous societal risk for necessary commodities. Indeed, Garrett Hardin emphasized that a shortage
of supply could also be perceived as a ‘longage’ of demand, as the two are inversely related. From this vantage point shortages can
be attributed to population growth as much as resource scarcity.
In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning
towards a higher price point due to the limited supply availability. This will prioritize who receives the good or service based upon
their willingness and ability to pay a premium for the specific item in demand, leveraging those along the demand curve who are at
higher levels with higher ability and willingness to pay.
Changes in Demand and Supply and Impacts on Equilibrium

Alterations to overall supply or demand dictate the cross-section or equilibrium, ascertaining price and volume for a product or
service.
Illustrate how changes in supply or demand impact the market equilibrium
The interdependent relationship between the supply of a given product or service and the overall demand exercised by interested
parties generates a theoretical equilibrium point, dictating the average market price and purchased volume relative to that price. In a
static market it would be reasonable to assume that prices and volumes would remain fairly predictable and consistent relative to
the population, but realistic markets are not static. Instead, markets are in constant flux as demands and supplies are subjected to
varying driving forces and influences. These shifts play a critical role in altering market equilibrium price points and volumes for
products and services, requiring constant vigilance and adaptation by providers and consumers. To better understand market
variations, it is useful to examine how changes in supply and demand may occur, as well as the impacts and implications of these
changes.
Demand Shifts
Demand shifts are defined by more or less of a given product or service being required at a fixed price, resulting in a shift of both
price and quantity. As would be assumed, an increase in demand will shift price upwards and volume to the right, increasing the
overall value of both metrics relative to the prior equilibrium point. Alternately, a decrease in demand will shift price downwards
and volume to the left, decreasing both measurements to realign equilibrium with a reduced demand.
Demand Shifts: In this graph, the demand curve (red) has been affected by an increase in demand. This consequently increases
price at a given volume.
Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and
circumstances. Demand shifts can therefore often be affected by economic factors such as average spending power per person in a
given economy or overall average income. Demand can also be affected by cultural changes, demographic shifts, availability of
substitutes, environmental factors and concerns (e.g. climate change), politics, and advances in science (e.g. declining demand for
unhealthy foods). Demand is particularly malleable in respect to goods that are not necessities, thus are desired or not based upon
sociological norms.
Supply Shifts
Supply shifts are defined by more or less of a particular product/service being available to fulfill a given demand, affecting the
equilibrium point by shifting the supply curve upwards or downwards. A supply shift to the right, indicating more availability of
the specified product or service, will create a lower price point and a higher volume assuming a fixed demand. Alternately, a
decrease in supply with a consistent given demand will see an increase in price and a decrease in quantity. This is an intuitive
theory underlining the fact that scarcity is relevant to the willingness to pay.
Supply Shifts: In this supply and demand chart we see an increase in the supply provided, shifting quantity to the right and price
down. More of a given product, assuming the same demand, will result in lower price points at the equilibrium.
Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of external factors. As discussed above, scarcity
plays a critical role in pricing and thus controlling supply is often even considered a strategic play by companies in specific
industries (most notably industries like precious stones, rare earth metals, etc.). Supply shifts can also be a result of technological
advances, over-utilization or consumption, globalization, supply-chain efficiency, and economics. For example, the discovery of a
new gold deposit, acts as a shock to the supply of gold, shifting the curve right.
Equilibrium
In combining these two potential shifts, equilibrium is constantly subjected to both factors resulting in supply shifts and factors
resulting in demand shifts. Due to the demand curve sloping downward and the supply curve sloping upwards, they inadvertently
will cross at some given point on any supply/demand chart. This cross-section, or equilibrium, serves as a price and quantity
tracking point based upon the consistent inputs of overall demand and supply availability. Any change in either factor will result in
immediate impact on equilibrium, balancing the new demand or supply with a corresponding volume and appropriate average price
point.
Key Points
The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the
ideal price and quantity of a given product or service in a marketplace.
A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity
demanded.
Market clearing requires a variety of assumptions which simplify the complexities of real markets to coincide with a more
theoretical framework, most centrally the assumptions of perfect competition and Say’s Law.
While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. The
concepts of consolidated markets and ‘sticky’ markets reduces the accuracy of these models.
Surpluses, or excess supply, essentially indicates that the quantity of a good or service exceeds the demand for that particular
good at the price in which the producers would wish to sell ( equilibrium level).
In a perfectly competitive market, excess supply is equivalent to the quantity available in the market beyond the equilibrium
point of intersection between supply and demand. This will result in a shift in market equilibrium towards lower price points.
Shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the consumers.
This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand
relationship.
In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning
towards a higher price point due to the limited supply availability.
The interdependent relationship between the supply of a given product or service and the overall demand exercised by
interested parties generates a theoretical equilibrium point, dictating the average market price and purchase volume relative to
that price.
Markets are in constant flux as demands and supplies are subjected to varying driving forces and influences. These shifts play a
critical role, altering market equilibrium price points and volumes for products and services.
Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and
circumstances.
Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of externalities. Scarcity, or the lack of
availability for a particular material, is a core driving force for overall supply.
Due to a demand curve ‘s sloping downward and a supply curve ‘s sloping upwards, the curves will eventually cross at some
point on any supply/demand chart. This point of equilibrium serves as a price and quantity tracking point.
Key Terms
Say’s Law: The idea that money is perishable.
Incumbents: A holder of a position as supplier to a market or market segment that allows the holder to earn above-normal
profits.
Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that
opportunity); the most valuable forgone alternative.
Disequilibrium: The loss of equilibrium or stability, especially due to an imbalance of forces.
surplus: That which remains when use or need is satisfied, or when a limit is reached.
shortage: Not enough or not sufficient for a given demand.
scarcity: An insufficiency or lack of availability; a shortage.
equilibrium: A condition in which competing forces are in balance.
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Why Governments Intervene In Markets
Governments intervene in markets when they inefficiently allocate resources.
Identify reasons why the government might choose to intervene in markets
Governments intervene in markets to address inefficiency. In an optimally efficient market, resources are perfectly allocated to
those that need them in the amounts they need. In inefficient markets that is not the case; some may have too much of a resource
while others do not have enough. Inefficiency can take many different forms. The government tries to combat these inequities
through regulation, taxation, and subsidies. Most governments have any combination of four different objectives when they
intervene in the market.
Maximizing Social Welfare

In an unregulated inefficient market, cartels and other types of organizations can wield monopolistic power, raising entry costs and
limiting the development of infrastructure. Without regulation, businesses can produce negative externalities without consequence.
This all leads to diminished resources, stifled innovation, and minimized trade and its corresponding benefits. Government
intervention through regulation can directly address these issues.
Another example of intervention to promote social welfare involves public goods. Certain depletable goods, like public parks,
aren’t owned by an individual. This means that no price is assigned to the use of that good and everyone can use it. As a result, it is
very easy for these assets to be depleted. Governments intervene to ensure those resources are not depleted.
Macro-Economic Factors
Governments also intervene to minimize the damage caused by naturally occurring economic events. Recessions and inflation are
part of the natural business cycle but can have a devastating effect on citizens. In these cases, governments intervene through
subsidies and manipulation of the money supply to minimize the harsh impact of economic forces on its constituents.
Socio-Economic Factors
Governments may also intervene in markets to promote general economic fairness. Government often try, through taxation and
welfare programs, to reallocate financial resources from the wealthy to those that are most in need. Other examples of market
intervention for socio-economic reasons include employment laws to protect certain segments of the population and the regulation
of the manufacture of certain products to ensure the health and well-being of consumers.
Former President Bill Clinton signing welfare reform: Former President signing a welfare reform bill. Welfare programs are one
way governments intervene in markets.
Other Objectives
Governments can sometimes intervene in markets to promote other goals, such as national unity and advancement. Most people
agree that governments should provide a military for the protection of its citizens, and this can be seen as a type of intervention.
Growing a large and impressive military not only increases a country’s security, but may also be a source of pride. Intervening in a
way that promotes national unity and pride can be an extremely valuable goal for government officials.
Price Ceilings
A price ceiling is a price control that limits how high a price can be charged for a good or service.
Define price ceilings
A price ceiling is a price control that limits the maximum price that can be charged for a product or service. Generally ceilings are
set by governments, although groups that manage exchanges can set ceilings as well. The purpose of a price ceiling is to protect
consumers of a certain good or service. By establishing a minimum price, a government wants to ensure the good is affordable for
as many consumers as possible.
US Poster for Price Ceilings: Governments often impose price ceilings in times of war to ensure goods are available to as many
people as possible.
An example of a price ceiling is rent control. These regulations require a more gradual increase in rent prices than what the market
may demand. This regulation is meant to protect current tenants. Without rent control, there could be situations where the demand
for housing in an area could cause rent prices to make a substantial jump. Unable to afford the new, significantly higher rent, a
majority of the neighborhood’s tenants may be forced to move out of the neighborhood. Rent controls limit the possibility of tenant
displacement by minimizing the amount by which rent can be increased.
By definition, however, price ceilings disrupt the market. By setting a maximum price, any market in which the equilibrium price is
above the price ceiling is inefficient. There will be excess demand because the price cannot increase enough to clear the excess.
For a price ceiling to be effective, it must be less than the free-market equilibrium price. This is the price established through
competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by
sellers. It is also the price that the market will naturally set for a given good or service. If the price ceiling is higher than what the
market would already charge, the regulation would not be effective. As a result, a government will do significant research into the
current market conditions for a good before setting a price ceiling.
Price Ceiling Impact on Market Outcome

A binding price ceiling will create a surplus of supply and will lead to a decrease in economic surplus.
Explain how price controls lead to economic inefficiency
A price ceiling will only impact the market if the ceiling is set below the free-market equilibrium price. This is because a price
ceiling above the equilibrium price will lead to the product being sold at the equilibrium price.If the ceiling is less than the
economic price, the immediate result will be a supply shortage. As you can see from the chart below, a lower base price means less
of a good will be produced. The quantity demanded will increase because more people will be willing to pay the lower price to get
the good while producers will be willing to supply less, leading to a shortage.
Price Ceiling Chart: If a price ceiling is set below the free-market equilibrium price (as shown where the supply and demand
curves intersect), the result will be a shortage of the good in the market. The dead weight loss, represented in yellow, is the
minimum dead weight loss in such a scenario. If individuals who value the good most are not capable of purchasing it, there is a
potential for a higher amount of dead weight loss.
A price ceiling will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total
welfare, is the sum of consumer and producer 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 that they are willing pay. Producer surplus is the amount that
producers benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price
ceiling will lower the price of a good, which means that the the producer surplus will decrease. While the effective price ceiling
will also decrease the price for consumers, any benefit gained from that will be minimized by decreased sales caused by decreased
available supply for sale from producers due to the decrease in price. This translates into a net decrease total economic surplus,
otherwise known as deadweight loss. This loss is signified in the attached chart as the yellow triangle.
Rationing
If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the
greatest number of consumers. One way the government may ration the good is to issue ticket to consumers. A government will
only allow as much of good to be out in the marketplace as there are available tickets. To obtain the good, the consumer must
present the ticket and the money to the vendor when making the purchase. This is generally considered a fair way to minimize the
impact of a shortage caused by a ceiling, but is generally reserved for times of war or severe economic distress.
Black Market
Prolonged shortages caused by price ceilings can create black markets for that good. A black market is an underground network of
producers that will sell consumers as much of a controlled good as they want, but at a price higher than the price ceiling. Black
markets are generally illegal. However these markets provide higher profits for producers and more of a good for a consumers, so
many are willing to take the risk of fines or imprisonment.
Price Floors
A binding price floor is a price control that limits how low a price can be charged for a product or service.
Define price floors
A price floor is a price control that limits how low a price can be charged for a product or service. Generally floors are set by
governments, although groups that manage exchanges can set price floors as well. The purpose of a price floor is to protect
producers of a certain good or service. By establishing a minimum price, a government seeks to promote the production of the good
or service and ensure that the producers have sufficient resources to go about their work.
For a price floor to be effective, it must be greater than the free-market equilibrium price. This is the price established through
competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by
sellers. It is also the price that the market will naturally set for a given good or service. If the price floor is lower than what the
market would already charge, the regulation would serve no purpose. Since the price is set artificially high, there will be a surplus:
there will be a higher quantity supplied and a lower quantity demanded than in a free market. As a result, a government will
generally do significant research into the current market conditions for a good or service before setting a price floor.
Price Floor: If a price floor is set above the equilibrium price, consumers will demand less and producers will supply more.
An example of a price floor is the federal minimum wage. In this case the suppliers are employees and employers are the
consumers. The federal government has established a price that all employers must pay their workers. Obviously employers can
pay more than that amount, but they cannot pay less. The purpose of setting this floor is to ensure that all employees make enough
money from their jobs to provide for their basic needs.
History of the Federal Minimum Wage: History of the federal minimum wage in real and nominal dollars. The federal minimum
wage is one example of a price floor.
Price Floor Impact on Market Outcome

Binding price floors typically cause excess supply and decreased total economic surplus.
Show how price floors contribute to market inefficiency
A price floor will only impact the market if it is greater than the free-market equilibrium price. If the floor is greater than the
economic price, the immediate result will be a supply surplus. As you can see from, a higher base price will lead to a higher
quantity supplied. However, quantity demand will decrease because fewer people will be willing to pay the higher price. This will
lead to a surplus of supply.
Surplus from a price floor: If a price floor is set above the free-market equilibrium price (as shown where the supply and demand
curves intersect), the result will be a surplus of the good in the market.
A price floor will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total welfare,
is the sum of consumer and producer 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 that they are willing pay. Producer surplus is the amount that producers
benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price floor will raise
the price of a good, which means that the the consumer surplus will decrease. While the effective price floor will also increase the
price for producers, any benefit gained from that will be minimized by decreased sales caused by decreased demand from
consumers due to the increase in price. This translates into a net decrease total economic surplus, otherwise known as deadweight
loss.
Since well designed price floors create surpluses, the big issue is what to do with the excess supply. The first option is to let
inventories grow and have the private producers bear the cost of storing it. The other option is for the government that set the price
floor to purchase the excess supply and store it on its own. The government could then sell the surplus off at a loss in times of a
food shortage.
Introduction to Deadweight Loss

Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced at its pareto optimal level.
Define deadweight loss
Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced and produced at its pareto
optimal level. When output is at its pareto optimal point, the price, production, and consumption of a good cannot be altered for one
person’s benefit without making at least one other worse off. In a perfectly competitive market, products are priced at the pareto
optimal point.
When deadweight loss occurs, it comes at the expense of either the consumer economic surplus or the producer’s economic
surplus. Consumer surplus is the gain that consumers receive when they are able to purchase a product for less than the price they
are willing to pay; producer surplus is the benefit producers receive when the sell a product for more than they are willing to sell
for. While price controls, subsidies and other forms of market intervention might increase consumer or producer surplus, economic
theory states that any gain would be outweighed by the losses sustained by the other side. This net harm is what causes deadweight
loss.
Deadweight loss can be visually represented on supply and demand graphs. Known as Harberger’s triangle, the deadweight loss
equals the area within the following three points:
Deadweight loss: This chart illustrates the deadweight loss created when a price floor is instituted on the market for a good. The
amount of deadweight loss is shown by the triangle highlighted in yellow. This area is known as Harberger’s triangle.
where the supply and demand curve intersect, otherwise known as the free market equilibrium;
the point on the supply curve where the y-coordinate equals the non-pareto optimal price;
the point on the demand curve where the y-coordinate equals the non-pareto optimal price.
Example – Price Ceilings and Deadweight Loss

The chart above shows what happens when a market has a binding price ceiling below the free market price. Without the price
ceiling, the producer surplus on the chart would be everything to the left of the supply curve and below the horizontal line where y
equals the free market equilibrium price. The consumer surplus would equal everything to the left of the demand curve and above
the free market equilibrium price line.
With the price ceiling, instead of the producer’s surplus going all the way to the pareto optimal price line, it only goes as high as the
price ceiling.The consumer surplus extends down to the price ceiling, but it is limited on the right by Harberger’s triangle. In this
case, the reason for that limitation is due to quantity produced. The consumer would purchaser more of the product at the ceiling
price, but the producers are unwilling to supply enough to meet that demand because it is not profitable. As a result all of the goods
that might have been produced and consumed if the good was priced optimally are not, representing a net loss for society.
Arguments for and Against Government Price Controls

Many argue that price controls ensure resource availability, but most economists agree that these controls should be used sparingly.
Justify the use of price controls when certain conditions are met
When unemployment is especially high or when there is a shortage of goods, it can be difficult for people to get what they need at
an affordable price. The main appeal of government imposed price controls is that they can ensure that citizens can purchase what
they need in times of national economic hardship.
USFA Depression Price Fixing Poster: During the depression the US government fixed prices on basic staples, such as food, to
ensure people would be able to obtain their basic necessities.
Well designed price controls can do three things. First, these regulations can ensure that a basic staple, such as food, remains
affordable to most of a country’s citizens. Second, regulation can protect the producers of a good and ensure that they get sufficient
revenue. This in turn limits the possibility of shortages, which benefits consumer. Finally, when shortages occur, price controls can
prevent producers from gouging their customers on price.
Generally price controls are used in combination with other forms of government economic intervention, such as wage controls and
other regulatory elements.
While price controls may appear to be a sound decision in theory, most economists believe these controls should be used sparingly.
By keeping prices artificially low through price ceilings, consumers demand a higher quantity than producers are willing to supply,
leading to a shortage in the controlled product. As Nobel Prize winner Milton Friedman said, “We economists do not know much,
but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers
can’t sell tomatoes for more than two cents per pound. Instantly you’ll have a tomato shortage. ”
Price floors often lead to surpluses, which can be just as detrimental as a shortage. One of the best known price floors in the
minimum wage, which establishes a base line per hour wage that must be paid for work. As a result, employers hire fewer
employees than they would if they could pay workers lower than the minimum wage. As a result the supply of workers is greater
than the amount of work, which creates higher unemployment.
Taxes
Governments use its tax systems to raise funds for its programs and influence its citizens’ economic actions.
Categorize types of taxes into ad valorem taxes and excise taxes
Taxes are the primary means for governments to raise funds for its programs and to pay off its debts. It can also be used to
influence its citizens’ financial behavior.. Choosing the right set of rules that have all of the elements of a good tax system can be a
challenge for any government.
Tax: Taxes are a tool used by governments to raise money and influence their citizens’ economic choices.
Elements of a Good Tax System

Efficient: A tax system should raise the necessary revenues without unduly burdening the taxpayer.
Understandable: A tax system should be easily understandable by the average citizen who has to pay the tax.
Equitable: The tax burden should be distributed equitably among a nation’s citizens. Generally, this means that those that are
wealthier should pay more.
Benefit Principle: Generally, the people who use public services should pay for them with higher taxes. However this principle
is difficult to enforce in practice.
Two Types of Tax Systems

1. Direct Taxation: A direct tax is assessed on the income of the taxpayer and is generally collected before the taxpayer collects
his wages.
2. Indirect Taxation: An indirect tax is an avoidable tax assessed on certain activities, such as purchasing goods or services.
Examples of an indirect tax include sales tax and VAT (value added tax).
Types of Tax Structures

Proportional Tax: Otherwise known as a flat tax, a flat tax rate is applied to all earned income regardless of how much the
taxpayer earns. So a person making $20,000 would pay the same rate as a person making $120,000, but would pay significantly
less in real dollars.
Progressive Tax: The more a person earns, the higher the tax rate. Generally in a progressive tax system, income is divided into
“brackets. ” For example, assume a tax system divides earners into people two groups. Those who earn less than $100,000 pay
10% and people who earn $100,000 or more pay 20%. A person earning $20,000 would have to pay 10%, or $2,000, while a
person who earns $120,000 would have to pay 20%, or $24,000.
Regressive Tax: In a regressive tax system, poorer families pay a higher tax rate. Although a regressive tax system is never
explicitly used, some claim a sales tax is a type of regressive tax. Since high income earners spend a lower proportion of their
income on goods and services in comparison to low income earners, the rich tend to pay proportionally less sales tax.
Ad Valorem vs Excise Tax

Ad Valorem (or Value Added) and Excise Taxes are types of indirect taxes. Both are generally assessed on the sale of goods. These
two taxes differ in three ways:
1. An excise tax typically applies to a narrower range of products, such as gasoline, tobacco, and alcohol.
2. An excise tax is typically heavier than an ad valorem, accounting for a higher fraction of a product’s retail price.
3. Excise taxes are typically a fixed fee per unit, meaning that the government earns its revenue based on volume sold. Ad valorem
taxes are proportional to the price of the good, so the government earns revenue based on the value of the good or service being
sold.
Taxation Impact on Economic Output

Tax incidence falls mostly upon the group that responds least to price, or has the most inelastic price-quantity curve.
Analyze how changes in taxes affect the price of a good for sellers and buyers
Tax incidence is the effect a particular tax has on the two parties of a transaction; the producer that makes the good and the
consumer that buys it. The burden of the tax is not dependent on whether the state collects the revenue from the producer or
consumer, but on the price elasticity of supply and the price elasticity of demand. To understand how elasticities influence tax
incidence, its important to consider the two extreme scenarios and how the tax burden is distributed between the two parties.
Inelastic supply, elastic demand

Because supply is inelastic, the firm will produce the same quantity no matter what the price. Because demand is elastic, the
consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the
tax causes the market price to increase and the quantity demanded to decrease. Because consumption is elastic, the price consumers
pay doesn’t change very much. Because production is inelastic, the amount sold changes significantly. The producer is unable to
pass the tax onto the consumer and the tax incidence falls on the producer.
Tax Incidence of Producer: When supply is inelastic but demand is elastic, the majority of the tax is paid for by the consumer.
Since quantity demanded drops significantly in this scenario, the producer is forced to sell less.
Elastic supply, inelastic demand

Consumption is inelastic, so the consumer will consume the same quantity no matter the price. The producer will be able to
produce the same amount of the good, but will be able to increase the price by the amount of the tax. As a result, the entirety of the
tax will be borne by the consumer.
Similarly elastic supply and demand

Generally consumers and producers are neither perfectly elastic or inelastic, so the tax burden is shared between the two parties in
varying proportions. If one party is comparatively more inelastic than the other, they will pay the majority of the tax.
Increasing tax
If the government increases the tax on a good, that shifts the supply curve to the left, the consumer price increases, and sellers’
price decreases. A tax increase does not affect the demand curve, nor does it make supply or demand more or less elastic. This
potential increase in tax could be called marginal, because it is a tax in addition to existing levies.
Key Points
The government tries to combat market inequities through regulation, taxation, and subsidies.
Governments may also intervene in markets to promote general economic fairness.
Maximizing social welfare is one of the most common and best understood reasons for government intervention. Examples of
this include breaking up monopolies and regulating negative externalities like pollution.
Governments may sometimes intervene in markets to promote other goals, such as national unity and advancement.
For a price ceiling to be effective, it must be less than the free-market equilibrium price.
The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a maximum price, a
government wants to ensure the good is affordable for as many consumers as possible.
Rent control is an example of a price ceiling.
A price ceiling has an economic impact only if it is less than the free-market equilibrium price.
An effective price ceiling will lower the price of a good, which decreases the producer surplus. The effective price ceiling will
also decrease the price for consumers, but any benefit gained from that will be minimized by the decreased sales due to the drop
in supply caused by the lower price.
If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the
greatest number of consumers.
Prolonged shortages caused by price ceilings can create black markets for that good.
A price floor is economically consequential if it is greater than the free-market equilibrium price.
Price floors lead to a surplus of the product.
Supply surpluses created by price floors are generally added to producer’s inventory or are purchased by governments.
Consumer surplus is the gain obtained by consumers because they can obtain a product for a lower price than they would be
willing to pay.
Producer surplus is the benefit producers get by selling at a price higher than the lowest price they would sell for.
Deadweight loss can be caused by monopolies, binding price controls, taxes, subsidies, and externalities.
When deadweight loss occurs, it comes at the expense of consumer surplus and/or producer surplus.
Deadweight loss can be visually represented on supply and demand graphs as a figure known as Harberger’s triangle.
The main appeal of governmental imposed price controls is that they can ensure that citizens can purchase what they need in
times of national economic hardship.
Well designed price controls can ensure that basic staples are affordable, minimize the possibility of shortages, and prevent
price gouging when shortages occur.
By keeping prices artificially low through price ceilings, economists argue that demand is increased to a point where supply
cannot keep up, leading to a shortage in the controlled product.
Price floors often lead to surpluses, which can be just as detrimental as a shortage.
A good tax system should be efficient, understandable and equitable. It should also allocate the costs of public services to those
who use it, although that principle is hard to execute in practice.
A direct tax is assessed on a person’s income. Indirect taxes are assessed on an individual’s participation in certain activities,
such as making a purchase.
The three types of tax systems are proportional, progressive, and regressive.
Ad valorem and excise taxes are two types of indirect taxes.
When supply is inelastic and demand is elastic, the tax incidence falls on the producer.
When supply is elastic and demand is inelastic, the tax incidence falls on the consumer.
Tax incidence is the analysis of the effect a particular tax has on the two parties of a transaction; the producer that makes the
good and the consumer that buys it.
A marginal tax is an increase in a tax on a good that shifts the supply curve to the left, increases the consumer price, and
decreases the price for the sellers.
Key Terms
inefficient market: An economy where social optimality is not acheived; an economy where resources are not optimally
allocated
free-market equilibrium price: The price established through competition such that the amount of goods or services sought by
buyers is equal to the amount of goods or services produced by sellers
Price ceiling: An artificially set maximum price in a market.
black market: trade that is in violation of restrictions, rationing or price controls
free-market equilibrium price: The price established through competition such that the amount of goods or services sought by
buyers is equal to the amount of goods or services produced by sellers
price floor: A mandated minimum price for a product in a market.
another.
Price control: A law that sets the maximum or minimum amount for which a good may be sold.
staple: A basic or essential supply.
progressive: Increasing in rate as the taxable amount increases
regressive: Whose rate decreases as the amount increases.
Tax incidence: The effect a particular tax has on the two parties of a transaction.
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CHAPTER OVERVIEW
30: Current Topics in Macroeconomics

Topic hierarchy
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Boundless.
Arguments For and Against Discretionary Monetary Policy
Discretionary policies refer to subjective actions taken in response to changes in the economy.
Contrast discretionary and rules-based monetary policy.
Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules;
instead, they use subjective judgment to treat each situation in a unique manner. For much of the 20th century, governments
adopted discretionary policies to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation,
output, and unemployment. However, following the stagflation of the 1970s, policymakers were attracted to policy rules.
Discretionary Policy
A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can
be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under
control, but then relax its stance later. This could make the policy noncredible and ultimately ineffective.
Rules-based Policy
A rule-based policy can be more credible, because it is more transparent and easier to anticipate, unlike discretionary policy. Policy
is implemented based on indicator events in the economy and the policy is expected and carried out in a timely manner. Further, as
commented by Milton Friedman who argued in favor of a rules-based approach, the dynamics of discretionary policy present a lag
between observation and implementation. This can create compounding issues related to the discretionary policy enacted.
However, a strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain
circumstances.
Milton Friedman: Milton Friedman was a Nobel Prize (1976) recipient in the field of Economics and was a supporter of rules-
based monetary policy.
Compromise
A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For
instance, the Federal Reserve Bank, European Central Bank, Bank of England, and Reserve Bank of Australia all set interest rates
without government interference, but do not adopt a strict rules-based policy stance. In this case the central banking authorities
have autonomy and are able to use monetary policy to enable their mandate of economic growth and full employment. The policies
they enact cannot be destabilized by government fiscal policy.
Arguments For and Against Fighting Recession with Expansionary Monetary Policy
Expansionary monetary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates.
Assess the value of discretionary expansionary monetary policy and the associated shortcomings.
Expansionary monetary 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 investing, leading to overall economic growth. Monetary policy, to a great extent, is
the management of expectations between interest rates, the price of the use of money, and the total supply of money. Monetary
policy uses a variety of discretionary tools to control one or both of these to influence outcomes like economic growth, inflation,
exchange rates with other currencies, and unemployment. When the central bank is in complete control of the money supply, the
monetary authority has the ability to alter the money supply and influence the interest rate to achieve policy goals.
Money supply: The increase in the money supply is the primary conduit for expansionary monetary policy.
However, the success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding
of central bank operations related to interest rates and money supply effects on the part of the public, in general. For example, if the
central bank is implementing expansionary policy but is committed to keeping interest rates low, the central bank needs to convey
this policy with credibility, otherwise economic agents may assume that expansionary policy will lead to inflation and begin
augmenting behavior to initiate the outcome expected, higher inflation.
Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets
(but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body.
Arguments For and Against Fighting Recession with Expansionary Fiscal Policy
Expansionary fiscal policies, which are usually implemented during recessions, attempt to increase economic demand.
Evaluate the pros and cons of fiscal policy intervention during recession
Fiscal policy is a broad term, describing the policies enacted around government revenue and expenditure in order to influence the
economy. Governments can increase their revenue by increasing taxes, or increase their expenditure by spending money on
programs.
Fiscal policy: Taxes: Taxes have not only been a way to initiate fiscal policy intervention, but have also been used to solidify
popular approval. In the picture above former President George W. Bush is signing into effect the Tax Relief Reconciliation Act of
2001.
Expansionary fiscal policies are usually implemented during recessions because they attempt to increase economic demand, and as
a result, increase economic output which is reduced during a recession. Expansionary fiscal policies involve reducing taxes or
increasing government expenditure.
Remember that government revenue is based on collected taxes. When taxes exceed government spending, the government is
characterized as having a surplus. When taxes equal government expenditures, the government has a balanced budget. When the
government spends more than the revenue it collects, it has a deficit. Increasing government spending, creating a budget deficit,
and financing the shortfall through debt issuance are typical policy actions in an expansionary fiscal policy scenario.
Due to the funding process of expansionary policy, there is a lack of consensus among economists with respect to the merits of
fiscal stimulus. The discord mostly centers on crowding out, defined as government borrowing leading to higher interest rates that
in turn may offset the stimulative impact of government spending. When the government runs a budget deficit, funds will need to
come from public or foreign borrowing. As a result, the government issues bonds. This raises interest rates across the economy
because government borrowing increases demand for credit in the financial markets. This may in turn reduce aggregate demand for
goods and services, which defeats the purpose of a fiscal stimulus.
Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending
through investment (infrastructure, repair, construction) will provide stimulus to increase economic growth by directly influencing
consumption or the government expenditure component of GDP.
Arguments For and Against Inflation Targeting Policy Interventions

Inflation targeting often succeeds in controlling inflation and anchoring expectations, but may limit a central bank’s flexibility.
Argue that central banks should maintain inflation targets, Argue that central banks should not maintain inflation targets
Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to
steer actual inflation towards the target. For example, in the United States, the Federal Reserve implicitly maintains a target
inflation range of 1.7%-2.0%. When inflation falls below this range, the Fed would lower interest rates and raising the money
supply in order to push inflation up. Likewise, when inflation rises above the target range, the Fed would raise interest rates and
decrease the money supply in order to suppress the high level of inflation. While the inflation rate and the interest rate generally
have an inverse relationship, these tools are not always successful in affecting inflation – for example, in response to the 2008
financial crisis and ensuing recession, the Fed raised its target inflation level to 2% and lowered interest rates to nearly zero. This
did not, however, succeed in raising inflation to 2%.
Inflation Targeting: The relationship between the money supply and the inflation rate is not exact, but it suggests that a central
bank can often affect inflation by adjusting the money supply through higher or lower interest rates.
Argument in Favor of Inflation Targeting

Proponents of inflation targeting argue that a volatile inflation rate has negative effects for an economy. High levels of inflation eat
away at savings, increase menu costs and shoe-leather costs, discourage lending, and may create an inflationary spiral that leads to
hyperinflation. Inflation targeting has been successful in keeping inflation levels low and avoiding many of these negative effects.
Further, inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future
inflation. When the central bank announces an inflation target of 2%, the public knows that if inflation goes too far above or below
that level, the central bank will take action. This certainty stimulates economic activity. Further, the public’s expectations about
inflation tend to be a self-fulfilling prophecy. When consumers expect high inflation they spend their money immediately,
attempting to avoid higher future prices. This increase in demand leads to higher prices, causing more inflation. Likewise, when
consumers expect deflation they tend to save their money, delaying consumption until prices fall. This decrease in demand causes
producers to sell their goods at lower prices, and the cycle continues. Inflation targeting sets consumers’ expectations, making a
certain inflation level easier to maintain.
Arguments Against Inflation Targeting

On the other hand, some argue that the costs of inflation targeting exceed the benefits. If the rule is implemented very strictly, an
inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions. During a
recession, for example, central banks shouldn’t raise the interest rate even if inflation is above the target level. Further, sometimes
higher inflation is a good thing because it stimulates spending. A central bank with a strict inflation targeting rule, however, would
not allow that higher inflation rate even if it were otherwise beneficial.
Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best
variable to target. Adherents of market monetarism, for example, argue that targeting a nominal national income (nominal GDP)
would be more effective than targeting inflation. Others suggest targeting long-run inflation, which takes the exchange rate into
account, rather than the short-term inflation rate.
Key Points
A discretionary policy allows policymakers to respond quickly to events.
A rule-based policy can be more credible because it is more transparent and easier to anticipate, unlike discretionary policy.
A strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain
circumstances, creating a need for a compromise between discretionary and rules-based policy.
The success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of
central bank operations related to interest rates and money supply effects on the part of the public, in general.
Without central bank credibility with respect to low interest rate targets, economic agents may assume that expansionary policy
will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.
Announcements can be made credible in various ways. One method would be to establish an independent central bank with low
inflation targets (but no output targets).
Government can enact changes in fiscal policy by changing taxes and government spending levels in various sectors.
Fiscal stimulus through the debt creation channel, may result in reducing the availability of loanable funds, increasing interest
rate which may in turn cause a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending
through investment will provide stimulus to increase economic growth by directly influencing consumption or the government
expenditure component of GDP.
Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to
steer actual inflation towards the target.
Inflation targeting has often been successful in keeping inflation levels low and avoiding many of its negative effects.
Inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future
inflation.
On the other hand, if the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in
responding to changing economic conditions.
Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best
variable to target.
Key Terms
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.
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.
discretionary: Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or
judgment.
fiscal stimulus: Involves government spending exceeding tax revenue, and is usually undertaken during recessions.
crowding out: A drop in private investment caused by increase in government investment.
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CHAPTER OVERVIEW
31: International Trade

Topic hierarchy
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1
Reasons for Trade
Countries benefit when they specialize in producing goods for which they have a comparative advantage and engage in trade for
other goods.
Discuss the reasons that international trade may take place
International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap
mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other
products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic
opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to
other nations.
International Trade: Countries benefit from producing goods in which they have comparative advantage and trading them for
goods in which other countries have the comparative advantage.
In addition to comparative advantage, other reasons for trade include:
Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot
of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods
of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost
declines as output increases.
Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help
promote diplomatic (rather than military) solutions to international problems.
Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater
responsiveness to consumer wants and needs, and a wider variety of products.
To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.
Understanding Production Possibilities

The production possibility frontier shows the combinations of output that could be produced using available inputs.
Explain the benefits of trade and exchange using the production possibilities frontier (PPF)
In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be
produced using the same total amount of the factors of production. It shows the maximum possible production level of one
commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An economy that is
operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without
decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the
PPF, the production of guns would need to be sacrificed in order to produce more butter. If production is efficient, the economy can
choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of
butter and guns is required.
Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on the PPF. Point X,
however, is unattaible with existing resources and technology if trade does not occur.
If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce
more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing
resources and technology if trade does not occur with an outside producer.
The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress makes it
possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be
produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply
of raw materials is depleted, or a natural disaster decreases the stock of physical capital.
Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the
consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made
up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of
each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their
comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher
than the quantity available under autarky.
Defining Absolute Advantage

A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.
Relate absolute advantage, productivity, and marginal cost
Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a
country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less
time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the
ability of a country to produce specific goods at a lower opportunity cost.
A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For
example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to
some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much
lower unit labor costs.
China and Consumer Electronics: Many consumer electronics are manufactured in China. China can produce such goods more
efficiently, which gives it an absolute advantage relative to many countries.
Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3
workers. Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in
producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number
of workers.
Absolute Advantage: Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount
of resources than Party A.
If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods
and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their
production possibilities frontiers, and are thus able to consume more goods as a result.
Defining Comparative Advantage

A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.
Analyze the relationship between opportunity cost and comparative advantage
Comparative Advantage
In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and
opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all
goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the
opportunity cost of importing is lower than the cost of producing them locally.
Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both
products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having
more and/or better resources or discovering improved production techniques.
Determining Comparative Advantage

Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players.
Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys
and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that
Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the
production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources
more efficient across both countries.
Comparative Advantage: Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a
comparative advantage in producing CD players. Both nations can benefit from trade.
For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the
opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while
Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).
Comparative vs Competitive Advantage

It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are
different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a
product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or
relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we
more often discuss comparative advantage.
Absolute Advantage Versus Comparative Advantage

Absolute advantage refers to differences in productivity of nations, while comparative advantage refers to differences in
opportunity costs.
Differentiate between absolute advantage and comparative advantage
Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity
inputs to produce a good is said to have an absolute advantage in producing that good.
The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time. Country A
uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit,
and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in
making both food and clothing.
Absolute Advantage: Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in
food.
Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than
another. Even if one country has an absolute advantage in producing all goods, different countries could still have different
comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because
each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage
drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to
increased productivity.
For example, consider again Country A and Country B in. The opportunity cost of producing 1 unit of clothing is 2 units of food in
Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in
Country A, Country B has a comparative advantage in clothing.
Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B
specializes clothing. The countries will then trade, and each will gain.
Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.
Benefits of Specialization
Specialization leads to greater economic efficiency and consumer benefits.
Discuss the effects of specialization on production
Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However,
specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:
Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale
for the production of these goods. They benefit from economies of scale , which means that the average cost of producing the
good falls (to a certain point) because more goods are being produced. Similarly, countries can benefit from increased learning.
They simply are more skilled at making the product because they have specialized in it. These effects both contribute to
increased overall efficiency for countries. Countries become better at making the product they specialize in.
Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally more
goods are produced and prices are lower. Consumers benefit from these lower prices and greater quantity of goods.
Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to
benefit further from economies of scale.
Gains from trade: Suppose that Britain and Portugal each produce wine and cloth. Britain has a comparative advantage in
cloth and Portugal in wine. By specializing and then trading, Britain can get a unit of wine for only 100 units of labor by trading
cloth for labor instead of taking 110 units of labor to produce the wine itself (assuming the price of Cloth to Wine is 1).
Similarly, Portugal can specialize in wine and get a unit of cloth for only 80 units of labor by trading, instead of the 90 units of
labor it would take to produce the cloth domestically. Each country will continue to trade until the price equals the opportunity
cost, at which point it will decide to just produce the other good domestically instead of trading. Thus (in this example with no
trade costs) both countries benefit from specializing and then trading.
Of course, there are also some potential downsides to specialization:
Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For
example, firms in United States may see demand for their products fall due to cheaper imports from China. This may lead to
structural unemployment.
Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service produced by a
country. For example, the global demand for rubber has fallen due the the availability of synthetic substitutes. Countries may
experience high levels of persistent structural unemployment and low GPD because demand for their products has fallen.
Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that country. Political or
economic changes in the second country may impact the supply of goods or services available to the first.
As a whole, economists generally support specialization and trade between nations.
Relationship Between Specialization and Trade

Comparative advantage is the driving force of specialization and trade.
Discuss how countries determine which goods to produce and trade
Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than
producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for
a different surplus good of another country. The traders decide on whether they should export or import goods depending on
comparative advantages.
Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient,
because they have the ability to produce both products. However, specializing in the product for which they have a comparative
advantage and then trading would allow both countries to consume more than they would on their own.
One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but
this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When
countries decide what products to specialize in, the essential question becomes who could produce the product at a lower
opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one
could have gotten if one produced another product instead of one unit of the given product.
For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard. This means that in the same amount of
time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3
bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing
ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity
cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard.
Comparative Advantage: Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in
producing mustard.
There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This
doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other –
but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of
consumption as producing all goods domestically.
Key Points
International trade is the exchange of capital, goods, and services across international borders or territories.
Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of
other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency
gains for domestic producers.
The production possibilities curve shows the maximum possible production level of one commodity for any production level of
another, given the existing levels of the factors of production and the state of technology.
Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur
with an external producer.
Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute
quantity of goods available for consumption is higher than the quantity that would be available under national economic self-
sufficiency.
A country that has an absolute advantage can produce a good at lower marginal cost.
A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower
opportunity cost.
Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of
outputs becomes available to the trading nations.
Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not
necessarily related to a lower opportunity cost.
The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that
good.
Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than
another.
The existence of a comparative advantage allows both parties to benefit from trading, because each party will receive a good at
a price that is lower than its opportunity cost of producing that good.
Whenever countries have different opportunity costs in production they can benefit from specialization and trade.
Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive
sectors.
The disadvantages of specialization include threats to uncompetitive sectors, the risk of over-specialization, and strategic
vulnerability.
Nations decide whether they should export or import goods based on comparative advantages.
Generally, nations can consume more by specializing in a good and trading it for other goods.
When countries decide which country will specialize in which product, the essential question becomes who could produce the
product at a lower opportunity cost.
Key Terms
comparative advantage: The ability of a party to produce a particular good or service at a lower marginal and opportunity cost
over another.
Production possibilities frontier: A graph that shows the combinations of two commodities that could be produced using the
same total amount of each of the factors of production.
Autarky: National economic self-sufficiency.
Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.
Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that
opportunity); the most valuable forgone alternative.
competitive advantage: Something that places a company or a person above the competition
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Exports: The Economic Impacts of Selling Goods to Other Countries
Exporting is a form of international trade which allows for specialization, but can be difficult depending on the transaction.
Evaluate the effects of international trade on exporting countries
Exports
Export is defined as the act of a country shipping goods and services out of the port of a country. In international trade, an export
refers to the selling of goods and services produced in the home country to other markets (other countries). The seller of the goods
and services is referred to as the “exporter.”
Exports: The map shows the primary exporters for countries around the globe. The colors indicate the leading merchandise export
destination for the indicated country (the United States main export destination is the European Union). Exporting is the act of
shipping goods and services to other countries.
Protecting Exports
In order to protect exports, commercial goods are subject to customs authorities for both the exporting and importing countries.
Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods
and services that are exported to other countries.
Impact of Exports
Exporting goods and services has both advantages and disadvantages for countries involved in international trade.
Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products. It is
viewed as a low-risk mode of production and trade. Exporters also experience internationalization advantages which are the
benefits of retaining a core competence within a company and threading it through the value chain instead of obtaining a license to
outsource or sell the goods or services.
Disadvantages of exporting are mainly the result of manufacturers having to sell their goods to importers. In domestic sales,
manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face and extra
layer in the chain of distribution which squeezes the margins. As a result, manufacturers may have to offer lower prices to the
importers than to domestic wholesalers in order to move their product and generate business.
Imports: The Economics Impacts of Buying Goods from Other Countries

Imports are critical for many economies; they are the defining financial transactions of international trade and account for a large
portion of the GDP.
Evaluate the effects of international trade on an importing country
Imports
Imports are defined as purchases of good or services by a domestic economy from a foreign economy. The domestic purchaser of
the good or service is called an importer. Imports and exports are critical for many economies and they are the defining financial
transactions of international trade.
Protecting Imports
Due to the economic importance of imports, countries enact specific laws, barriers, and policies in order to regulate international
trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive
quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, consumer surplus increases.
The price of a good or service will decrease while the quantity consumed will increase.
Impacts of Buying Imported Goods

On a national level, in most countries international trade and importing goods represents a significant share of the gross domestic
product (GDP). International trade has a significant economic, social, and political importance in many countries. Imports provide
countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and
services within its own borders.
Imports: The map shows the largest importers on an international scale. The color indicates the leading source of merchandise
imports for the indicated country (the United States’ imports the largest percentage of its goods from China). Imports account for a
significant share in the gross domestic product (GDP) of a country.
International trade is generally less expensive than domestic trade despite additionally imposed costs, taxes, and tariffs. However,
the factors of production are usually more mobile domestically than internationally (capital and labor). It is common for countries
to import goods rather than a factor of production. For example, the U.S. imports labor-intensive goods from China. Instead of
importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor.
On a business level, companies take part in direct-imports, which occur when a major retailer imports goods that are designed
locally from an overseas manufacturer. The direct-import program allows the retailer to bypass the local supplier and purchase the
final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.
Costs of Trade
Free trade is a policy where governments do not discriminate against imports and exports; creates a large net gain for society.
Identify the groups that benefit and the groups that are harmed by free trade policies
Free Trade
Free trade is a policy where governments do not discriminate against exports and imports. There are few or no restrictions on trade
and markets are open to both foreign and domestic supply and demand.
Advantages
Free trade is beneficial to society because it eliminates import and export tariffs. Restricted trade affects the welfare of society
because although producers experience increases in surplus and additional revenue, the loss faced by consumers is greater than any
benefit obtained. When a country trades freely with the rest of the world, it should theoretically produce a net gain for society and
increases social welfare. Free trade policies consist of eliminating export tariffs, import quotas, and export quotas; all of which
cause more losses than benefits for a country. With free trade in place, the producers of the exported good in exporting countries
and the consumers in importing countries all benefit.
Tariffs: This image shows what happens to societal welfare when free trade is not enacted. Tariffs cause the consumer surplus
(green area) to decrease, while the producer surplus (yellow area) and government tax revenue (blue area) increase. The amount of
societal loss (pink area) is larger than any benefits experienced by the producers and government. Free trade does not have tariffs
and results in net gain for society.
Disadvantages
One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade
diversion. It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does
not always occur if a high cost producer has a free trade agreement and the low cost producer does not. When free trade is applied
to only the high cost producer it can lead to trade diversion to not the most efficient producer, but the one facing the lowest trade
barriers, and a net economic loss. Free trade is highly effective and provides society with a net gain, but only if it is applied.
Due to industry specializations, many workers are displaced and do not receive retraining or assistance finding jobs in other
sectors. The nature of industries and trade increases economic inequality. As a result of unskilled workers the wages within the
various industries may decline.
Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where
there is not comparative advantage. Despite this disadvantage, the level of output that is generated by free trade for both the
“winner” and the “loser” is increased substantially.
The Results of Free Trade

Economists have studied free trade extensively and although it creates winners and losers, the main consensus is that free trade
generates a large net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the U.S.
should eliminate any remaining tariffs and trade barriers. Economists professor N. Gregory Mankiw explained that, “few
propositions command as much consensus among professional economists as that open world trade increases economic growth and
raises living standards.”
Key Points
Export is defined as the act of shipping goods and services out of the port of a country.
Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the
goods and services that are exported from the country.
Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products.
Due to an extra layer in the chain of distribution which squeezes the margins, exporters may have to offer lower prices to the
importers than to domestic wholesalers in order to move their product and generate business.
Imports are defined as purchases of good or services by a domestic economy from a foreign economy.
Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive
quotas, and government regulations.
In most countries, international trade and importing goods represents a significant share of the gross domestic product ( GDP ).
International trade is generally more expensive than domestic trade due to additionally imposed costs, taxes, and tariffs.
On a business level, companies take part in direct-imports; a major retailer imports goods from an overseas manufacturer in
order to save money.
Free trade eliminates export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country.
With free trade in place the producers in exporting countries and the consumers in importing countries all benefit.
One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade
diversion.
Trade restricts displaces workers, makes overcoming unemployment challenging, increases economic inequality, and can lower
wages.
When free trade is applied to only the high cost producer it can lead to trade diversion and a net economic loss.
Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where
there is not comparative advantage.
Key Terms
trade: Buying and selling of goods and services on a market.
export: Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in
trade.
protectionism: A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on
imports.
import: To bring (something) in from a foreign country, especially for sale or trade.
tariff: A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties
themselves.
free trade: International trade free from government interference, especially trade free from tariffs or duties on imports.
Export. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Export. License: CC BY-SA: Attribution-ShareAlike
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The Importance of Trade
International trade is an integral part of the modern world economy.
Discuss the reasons of the U.S. increase in international trade participation after World War II
Economists generally support trade because it allows for increased overall utility for both countries. Gains from trade are
commonly described as resulting from:
Silk Road Trade: Even in ancient times, people benefited from widespread international trade. The benefits from international
trade have increased as costs decline and the international system becomes better integrated.
specialization in production from division of labor (according to one’s comparative advantage), economies of scale, scope, and
agglomeration and relative availability of factor resources in types of output by farms, businesses, location and economies
a resulting increase in total output possibilities
trade through markets from sale of one type of output for other, more highly valued goods.
The Rise of International Trade

International trade is important, and, over time, has become more important. There have been three primary reasons for this
increase in importance.
First, there have been large reductions in the cost of transportation and communication. It is now much cheaper to not only operate
internationally and trade with foreign partners, but also to exchange information between potential buys and sellers.
Second, technological advances have made international production and trade easier to coordinate. More efficient
telecommunications, from the first transatlantic telephone cable in 1956 to the popularization of the internet in the 1980s and
1990s, have allowed companies to exchange goods more efficiently and lowered the costs of international integration.
Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also
contributed to the rise in international trade.
Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of
international monetary management has shaped the relationship between the world’s major industrial states and has resulted in a
much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after
World War II, the Bretton Woods Conference set up regulations for production of their individual currencies to maintain fixed
exchange rates between countries with the aim of more easily facilitating international trade.This was the foundation of the U.S.
vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via
fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed
exchange rates, the goal of more open economies and free international trade remained.
The Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain
period.
Explain the relationship between the trade balance of a nation and its economic well-being
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain
period, measured in the currency of that economy. It is the relationship between a nation’s imports and exports. It is measured by
finding the country’s net exports. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a
negative balance is referred to as a trade deficit or, informally, a trade gap.
Factors that can affect the balance of trade include:
The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing
economy
The cost and availability of raw materials, intermediate goods, and other inputs
Currency exchange rate
Multilateral, bilateral, and unilateral taxes or restrictions on trade
Non-tariff barriers such as environmental, health, or safety standards
The availability of adequate foreign exchange with which to pay for imports
Prices of goods manufactured at home
In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial
goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the
United States and Australia) the trade balance will worsen at the same stage in the business cycle.
Twin Deficits Hypothesis

The twin deficits hypothesis is a concept from macroeconomics that contends that there is a strong link between a national
economy’s current account balance and its government budget balance. This link can be seen from considering the national
accounting model of the economy:
Y = C + I + G + (N X) (31.3.1)
Y represents national income or GDP, C is consumption, I is investment, G is government spending, and N X stands for net
exports (exports minus imports). This represents GDP because all the production in an economy (the left hand side of the equation)
is used as consumption (C ), investment (I ), or government spending (G), and the leftover production is exported (N X ).
Another equation defining GDP using alternative terms (which in theory results in the same value) is:
Y = C +S +T (31.3.2)
Y is again GDP, C is consumption, S is savings, and T is taxes. This is because national income is also equal to output, and all
individual income either goes to pay for consumption (C ), to pay taxes (T ), or becomes savings (S ).
Since Y = C +I +G+NX , and Y −C −T = S , then S = G − T + N X + I , which simplifies to:
(S − I ) + (T − G) = (N X) (31.3.3)
If (T − G) is negative, we have a budget deficit. Assuming that the economy is at potential output (meaning Y is fixed), if the
budget deficit increases and savings and investment remain the same, then net exports must fall, causing a trade deficit. Thus,
budget deficits and trade deficits go hand-in-hand.
Twin Deficits in the US: In the U.S., net borrowing has tended to have a direct relationship with net imports. The red line
represents net imports, which is equivalent to the negative balance of trade, and the black line represents net borrowing, which is
equivalent to the government budget deficit. Although the two are not identical, a rise in one tends to accompany a rise in the other,
and vice versa.
The twin deficits hypothesis implies that as the budget deficit grows, net capital outflow from a country falls. This is because the
nation is financing its spending by selling assets to foreigners. The total rate of national savings falls, which may lead to an increase
in the interest rate as lending to the country (i.e. buying bonds and other financial assets) becomes more risky.
Key Points
The international market serves as an important place for the exchange of goods and services.
Economic theory shows that there are gains from trade for both countries involved.
Advances in transportation has dramatically reduced the costs of moving goods around the globe.
Technological advances have made international production and trade easier to coordinate.
Trade barriers between countries have fallen and are likely to continue to fall.
A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to
as a trade deficit or, informally, a trade gap.
Factors that can affect the balance of trade include the currency exchange rate, cost of inputs, barriers to trade such as tariffs and
regulations, and the prices of domestic goods.
The twin deficits hypothesis contends that there is a strong positive relationship between a national economy’s current account
balance and its government budget balance.
Key Terms
comparative advantage: The ability of a party to produce a particular good or service at a lower margin and opportunity cost
over another.
production possibilities curve: 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
net capital outflow: The net flow of funds being invested abroad by a country during a certain period of time.
net exports: The difference between the monetary value of exports and imports.
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Economic Globalization. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Economic_globalization. License: CC
International Trade. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/International_trade. License: CC BY-SA:
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Tariffs
Tariffs are taxes levied on goods entering or exiting a country, and have consequences for both domestic consumers and producers.
Discuss the consequences of a tariff for a domestic economy
One barrier to international trade is a tariff. A tariff is a tax that is imposed by a government on imported or exported goods. They
are also known as customs duties.
Types of Tariffs
Tariffs can be classified based on what is being taxed:
Import tariffs: Taxes on goods that are imported into a country. They are more common than export tariffs.
Export tariffs: Taxes on goods that are leaving a country. This may be done to raise tariff revenue or to restrict world supply of a
good.
Tariffs may also be classified by their purpose:
Protective tariffs: Tariffs levied in order to reduce foreign imports of a product and to protect domestic industries.
Revenue tariffs: Tariffs levied in order to raise revenue for the government.
Tariffs can also be classified on how the duty amount is valued:
Specific tariffs: Tariffs that levy a flat rate on each item that is imported. For example, a specific tariff would be a fixed $1,000
duty on every car that is imported into a country, regardless of how much the car costs.
Ad valorem tariffs: Tariffs based on a percentage of the value of each item. For example, an ad valorem tariff would be a 20%
tax on the value of every car imported into a country.
Compound tariffs: Tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might
consist of a fixed $100 duty plus 10% of the value of every imported car.
Consequences of Levying a Tariff

To see the effects of levying an import tariff, consider the example shown in. Assume that there is an import tax levied on a good in
a domestic country, Home. The domestic supply of the good is represented by the diagonal supply curve, and world supply is
perfectly elastic and represented by the horizontal line at P . Before a tariff is levied, the domestic price is at P , and the quantity
w w
demanded is at D (with quantity S provided domestically, and quantity D − S imported).
Effects of a Tariff: When a tariff is levied on imported goods, the domestic price of the good rises. This benefits domestic
producers by increasing producer surplus, but domestic consumers see a small consumer surplus.
When the tariff is imposed, the domestic price of the good rises to P . Now, more of the good is provided domestically; instead of
t
producing S , it now produces S . Imports of the good fall, from the quantity D − S to the new quantity D − S . With the higher
∗ ∗ ∗
prices, domestic producers experience a gain in producer surplus (shown as area A). In contrast, because of the higher prices,
domestic consumers experience a loss in consumer surplus; consumer surplus shrinks from the area above P to the area above P
w t
(it shrinks by the areas A, B, C, and D).

Because the tariff is a tax, the government gains some revenue. The government charges a tariff amount of P − P on every t w
imported good. The amount of revenue is equal to the tariff amount times the number of imported goods, or (P − P )(D − S ) .
t w
∗ ∗
This results in a governmental gain of area C.

In this example, domestic producers and the government both gain from the import tariff, and domestic consumers lose. However,
if the world price is higher than the domestic price, a tariff will not change the price or quantity consumed of a good.
Quotas
Quotas are limitations on imported goods, come in an absolute or tariff-rate varieties, and affect supply in the domestic economy.
Discuss the economic consequences of different kinds of quotas
Barriers to trade exist in many forms. A tariff is a barrier to trade that taxes imports or exports, thus increasing the cost of a good.
Another barrier to trade is an import quota, which places a limit on the amount of a good that may enter a country.
Types of Quotas
There are two main types of import quota: the absolute quota and the tariff-rate quota.
An absolute quota is a limit on the quantity of specific goods that may enter a country during a certain time period. Once the quota
has been fulfilled, no other goods may be imported into the country. An absolute quota may be set globally, in which case goods
may be imported from any country until the goal has been reached. An absolute quota may also be set selectively for certain
countries. As an example, suppose an absolute, global quota for pens is set at 50 million. The government is setting a limit that, in
total, only 50 million pens can be imported. If there were a selective, absolute quota, only 50 million pens would be able to be
imported, but this total would be divided among exporting countries. Country A might only be able to export 10 million pens,
Country B might be able to export 25 million pens, and Country C might be able to export 15 million pens. Collectively, the total
imports equal 50 million pens, but the proportions of pens from each country are set.
A tariff-rate quota is a two-tier quota system that combines characteristics of tariffs and quotas. Under a tariff-rate quota system, an
initial quota of a good is allowed to enter the country at a lower duty rate. Once the initial quota is surpassed, imports are not
stopped; instead, more of the good may be imported, but at a higher tariff rate. For example, under a tariff-rate quota system, a
country may allow 50 million pens to be imported at the low tariff rate of $1 each. Any pen that is imported after this first-tier
quota has been reached would be charged a higher tariff, say $3 each.
Reasons to Implement Quotas

Quotas are often implemented for similar reasons as other trade barriers. Often, quotas are instituted to:
Protect domestic industries and employment: By reducing the number of foreign imports, domestic suppliers must produce
more to meet domestic demand. By producing more, the suppliers must hire more domestic workers, increasing employment.
Additionally, setting quotas to reduce foreign competition allows domestic “infant industries,” or young, small industries, to
grow and mature to a competitive level.
Protect against unfair trade practices: Setting a quota helps protect a domestic economy from unfair trade practices such as
dumping, the pricing of imports below production cost. By restricting imports, quotas minimize the impact of such activities.
Protect national security: Import quotas discourage imports and encourage domestic production of goods that may be necessary
to the security of the country. By protecting and encouraging the growth of these defense-related industries, a country will not
have to be dependent on foreign imports in the event of a war.
Consequences of Quotas
Like other trade barriers, quotas restrict international trade, and thus, have consequences for the domestic market. In particular,
quotas restrict competition for domestic commodities, which raises prices and reduces selection. This hurts the domestic consumer,
who experiences a loss in consumer surplus. On the other hand, this very action benefits the domestic producer, who sees an
increase in producer surplus. Often, the increase in producer surplus is not enough to offset the loss in consumer surplus, so the
economy experiences a loss in total surplus.
Quotas may also foster negative economic activities. Import quotas may promote administrative corruption, especially in countries
where import quotas are given to selected importers. There are incentives to give the quotas to importers who can provide the most
favors or the largest bribes to officials. Quotas may also encourage smuggling. As quotas raise the price of domestic goods, it
becomes profitable to try and circumvent the quota by bringing in goods illegally, or in excess of the quota.
Other Barriers
Barriers to trade include specific limitations to trade, customs procedures, governmental participation, and technical barriers to
trade.
Distinguish different barriers to trade
In addition to tariffs and quotas, other barriers to trade exist. They can be divided into four separate categories: specific limitations
to trade, customs and administrative procedures, government participation, and technical barriers to trade.
Specific Limitations to Trade

This category of trade barriers stems from regulations on international trade. Some examples include:
Local content requirements, or domestic content requirements, are rules that mandate how much of a product must be produced
domestically in order to qualify for lowered tariffs or other preferential treatment.
Embargoes are prohibitions on trade ban imports or exports, and may apply to certain categories of products, or strictly to goods
supplied by certain countries.
Customs and Administrative Procedures

This category of trade barriers refers to trade impediments that stem from governmental procedures and controls. Some examples
include:
Bureaucratic delays: Delays at ports or other country entrances caused by administrative or bureaucratic red-tape increase
uncertainty and the cost of maintaining inventory.
Anti-dumping duties: In international trade, dumping refers to a form of predatory pricing in which exported products are priced
below the cost of production or below the price charged in the home market. Anti-dumping duties are usually extra taxes levied
on the product to neutralize the predatory pricing and bring the price closer to the “normal value. “
Government Participation
This category of trade barriers represents direct governmental involvement in international trade. Some examples include:
Government procurement programs: Public authorities, such as government agencies, are much like private interests in that they
must also buy goods and services. Unlike private interests, governments are more likely to buy domestically produced goods
and services, rather than the lowest-cost commodities. Because government procurement often represent a significant portion of
a country’s GDP, foreign suppliers are at a disadvantage to domestic ones when it comes to these programs.
Export subsidies: Export subsidies are production subsidies granted to exported products, usually by a government. With export
subsidies, domestic producers can sell their commodities in foreign markets below cost, which makes them more competitive.
Countervailing duties: Countervailing duties, or anti-subsidy duties, are extra duties levied on imports in order to neutralize an
export subsidy. If a country discovers that a foreign country subsidizes its exports, and domestic producers are injured as a
result, a countervailing duty can be imposed in order to reduce the export subsidy advantage. In that respect, countervailing
duties are similar to anti-dumping duties in that they both bring a imported product’s value closer to the “normal value. “
Technical Barriers to Trade

Technical barriers to trade are non-tariff barriers to trade that refer to standards implemented by countries. Because these standards
must be met before goods are allowed to enter or leave a country, they represent international trade barriers. Some examples
include:
Sanitary and phytosanitary measures: These are health standards for plants, animals, and other products, and are designed to
protect humans, animals, and plants from pests or diseases.
Rules for product weights, sizes, or packaging.
Standards for labeling and testing products.
Ingredient or identity standards.
Key Points
Tariffs can be levied on goods being imported in a country ( import tariff), or exported from a country ( export tariff). They may
be levied in order to protect domestic producers (protective tariff), or to raise revenue for the government (revenue tariff).
Specific tariffs levy a fixed duty on a good. Ad valorem tariffs are based on a percentage of the good’s value. Compound tariffs
are a combination of specific and ad valorem tariffs.
Tariffs often increase domestic producer surplus and the quantity of a good supplied domestically, but hurt domestic consumer
surplus.
There are two types of quotas: absolute and tariff -rate. Absolute quotas are quotas that limit the amount of a specific good that
may enter a country. Tariff-rate quotas allow a quantity of a good to be imported under a lower duty rate; any amount above this
is subject to a higher duty.
Justifications for the use of quotas include protection for domestic employment and infant industries, protection against unfair
foreign trade practices, and protection of national security.
Quotas often hurt domestic consumers and benefit domestic producers. Quotas may also provide incentives for administrative
corruption and smuggling.
Specific limitations to trade barriers include local content requirements and embargoes. This category of barriers comes from
trade regulations.
Customs and administrative procedure barriers include bureaucratic red tape and anti- dumping practices. This category of
barriers comes from government procedures.
Governmental participation barriers include government procurement programs, export subsidies, and countervailing duties.
This category of barriers involves the direct participation of government in trade.
Technical barriers to trade include sanitary regulations, measurement and labeling standards, and ingredient standards. This
category of barriers involves health, safety, and measurement standards.
Key Terms
themselves.
absolute quota: A limitation of the quantity of certain goods that may enter commerce during a specific period.
quota: A restriction on the import of something to a specific quantity.
tariff-rate quota: Allows a specified quantity of imported goods to be entered at a reduced rate of duty during the quota period,
with quantities entered in excess of the quota limit subject to a higher duty rate.
Dumping: Selling goods at less than their normal price, especially in the export market.
countervailing duty: A tax levied on an imported article to offset the unfair price advantage it holds due to a subsidy paid to
producers or exporters by the government of the exporting country if such imports cause or threaten injury to a domestic
industry.
embargo: A ban on trade with another country.
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National Security Argument
National security protectionist arguments pertain to the risk of dependency upon other nations for economic sustainability.
Evaluate the arguments in favor of the use of trade protectionism in the security industry
Economic interdependence and globalization has resulted in a system, where each country is largely dependent upon other
countries for economic sustainability (though to varying degrees). This results in a substantial national security threat in the form of
conflicting or offensive trade strategies between countries. Indeed, economics is often used directly as a weapon of war and conflict
via trade sanctions. This highlights a critical protectionist argument pertaining to the very real risk of dependency upon other
nations for economic sustainability.
Trade and Conflict

An interesting discussion in economics is the relationship between trade and conflict. It has been noted, somewhat intuitively and
empirically, that conflict reduces trade. However, is it also the case that trade reduces conflict? This question is largely unanswered,
although the stances are becoming more highly developed. It is hypothesized that trade does not necessarily reduce conflict, but
instead changes the nature of the conflict. Economic levers are much more practical than military levers, and are often used for
similar reasons. For this reason, it is difficult to separate trade and conflict completely because there is some critical overlap
between the two. This is a fundamental foundation for the trade protectionism logic from a national security perspective.
Trade During Conflict

A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during
wartime can be a substantial threat to a nation depending on the scale and scope of the conflict (most notably who is involved). For
example, consider World War II. In this scenario Germany was largely isolated in the conflict, and therefore had extremely limited
trade partners. Direct conflict will almost always result in a complete cease in trading not only between the country in which the
war is occurring, but also any of that country’s allies (who may or may not be directly involved). However, some argue self-
sufficiency (via protectionism) in war is not necessary, as friendly nations will still provide trade and economic support.
Sanctions also play a dramatic role as an offensive militaristic maneuver. Iran and North Korea are strong modern examples as well
as the recent history of the U.S.-Iraq war. In all of these circumstances, either the U.S. alone or along with a number of allies
(representing substantial consumption percentages) actively limited the ability for these countries to trade and generate economic
value for their nations (and subsequently their people). While this looks purely economic, it has important social and humanitarian
implications as well. The chart makes this case quite clearly, pointing out the death toll in wartime if economic levers are utilized.
Infant Mortality in Iraq During Sanctions: This graphic underlines the indirect consequences of employing economic levers (i.e.
sanctions) in a militaristic fashion during a conflict. While the justification for these figures is complex, including other war-related
factors, the correlation is quite clear. Diminishing a country’s economic prospects will in turn result in loss of life, particularly in
developing nations.
Protectionism
Combining these ideas, it is clear that there is substantial national security value to trade protectionism. However, the opportunity
cost of leveraging the ever-growing global markets make this an unattractive prospect if taken to any extreme, as the benefits of
global trade rapidly offset the risk of economic dependency upon hostile nations.
Infant Industry Argument

Economic markets are inherently competitive and newer economies are vulnerable to their more developed counterparts in other
countries.
Discuss the use of trade protectionism to promote new industries
Trade protectionism is defined as national policy restricting international economic trade to alter the balance between imports and
goods manufactured domestically, usually executed via policies and governmental regulations such as import quotas, tariffs, taxes,
anti-dumping legislation, and other limitations.
Arguments for Protecting Infant Industry

The primary purpose for this system is as the name implies: protection. Economic markets are inherently competitive, and newer
economies are highly vulnerable to their more developed counterparts in other countries for a variety of reasons. The infant
industry argument is that new industries need protection until they have become efficient enough to compete in the world market.
Despite the standard argument from mainstream economists postulating that free trade and open markets is the ideal system to
allow for capitalistic development, there are many economists who believe that some degree of protectionism is the only way to
minimize income gaps and substantial inequity from economy to economy (see ). The primary advantage to countries with higher
economic power and bigger corporations is simply economies of scale and economies of scope, in addition to being further along
the experience curve.
Economies of Scale: The basic premise behind economies of scale is that higher production quantity reduces cost per unit,
ultimately allowing for the derivation of economic advantage in the market. Infant industries generally do not have the capacity to
do this.
GDP by Country: This map demonstrates the vast difference in overall economic power across the globe, underlining the
inequities that need to be addressed in economic policy formulation.
History has proven the value of protection for the countries employing tariff-based international trade policies. Alexander Hamilton
first pointed out the inequities of developing economies with young industry in 1790, which was later picked up and developed by
Daniel Raymond and Friedrich List in the 19th century. Around this time frame, the United States was employing heavy tariffs to
protect their fragile economic system as the economy began to achieve autonomy after British rule. Indeed, Britain employed
similarly protectionist policies during this time frame, setting the tone for large economic expansion in the longer term.
Criticism
Of course, protective policy while industry develops domestically is not a cure all. In Brazil in the 1980’s there were heavy
protective policies in place to defend Brazil’s nascent computer industry from highly evolved competitors internationally. While
this seemed practical, what ended up happening was quite damaging for Brazil. Technology advanced rapidly, and without strategic
alliances on a global scale, Brazil largely missed out on these advances. This protectionism seems to have damaged industry
prospects on a global level for Brazil in this scenario.
From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant
industry situations). The reason for this is quite simply the significant jump in prosperity as international trade expanded, and the
huge capacity for specialization, economies of scale, technology sharing, and a host of other advantages that have been a direct
result of free global markets. The problem still remains, however, that this prosperity is often unregulated and of the greatest
benefit to the influential players in established economies, sometimes at the expense of exploitation of developing nations (cheaper
labor, reduced governmental oversight, etc.). As a result of this, protecting infant industries can benefit the nation employing them,
but generally with the opportunity cost of global value.
Unfair Competition Argument

One of the strongest arguments for trade protectionism is unfair competition emerging due to differences in policy and enforcement
ability.
Examine the use of protectionism as a way of addressing unfair competitive practices
Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade
and trade protectionism to capture the most value. In many ways, the global markets are torn between pursuing what is best on the
global level and what is best at the domestic level, and there is sometimes dissonance between the two. One of the strongest
arguments for some degree of trade protectionism is the tendency for unfair competition to emerge, particularly in developing
markets without the infrastructure to monitor their businesses and enforce penalties. This is called the unfair competition argument.
Dumping
A popular recent topic is anti-dumping policies directed at international players looking to undercut domestic business through
selling at dramatically reduced prices. This can be a substantial threat, particularly from economies where labor laws are lax and
workers are exploited to create extremely low cost goods. This is also a risk when governments get too involved in business, a
criticism often pointed out in China. Governments can provide subsidies to reduce costs for domestic companies. This can also be a
threat in infant industries, where larger and more established players can push out smaller players via undercutting prices,
absorbing losses until the competition goes bankrupt.
Offsetting this threat has been an ongoing struggle, with the emergence of international trade agreements and organizations like the
World Trade Organization (WTO) playing an increasingly large role. One of the struggles with international trade is the difficulty
of enforcement between nations, and the WTO plays a critical role in identifying malpractice and addressing it.
Intellectual Property
Another critical risk in the global market is intellectual property (IP) protection. Patents, in a domestic system, protect the innovator
to allow them to generate returns on the substantial time investment required to invent or innovate new products or technologies.
On a global scale, however, it is quite common for developing nations to copy new technologies via reverse engineering. This
results in copycats violating the patents in an environment where the infrastructure domestically will probably not take legal action.
This reduces the desire for innovation and places large economic risks on countries dependent upon this for growth.
This is addressed through international patent laws and trade agreements as well, alongside political pressures such as raising tariffs
and placing import quotas on countries suspected to be in violation of patents. The downside to this is that utilizing these measures
creates political unrest, global factions, and strained business relationships.
Mergers, Acquisitions, and Market Dominance

Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and
geographic diversification to be difficult to break up via domestic antitrust laws. demonstrates the substantial threat of deadweight
losses being incurred in economies where consolidation results in a lack of competitive forces to drive down price.
Economic Losses in a Monopoly: This chart highlights the very real risk of lost economic value in a monopolistic situation
(deadweight loss in yellow).
On the domestic level monopolies are widely seen as being addressed (though this is hotly debated by many economists in light of
the ‘too big to fail’ and ‘too big to jail’ banks). On a global scale it is even more difficult to regulate, as the size and scale of these
companies often extends beyond the power of the governments where these companies are located. This is addressed through
international standards and trade agreements, standardizing governmental policy on a global level to reduce the risk of monopoly
and unfair consolidation towards market dominance.
Jobs Argument
Many policy makers who are proponents of trade protectionism argue that limiting imports will create or save more jobs at home.
Analyze the use of trade restrictions for strategic purposes
Many policy makers who are proponents of trade protectionism make the argument that limiting imports will create more jobs at
home. This argument is predicated on the idea that buying more domestically will drive up national production, and that this
increased production will in turn result in a healthier domestic job market. Domestic industries will not have to compete with
foreign producers, and are therefore protected from losing marketshare to cheaper imports.
Trade Balance
It is useful to consider the concept of a trade balance, or net exports, in the context of the jobs argument. It is interesting to look at
to assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations’. The U.S. and China are a
great example of opposite sides of the spectrum, where the trade balance is heavy on one side of the spectrum.
Trade Balances on a Global Scale: It is interesting to look at this graph and assess the extremity to which some nations are
‘consumer nations’ and others are ‘producer nations. ‘ The U.S. and China are a great example of opposite sides of the spectrum,
where the trade balance is heavily on one side of the spectrum.
In the U.S. this has created a dramatic push for trade protectionism policies; something the United States has not actively pursued
in quite some time. The disastrous 2008 economic collapse via the clear-cut abuses by the banks, and the resulting drop in
employment rates, has created an incredibly tangible social and political agenda to bring production back to domestic jobs from
overseas. This sentiment towards protectionism is a direct result of the jobs argument in view of an imbalanced trade ratio, where
more exports (production and jobs at home) are required to sustain the ongoing consumption of imports.
Outsourcing
Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production
work to these locations. This is often a result of cheaper labor and easier systems of governance in those regions. The obvious
perspective, from a policy making context, is that these are jobs lost to overseas competitors. While this perspective is often
criticized for being short-sighted and against the modern economic view of free markets, it has resulted in policy makers providing
incentives to ‘bring jobs back home. ‘
This idea of limiting outsourcing in light of the protectionist jobs argument has resulted in governmental subsidies that work to
offset the costs of manufacturing domestically (in the U.S. particularly). These subsidies are essentially grants or tax breaks for
companies operating domestically and creating jobs, driving up employment rates via protectionist strategies.
Trade Restriction Strategies
Offsetting the threats of outsourcing and trade imbalances and driving domestic purchasing, and thus domestic production, is done
through a variety of political vehicles. Most notable among them are:
Import Quotas: This is the act of limiting the number of a certain good that can be purchasing from a given country, ensuring
that domestic producers maintain a portion of the market share.
Tariffs: Tariffs are fairly straight-forward, essentially taxes to bring goods into a given country. High tariffs will raise the cost
for foreign producers to sell their goods in a domestic system, providing strategic advantages for local producers. One of the
pitfalls of tariffs is the likelihood of retaliation, where the foreign government returns with similar tariffs. This will in turn
damage global prospects for domestic suppliers.
Anti-dumping:Anti-dumping legislation actively offsets the ability of low cost or highly subsidized producers in foreign
countries to undercut prices in a domestic system. Dumping is the process of selling goods far below market value to drive out
competition, often in pursuit of creating a monopoly.
Subsidies: On the other end of the spectrum, and as noted above, governments can provide subsidies to domestic producers to
lower their costs and drive up competitive ability. This can in turn create jobs.
A Summary of International Trade Agreements

International trade agreements are agreements across national borders that reduce or eliminate trade barriers to promote economic
exchange.
Identify at least three main international trade agreements
International trade agreements are trade agreements across national borders intended to reduce or eliminate trade barriers to
promote economic exchange. International trade encounters a variety of obstacles, some of which pertain to the protectionism
identified in other atoms, which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions. It
is also useful to create standards and norms across different countries, particularly for things like intellectual property law
recognition, which enables businesses to operate across borders.
There are quite a few international trade agreements, some of which are more formal than others. The trade agreements below
provide a fairly comprehensive overview of the current international trade environment:
World Trade Organization (WTO)

The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995,
designed to enable international trade while reducing unfair practices. In many ways, the WTO is more complex than other
international trade agreements because it incorporates a variety of smaller agreements into a larger framework. The WTO includes
upwards of 60 different agreements alongside 159 official members and 25 observers. underlines how effective and universal
international trade agreements are becoming. The WTO performs several objective functions as well if trade disputes arise, acting
as a framework for assessing appropriate international trade practices.
WTO Members: The World Trade Organization (WTO) is an organization designed to oversee and enable international trade. This
map shows how successful this has been on a global scale.
The core of the WTO is the most-favored nation (MFN) rule, which states that each WTO member must be charged the lowest
tariffs that an importer places on any country. For example, if the US charges Brazil a 5% tariff on imported clothes, and this is the
lowest tariff it has placed on any country in the WTO, all other WTO members must also be charged a 5% tariff. Every WTO
member gets charged the lowest tariff that an importer charges any other member.
North American Free Trade Agreement (NAFTA)

Unlike the WTO, which is an entirely global approach, most international agreements stem from geographic proximity. NAFTA is
a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers
between any of these countries (primarily in the form of tariffs). Generally speaking, the United States demonstrates a trade deficit
with these countries relative to goods and a surplus relative to services. The United States also demonstrates high and fast-growing
foreign direct investment (FDI) in both regions.
NAFTA Participants: This map outlines each of the countries involved in the North American Free Trade Agreement, an
international trade agreement focused on a geographic proximity.
There has been a great deal of controversy surrounding this trade agreement. Agriculture is not included in this agreement, and is
often a tough point of discussion for the WTO as well. Mexico is also a point tension due to the fact that it is developing
economically (compared to the U.S. and Canada who are considered already developed). Finally, Canadians have often objected to
the NAFTA agreements due to the way in which the United States FDI employs hostile takeovers. These agreements demonstrate
some of the validity behind trade protectionism and isolationism (as discussed in other atoms in this chapter).
Asia-Pacific Economic Cooperation (APEC)

The APEC forum is particularly interesting in the context of the above agreements, as it is slightly less formal than the above two
(it is referred to as a ‘forum’). The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region
promoting free trade, with a focus on newly industrialized economies (NIE). Developing nations gaining access to capital
investment and export agreements is the central outcome of APEC, driving economic growth through controlled global expansion.
This region represents over half of the world’s GDP and 40% of the overall world population, making this a critical region of the
world economy.
APEC Participants: The Asia-Pacific Economic Cooperation (APEC) is a forum of 21 countries in the Pacific Rim region,
focusing on free trade and economic cooperation.
Key Points
Economic interdependence and globalization has resulted in a unique capitalistic system, where each country is largely
dependent upon other countries for economic sustainability.
It has been noted, somewhat intuitively and empirically, that conflict reduces trade. This highlights the risk of conflict harming
an economy.
A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade
during wartime can be a substantial threat to a nation, as economic levers such as sanctions can be utilized.
Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. All of these economies
struggle(d) against harsh economic sanctions.
Combining these ideas, it is clear that there is substantial national security value to trade protectionism.
Trade protectionism is national policies restricting international economic trade to alter the balance between imports and goods
manufactured domestically through import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.
The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale, which
infant industries in developing countries often protect against.
The United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve
autonomy after British rule, which proved effective.
From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in
infant industry situations). The argument is that free markets add value on a global level, while protectionism confines
economic value to the nation employing it.
Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free
trade and trade protectionism to capture the most value.
A recent topic is anti- dumping policies directed at international players looking to undercut domestic business through selling
at dramatically reduced prices.
Another critical risk in the global market is intellectual property (IP) protection as patents are often ignored globally,
particularly by countries which lack the infrastructure to enforce IP laws.
Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power
and geographic diversification to be difficult to break up via domestic anti-trust laws.
This argument is predicated on the simply fact that buying more domestically will drive up national production, and that this
increased production will in turn result in a healthier domestic job market.
Local governments leverage subsidies, tariffs, import quotas, and anti- dumping policies to maximize strategic capacity
domestically, thus creating jobs.
A sentiment towards protectionism has developed in the U.S. due to the jobs argument in view of an imbalanced trade ratio,
where more exports (production and jobs at home) is required to sustain the ongoing consumption of imports.
Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production
work to these locations (outsourcing), motivating governments to bring these jobs back home.
Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity
domestically, thus creating jobs.
International trade encounters a variety of obstacles which reduce trade incentives. This is usually through tariffs, quotas, taxes,
and other trade restrictions.
The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995,
designed to enable international trade while reducing unfair practices.
NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment
barriers between any of these countries (primarily in the form of tariffs).
The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus
on newly industrialized economies (NIE).
Key Terms
sanction: A penalty, or some coercive measure, intended to ensure compliance; especially one adopted by several nations, or by
an international body.
Self-sufficiency: Able to provide for oneself independently of others.
Nascent: Emerging; just coming into existence.
Dumping: Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.
Subsidies: Financial support or assistance, such as a grant.
Reverse engineering: The process of analyzing the construction and operation of a product in order to manufacture a similar
one.
Import Quota: A restriction on the import of something to a specific quantity.
Trade Balance: The difference between the monetary value of exports and imports in an economy over a certain period of time.
Foreign direct investment: Investment into production or business in a country by an individual or company of another
country.
themselves.
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CHAPTER OVERVIEW
32: Open Economy Macroeconomics

Topic hierarchy
32.1: Capital Flows
32.3: Equilibrium
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Boundless.
1
32.1: Capital Flows
The Balance of Payments
The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world.
Explain the components and importance of the balance of payments
The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. This includes
payments for the country’s exports and imports, the sale and purchase of assets, and financial transfers. The BOP is given for a
specific period of time (usually a year) and in terms of the domestic currency.
Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Sources of funds include
exports, the receipt of loans or investment, and income from foreign assets. Whenever a country has an outflow of funds, such as
when the country imports goods and services or when it invests in foreign assets, it is recorded as a debit on the balance of
payments.
When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a
country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in
other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans
from other countries.
U.S. Current Account: The chart shows the current account deficit of the U.S., both in dollars and as a percent of GDP. Deficits in
the current account must be offset by surpluses in the financial and capital accounts.
Components of the Balance of Payments

The BOP can be expressed as:
BOP = C urrent Account + F inancial Account + C apital Account + Balancing I tem (32.1.1)
The current account records the flow of income from one country to another. It includes the balance of trade (net earnings on
exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors),
and cash transfers.
The financial account records the flow of assets from one country to another. It is composed of foreign direct investment, portfolio
investment, other investment, and reserve account flows.
The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national
income. Debt forgiveness would affect the capital account, as would the purchase of non-financial and non-produced assets such as
the rights to natural resources or patents.
The balancing item is simply an amount that accounts for any statistical errors and ensures that the total balance of payments is
zero.
The Current Account

The current account represents the sum of net exports, factor income, and cash transfers.
Calculate the current account
The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income
(earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as
it covers transactions in the “here and now” – those that don’t give rise to future claims.
The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A
nation has a trade deficit if its imports exceed its exports. Because the trade balance is typically the largest component of the
current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case.
Secluded economies like Australia are more likely to feature income deficits larger than their trade surplus.
The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received
from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments
is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their
families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc.
Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a
return. Typically, such transfers are done in the form of donations, aids, or official assistance.
Calculating the Current Account

Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income and cash
transfers.
Goods are traded by countries all over the world. When ownership of a good is transferred from a local country to a foreign
country, this is called an export. When a good’s ownership is transferred from a foreign country to a local country, this is called an
import. In calculating the current account, exports are marked as a credit (inflow of money) and imports are marked as a debit
(outflow of money).
Services can also be traded by countries. This happens frequently in the case of tourism. When a tourist from a local country visits
a foreign country, the local country is consuming the foreign services and this is counted as an import. Likewise, when a foreign
tourist comes and enjoys the services of a local country, this is counted as an export. Other services can also be transferred between
countries, such as when a financial adviser in one country assists clients in another.
A credit of income happens when a domestic individual or company receives money from a foreign individual or company. This
would typically take place when a domestic investor receives dividends from an investment made in a foreign country, or when a
worker abroad sends remittances back to the local country. Likewise, a debit in the income account takes place when a foreign
entity receives money from an investment in the local economy.
Finally, a credit in the cash transfers column would be a gift of aid from a foreign country to the domestic country. Similarly, a
debit in the cash transfers column might be the provision of official assistance by the local economy to a foreign economy.
Thus, a country’s current account can by calculated by the following formula:
C A = (X − M ) + N Y + N C T
Where C A is the current account, X and M and the export and import of goods and services respectively, N Y is net income from
abroad, and N C T is the net current transfers. When the sum of these four components is positive, the current account has a
surplus.
Global Current Accounts: The map shows the per capita current accounts surpluses and deficits of countries around the world
from 1980 to 2008. Deeper red implies a higher per capita deficit, while deeper green implies a higher per capita surplus.
The Financial Account

The financial account measures the net change in ownership of national assets.
Calculate the financial account
The financial account (also known as the capital account under some balance of payments systems) measures the net change in
ownership of national assets. When financial account has a positive balance, we say that there is a financial account surplus. A
financial account surplus means that the net ownership of a country’s assets is flowing out of a country – that is, foreign buyers are
purchasing more domestic assets than domestic buyers are purchasing of assets from the rest of the world. Likewise, we say that
there is a financial account deficit when the financial account has a negative balance. This occurs when domestic buyers are
purchasing more foreign assets than foreign buyers are purchasing of domestic assets. For example, a financial accounts deficit
would exist when Country A’s citizens buy $200 million worth of real estate overseas, while overseas investors purchase only $100
million worth of real estate within Country A.
Calculating the Financial Account

The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account
flows.
Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings,
or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item on
the financial account. If a nation’s citizens are investing in foreign countries, there is an outbound flow that will count as a deficit.
After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current
account rather than the financial account.
FDI in Austria: Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than
Austrian investors do in the rest of the world. This contributes to a financial account surplus.
Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as short term
investment. As with FDI, the income derived from these assets is recorded in the current account; the financial account entry will
just be for any buying or selling of the portfolio assets in the international financial markets.
Other investment includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in
different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and/or the exchange
rate between currencies. Sometimes this category can include the reserve account.
The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital
flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency),
especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while
outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the
central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can
intervene. Such intervention affects the financial account. Purchases of foreign currencies, for example, will increase the deficit and
vis versa.
To calculate the total surplus or deficit in the financial account, sum the net change in FDI, portfolio investment, other investment,
and the reserve account.
Interest Rates and the Financial Account

The outflow or inflow of assets in the financial account depends in large part on the domestic interest rate and how it compares to
interest rates in other countries. A higher central bank interest rate will tend to increase the interest rate on all domestic financial
assets, such as bonds, loans, and government securities. In general, if interest rates are higher in one country than another, an
investor would prefer to purchase financial assets in the country with the higher interest rate.
An increase in the domestic interest rate will therefore cause foreign investors to purchase more domestic assets, creating a
financial account surplus. Likewise, a fall in the domestic interest rate will cause domestic investors to purchase foreign assets in
place of domestic assets, and will cause a financial account deficit.
The Capital Account
The capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital
transfers.
Calculate the Capital Account
There are two common definitions of the capital account in economics. The first is a broad interpretation that reflects the net
change in ownership of national assets. Under the International Monetary Fund (IMF) definition, however, most of these asset
flows are captured in the financial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-
produced and non-financial assets, as well as capital transfers. The capital account is normally much smaller than the financial and
current accounts.
Like the financial account, a deficit in the capital account means that money is flowing out of a country and the country is
accumulating foreign assets. Likewise, a surplus in the capital account means that a money is flowing into a country and the
country is selling (or otherwise disposing of) non-produced, non-financial assets.
Calculating the Capital Account

The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers. Non-produced
and non-financial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires
the rights to mineral resources in a foreign country, there is an outflow of money and the domestic country acquires an asset,
creating a capital account deficit.
Natural Gas Rights: If a U.S. company sold its rights to drill for natural gas off the southern coast of the U.S., it would be
recorded as a credit in the capital account.
Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the
transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance
taxes, death levies, and uninsured damage to fixed asset. For example, if the domestic country forgives a loan made to a foreign
country, this transfer creates a deficit in the capital account.
Thus, the balance of the capital account is calculated as the sum of the surpluses or deficits of net non-produced, non-financial
assets, and net capital transfers.
Reason for a Zero Balance
Equilibrium in the market for a country’s currency implies that the balance of payments is equal to zero.
Discuss the long term equilibrium of a country’s balance of payments
Capital Flows
Trade within a country differs in one important way from trade between countries: unless the two nations share a common
currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods
and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in
order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France
and Chile requires that the firms exchange euros for pesos.
In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a
country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used
to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or
services from other countries.
Imaging that we are analyzing Italy’s economy and its currency transactions with the rest of the world. If an American buyer
wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets.
Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country’s currency.
Likewise, a country’s currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for eample,
are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied
when Italian purchasers acquire assets from other countries.
Equilibrium and Zero Balance

When a country’s balance of payments is equal to zero, there is equilibrium in the market for that country’s currency. Equilibrium
occurs when:
Quantity of currency demanded = quantity of currency supplied
We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets.
The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can
rewrite the relationship:
Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)
Finally, we can rearrange the above formula as:
Exports – imports = (domestic purchases of foreign assets) – (foreign purchases of domestic assets)
The left-hand term is net exports – the difference between the amount of goods and services a country exports and the amount that
it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is
positive and we say that the country has a current accounts surplus. When a country imports more than it exports this number is
negative and we say that the country has a current accounts deficit.
The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets
that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign
exchange market operations of a nation’s central bank ), along with loans and investments between the country and the rest of
world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded
in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange
operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive
and there is a financial account surplus.
If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa.
This holds true when a country’s currency market is in equilibrium and there are no external currency controls.
Exchange Rates: Exchange rates are constantly fluctuating to ensure that the quantity of currency supplied equals the quantity
demanded. Because of this, the inflows and outflows of money are equal, creating a balance of payments equal to zero.
Key Points
Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Whenever a country
has an outflow of funds, it is recorded as a debit on the balance of payments.
When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit.
BOP=Current Account+Financial Account+ Capital Account+Balancing Item.
The current account records the flow of income from one country to another.
The financial account records the flow of assets from one country to another.
The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national
income.
The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A
nation has a trade deficit if its imports exceeds its exports.
The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money
received from investments made abroad but also to remittances.
Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a
return.
A country’s current account can by calculated by the following formula: C A = (X − M ) + N Y + N C T .
A financial account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in
the domestic economy are spending on rest-of-world assets.
The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve
account flows.
Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery,
buildings, or even whole manufacturing plants.
Portfolio investment refers to the purchase of shares and bonds.
Other investment includes capital flows into bank accounts or provided as loans.
The reserve account is operated by a nation’s central bank to buy and sell foreign currencies.
A deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets.
The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers.
Non-produced and non-financial assets include things like drilling rights, patents, and trademarks.
Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country,
and the transfer of ownership on fixed assets.
Equilibrium in the foreign exchange market implies that the quantity of currency demanded = quantity of currency supplied.
The quantity of a currency demanded is from two sources: exports and rest-of-world purchases of domestic assets. The quantity
supplied of a currency is also from two sources: imports and domestic purchases of rest-of-world assets.
Therefore, exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases or rest-of-world assets).
Finally, this means that exports – imports = (domestic purchases of rest-of-world assets) – (rest-of-world purchases of domestic
assets).
In other words, the current account balances out the financial account and the balance of payments is zero.
Key Terms
balance of payments: A record of all monetary transactions between a country and the rest of the world
credit: An addition to certain accounts.
balance of trade: The difference between the monetary value of exports and imports in an economy over a certain period of
time.
debit: A sum of money taken out of an account.
debt forgiveness: The partial or total writing down of debt owed by individuals, corporations, or nations.
net exports: The difference between the monetary value of exports and imports.
foreign exchange: The changing of currency from one country for currency from another country.
Balance of payments. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Balance_of_payments. License: CC BY-
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en.wikibooks.org/wiki/IB_Econ...ce_of_payments. License: CC BY-SA: Attribution-ShareAlike
U.S. Trade Deficit Dollars and percentage GDP. Provided by: Wikipedia. Located at:
en.Wikipedia.org/wiki/File:U....entage_GDP.png. License: CC BY-SA: Attribution-ShareAlike
balance of trade. Provided by: Wiktionary. Located at: en.wiktionary.org/wiki/balance_of_trade. License: CC BY-SA:
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Introducing Exchange Rates
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another.
Explain the concept of a foreign exchange market and an exchange rate
In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which
one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US$) means that ¥91 will
be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.
Exchange Rates: In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency
trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange
rate that is quoted and traded today, but for delivery and payment on a specific future date.
How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to
or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the
rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading,
or else the margin may be recovered in the form of a commission or in some other way.
Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form
(such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on
documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is
available for resale immediately.
Finding an Equilibrium Exchange Rate

There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset
market model.
Differentiate between the Balance of Payment and Asset Market Models
Countries have a vested interest in the exchange rate of their currency to their trading partner’s currency because it affects trade
flows. When the domestic currency has a high value, its exports are expensive. This leads to a trade deficit, decreased production,
and unemployment. If the currency’s value is low, imports can be too expensive though exports are expected to rise.
Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate.
Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we
know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England
If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will
adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g.
haircuts), and there are transportation costs so the law does not always hold.
The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.
Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current
account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers,
or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global
market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus
stabilizing the trade balance and bringing the currency towards equilibrium.
Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the
increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent,
financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of
the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset
market model.
Share of Stock: The key difference between the balance of payments and asset market models is that the former includes financial
assets, such as stock, in its calculation.
The asset market model views currencies as an important element in finding the equilibrium exchange rate. Asset prices are
influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on
the future worth of the assets. The asset market model of exchange rate determination states that the exchange rate between two
currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.
These assets are not limited to consumables, such as groceries or cars. They include investments, such as shares of stock that is
denominated in the currency, and debt denominated in the currency.
Real Versus Nominal Rates

Real exchange rates are nominal rates adjusted for differences in price levels.
Calculate the nominal and real exchange rates for a set of currencies
Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms
of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is
defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different
perspectives. Below are descriptions of the two most common means of describing exchange rates.
Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the
change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency
over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services
that the currency is used to buy.
When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is
set on the open market and is based on how much of one currency another currency can buy.
Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio
of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring
the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be
necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences
in price levels.
A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one
to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the
purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of
one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the
PPP rate to the other currency and then purchase the market basket using that currency.
Groceries: Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries. PPP is
then used to help determine real exchange rates.
If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity
(PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.
Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2,
which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.
The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So,
in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate
would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket
of goods expressed in A (10). In this case, the real A/B exchange rate is 3.
Exchange Rate Policy Choices

A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an
exchange rate regime.
Explain the factors countries consider when choosing an exchange rate policy
When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no
system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a
few considerations a country needs to make when choosing a regime.
Stage of Economic Development
A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies.
Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency.
Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency
to pay their debts. If there is an unexpected depreciation in the local currency’s value, businesses and banks will find it much more
difficult to settle their debts. This puts the entire economy’s financial sector stability in danger.
Developing Countries: The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating
exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their
economies.
Balance of Payments
Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange
rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign
currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and
decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.
Monetary and Fiscal Policy

A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In
general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The
government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies.
Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these
tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business
cycle.
Exchange Rate Systems

The three major types of exchange rate systems are the float, the fixed rate, and the pegged float.
Differentiate common exchange rate systems
One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An
exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely
related to that country’s monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and
pegged float exchange.
Foreign Exchange Regimes: The above map shows which countries have adopted which exchange rate regime. Dark green is for
free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.
The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency’s value is allowed to
fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency.
The dollar is an example of a floating currency.
Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically
adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and
to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their
dynamism.
The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a
currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country’s government
decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The
central bank of a country remains committed at all times to buy and sell its currency at a fixed price.
To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and
gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess
supply of the country’s currency.
The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes
also peg to other currencies. These countries can either choose a single currency to peg to, or a “basket” consisting of the currencies
of the country’s major trading partners.
The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of
fixed and floating regimes. There are three types of pegged float regimes:
Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of
fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are
adjusted periodically by the country’s central bank. Generally the bands are adjusted in response to economic circumstances and
indicators.
Crawling pegs:A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows
gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed
exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain
value but, at the same time, to “glide” in response to external market uncertainties. In dealing with external pressure to
appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the
system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.
Pegged with horizontal bands:This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger
band of greater than one percent of the currency’s value.
Fixed Exchange Rates
A fixed exchange rate is a type of exchange rate regime where a currency’s value is fixed to a measure of value, such as gold or
another currency.
Explain the mechanisms by which a country maintains a fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is
fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
Reasons for Fixed Exchange Rate Regimes

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and
investments between the two countries easier and more predictable and is especially useful for small economies in which external
trade forms a large part of their GDP.
This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed
exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital
controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation’s government
can use to regulate flows from capital markets into and out of the country’s capital account. A fixed exchange rate regime should be
viewed as a tool in capital control.
How a Fixed Exchange Regime Works

Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is
one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the
government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the
price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus
increasing its foreign reserves.
Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This
method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such
as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China
used this method against the U.S. dollar.
PRC Flag: China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by
making it illegal to trade its currency at any other rate.
Managed Float
Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and
selling currencies.
Describe a managed float exchange rate and explain why countries choose managed floats
Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks
attempt to influence their countries’ exchange rates by buying and selling currencies. Almost all currencies are managed since
central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating
currency, it most likely exists as a managed float.
How a Managed Float Exchange Rate Works

Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the
range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
India: India has a managed float exchange regime. The rupee is allowed to fluctuate with the market within a set range before the
central bank will intervene.
Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price
support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in
reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.
Why Do Countries Choose a Managed Float
Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating
exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign
business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also
allows the country’s monetary policy to be freed up to pursue other goals, such as stabilizing the country’s employment or prices.
However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a
currency floats, there could be rapid appreciation or depreciation of value. This could harm the country’s imports and exports. If the
currency’s value increases too drastically, the country’s exports could become too costly which would harm the country’s
employment rates. If the currency’s value decreases too drastically, the country may not be able to afford crucial imports.
This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to
intervene and minimize the risks associated with a free floating currency. If a currency’s value increases or decreases too rapidly,
the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.
Key Points
Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where
currency trading is continuous.
In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
The foreign exchange rate is also regarded as the value of one country’s currency in terms of another currency.
The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current
account balance.
The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital
flows.
The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price
that just balances the relative supplies of, and demand for, assets denominated in those currencies. This includes financial
assets.
The measure of the differences in price levels is Purchasing Power Parity. The concept of purchasing power parity allows one to
estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the
purchasing power of the two countries’ currencies.
If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power
parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always
equal 1.
When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of
the associated prices of the goods and services that the currency is used to buy.
To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another.
The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.
A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies
since most of their liabilities are denominated in other currencies.
Floating exchange rates automatically adjust to trade imbalances while fixed rates do not.
A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand.
Because these tools are reserved for preserving the fixed rate, countries can’t use its monetary or fiscal policies to address other
economic issues.
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency ‘s value is allowed
to freely fluctuate according to the foreign exchange market.
A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to
maintain their currency value constant against a specific currency or good.
Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. These are a hybrid of fixed
and floating regimes.
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to.
A fixed exchange rate regime should be viewed as a tool in capital control. As a result, a fixed exchange rate can be viewed as a
means to regulate flows from capital markets into and out of the country’s capital account.
Typically, a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate.
Generally the central bank will set a range which its currency ‘s value may freely float between. If the currency drops below the
range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price
support or resistance.
A managed float regime is a hybrid of fixed and floating regimes. A managed float captures the benefits of floating regimes
while allowing central banks to intervene and minimize the risk of harmful effects due to radical currency fluctuations that are a
characteristic of floating regimes.
Key Terms
exchange rate: The amount of one currency that a person or institution defines as equivalent to another when either buying or
selling it at any particular moment.
depreciate: To reduce in value over time.
purchasing power parity: A theory of long-term equilibrium exchange rates based on relative price levels of two countries.
real exchange rate: The purchasing power of a currency relative to another at current exchange rates and prices.
nominal exchange rate: The amount of currency you can receive in exchange for another currency.
fixed exchange rate: A system where a currency’s value is tied to the value of another single currency, to a basket of other
currencies, or to another measure of value, such as gold.
floating exchange rate: A system where the value of currency in relation to others is allowed to freely fluctuate subject to
market forces.
exchange rate regime: The way in which an authority manages its currency in relation to other currencies and the foreign
exchange market.
pegged float exchange rate: A currency system that fixes an exchange rate around a certain value, but still allows fluctuations,
usually within certain values, to occur.
Managed Float Regime: A system where exchange rates are allowed fluctuate from day to day within a range before the
central bank will intervene to adjust it.
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32.3: Equilibrium
Open Economy Equilibrium
In an open economy, equilibrium is achieved when no external influences are present; the state of equilibrium between the
variables will not change.
Summarize the factors that determine the macroeconomic equilibrium state
Open Economy
In an open economy there there is a flow of funds across borders due to the exchange of goods and services. An open economy can
import and export without any barriers to trade, such as quotas and tariffs. Citizens in a country with an open economy typically
have access to a larger variety of goods and services. They also have the ability to invest savings outside of the country.
An open economy allows a country to spend more or less than what it earns through the output of goods and services every year.
When a country spends more than it make, it borrows money from abroad. If a country saves more money than it makes, it can lend
the difference to foreigners.
The equation used to determine the economic output of a country is Y = Cd + Id + Gd + N X
The economy’s output (Y ) equals the sum of the consumption of domestic goods (C ), the investment in domestic goods and
d
services (I ), the government purchase of domestic goods and services (G ), and the net exports of domestic goods and services (
d d
N X ). The sum of C , I , and G provides the domestic spending of a country, while X provides the foreign sources of spending.
The amount that a country saves is total of investment and net exports:
S = I +NX (32.3.1)
NX can also be considered the trade balance of a country. Therefore

Trade Balance = N X = S − I (32.3.2)
Consider, for example, what happens if domestic interest rates rise relative to foreign interest rates. Savings will increase and
investment will drop as investors borrow and invest abroad instead. The balance of trade will increase, affecting the health of the
economy. In an open economy, market actors can choose to save, spend, and invest either domestically or internationally, so
relative changes affect not only the flow of capital, but also the health of the economy as a whole.
In an open economy, equilibrium is achieved when supply and demand are balanced. When no external influences are present, the
state of equilibrium between the variables will not change. In the case of market equilibrium in an open economy, equilibrium
occurs when a market price is established through competition. For example, when the amount of goods and services sought by
buyers is equal to the amount of goods and services produced by sellers. When equilibrium is reached and the market price is
established in an open economy, the price of the goods or service will remain the same unless the supply or demand changes.
Equilibrium: The graph shows that the point of equilibrium is where the supply and demand are equal. In an open economy,
equilibrium is achieved when the amount demanded by consumers is equal to the amount of a goods or service provided by
producers.
There are three properties of equilibrium:
1. The behavior of agents is consistent,
2. No agent has an incentive to change its behavior, and
3. Equilibrium is the outcome of some dynamic process (stability).
In an open economy, equilibrium is reached through the price mechanism. For example, if there is excess supply (market surplus),
this would lead to prices cuts which would decrease the quantity supplied (reduces the incentive to produce and sell the product)
and increase the quantity demanded (by offering bargains), which would eliminate the original excess of supply. The interest rates
also adjust to reach equilibrium. Although consumption does not always equal production, the net capital outflow does equal the
balance of trade. The capital flows, which depend on interest rates and savings rates, also adjust to reach equilibrium.
Impacts of Policies and Events on Equilibrium

Government policies and outside events may affect the macroeconomic equilibrium by shifting aggregate supply or aggregate
demand.
Analyze the effects that events and policies can have on economic equilibrium
The macroeconomic equilibrium is determined by aggregate supply and aggregate demand. Much of economics focuses on the
determinants of aggregate supply and demand that are endogenous – that is, internal to the economic system. These include factors
such as consumer preferences, the price of inputs, and the level of technology. However, there are many factors that affect the
macroeconomic equilibrium that are exogenous to the economic system – that is, external to the economic model.
Supply Shock
One type of event that can shift the equilibrium is a supply shock. This is 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, which in turn affects the
equilibrium price. A negative supply shock (sudden supply decrease) will raise prices and shift the aggregate supply curve to the
left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output. A positive supply
shock (an increase in supply) will lower the price of said good by shifting the aggregate supply curve to the right. A positive supply
shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output.
Supply Shock and Equilibrium: A supply shock shifts the aggregate supply curve. In this case, a negative supply shock raises
prices and lowers output in equilibrium.
One extreme case of a supply shock is the 1973 Oil Crisis. When the U.S. chose to support Israel during the Yom Kippur War, the
Organization of Arab Petroleum Exporting Countries (OAPEC) responded with an oil embargo, which increased the market price
of a barrel of oil by 400%. This supply shock in turn contributed to stagflation and persistent economic disarray.
Inflation
Inflation can result from increased aggregate demand, but can also be caused by expansionary monetary policy or supply shocks
that cause large price changes. Changes in prices can shift aggregate demand, and therefore the macroeconomic equilibrium, as a
result of three different effects:
The wealth effect refers to the change in demand that results from changes in consumers’ perceived wealth. When individuals
feel (or are) wealthier, they spend more and aggregate demand increases. Since inflation causes real wealth to shrink and
deflation causes real wealth to increase, the wealth effect of inflation will cause lower demand and the wealth effect of deflation
will cause higher demand.
The interest rate effect refers to the way in which a change in the interest rate affects consumer spending. When prices rise, a
nominal amount of money becomes a smaller real amount of money, which means that the real value of money in the economy
falls and the interest rate (i.e. the price of money) rises. A higher interest rate means that fewer people borrow and consumer
spending (aggregate demand) falls.
Finally, the exchange rate effectrelates changes in the exchange rate to changes in aggregate demand. As above, inflation
typically causes the interest rate to rise. When the domestic interest rate is high compared to that in other countries, capital
flows into the country, the international supply of the domestic currency falls, and the price (i.e. exchange rate) of the domestic
currency rises. An increase in the exchange rate has the effect of increasing imports and decreasing exports, since domestic
goods are relatively more expensive. A decrease in net exports leads to a decrease in aggregate demand, since net exports is one
of the components of aggregate demand.
Trade Policies
Trade policies can shift aggregate demand. Protectionism, for example, is a policy that interferes with the free workings of the
international marketplace. By implementing protectionism policies such as tariffs and quotas, a government can make foreign
goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand.
Since the world demands more goods produced in the home country, the demand for the domestic currency increases and the
exchange rate rises.
Capital Flight
Capital flight occurs when assets or money rapidly flow out of a country due to an event of economic consequence. Such events
could be an increase in taxes on capital or capital holders, or the government of the country defaulting on its debt that disturbs
investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic
strength.
This leads to an increase in the supply of the local currency and is usually accompanied by a sharp drop in the exchange rate of the
affected country. This leads to dramatic decreases in the purchasing power of the country’s assets and makes it increasingly
expensive to import goods. Net exports rise as a component of aggregate demand.
Effect of a Government Budget Deficit on Investment and Equilibrium

A budget deficit will typically increase the equilibrium output and prices, but this may be offset by crowding out.
Evaluate the consequences of imbalances in the government budget
A government’s budget balance is determined by the difference in revenues (primarily taxes) and spending. A positive balance is a
surplus, and a negative balance is a deficit. The consequences of a budget deficit depend on the type of deficit.
U.S. Budget Deficits: The graph shows the budget deficits and surpluses incurred by the U.S. government between 1901 and 2006.
Although deficits may have an expansionary effect, this is not the primary purpose of running a deficit.
Cyclical Deficits
A cyclical deficit is a deficit incurred due to the ups and downs of a business cycle. At the lowest point in the business cycle, there
is a high level of unemployment. This means that tax revenues are low and expenditures (e.g., on social security and unemployment
benefits) are high, naturally leading to a budget deficit. Conversely, at the peak of the cycle, unemployment is low, increasing tax
revenue and decreasing spending, which leads to a budget surplus. The additional borrowing required at the low point of the cycle
is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.
This type of budget deficit serves as a stabilizer, insulating individuals from the effects of the business cycle without any specific
legislation or other intervention. This is because budget deficits can have stimulative effects on the economy, increasing demand,
spending, and investment. Higher spending on transfer payments puts more money into the economy, supporting demand and
investment. Furthermore, lower revenues mean that more money is left in the hands of individuals and businesses, encouraging
spending. As the economy grows more quickly, the budget deficit falls and the fiscal stimulus is slowly removed.
Structural Deficits
The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds
prevailing tax levels. Structural deficits are permanent, and occur when there is an underlying imbalance between revenues and
expenses.
This is the budget gap still exists when the economy is at full employment and producing at full potential output levels. It can only
be closed by increasing revenues or cutting spending. Unlike the cyclical budget deficit, a structural deficit is the result of
discretionary, not automatic, fiscal policy. While automatic stabilizers don’t actually shift the aggregate demand curve (because
transfer payments and taxes are already built into aggregate demand), discretionary fiscal policy can shift the aggregate demand
curve. For example, if the government decides to implement a new program to build military aircraft without adjusting any sources
of revenue, aggregate demand will shift to the right, raising prices and output.
Although both types of government budget deficits are typically expansionary during a recession, a structural deficit may not
always be expansionary when the economy is at full employment. This is due to a phenomenon called crowding out. When an
increase in government expenditure or a decrease in government revenue increases the budget deficit, the Treasury must issue more
bonds. This reduces the price of bonds, raising the interest rate. The increase in the interest rate reduces the quantity of private
investment demanded (crowding out private investment). The higher interest rate increases the demand for and reduces the supply
of dollars in the foreign exchange market, raising the exchange rate. A higher exchange rate reduces net exports. All of these
effects work to offset the increase in aggregate demand that would normally accompany an increase in the budget deficit.
Key Points
In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through
competition.
The trade balance is a function of savings and investment. Since actors can save or invest domestically or internationally
relative changes can have large effects on the trade balance and the health of the economy as a whole.
There are three properties of equilibrium: the behavior of agents is consistent, no agent has an incentive to change its behavior,
and equilibrium is the outcome of some dynamic process (stability).
One type of event that can shift the equilibrium is a 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.
An increase in the price level can lower aggregate demand as a result of the wealth effect, the interest rate effect, and the
exchange rate effect.
By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more
expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand.
Capital flight occurs when assets or money rapidly flow out of a country. This leads to an increase in the supply of the local
currency and a drop in the exchange rate. Net exports rise as a component of aggregate demand.
A government’s budget balance is the difference in government revenues (primarily from taxes ) and spending. If spending is
greater than revenue, there is a deficit. If revenue is greater than spending, there is a surplus.
A government deficit can be thought of as consisting of two elements, structural and cyclical. At the lowest point in the
business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures are high, leading
naturally to a budget deficit.
The additional borrowing required at the low point of the cycle is the cyclical deficit. The cyclical deficit will be entirely repaid
by a cyclical surplus at the peak of the cycle. This type of deficit serves as an automatic stabilizer.
The structural deficit is the deficit that remains across the business cycle because the general level of government spending
exceeds prevailing tax levels. Structural deficits are the result of discretionary fiscal policy and can shift the aggregate demand
curve to the right.
Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher
exchange rates, and fewer exports.
Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher
exchange rates, and fewer exports.
Key Terms
trade: Buying and selling of goods and services on a market.
protectionism: A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on
imports.
structural deficit: The portion of the public sector deficit which exists even when the economy is at potential; government
spending beyond government revenues at times of normal, predictable economic activity.
cyclical deficit: The deficit experienced at the low point of the business cycle when there are lower levels of business activity
and higher levels of unemployment.
Open economy. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Open_economy. License: CC BY-SA:
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CHAPTER OVERVIEW
33: Economic Crises

Topic hierarchy
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1
Causes of Banking Crises
Banking crises can be caused by inadequate governmental oversight, bank runs, positive feedback loops in the market and
contagion.
Describe some common causes of a banking crisis, Explain a bank run
In light of recent market and banking failures, the economic analysis of banking crises both historically and presently is a constant
source of interest and speculation. Banking crises are when there are widespread bank runs: an abnormal number depositors try to
withdraw their deposits because they don’t trust that the bank will have the deposits for withdrawal in the future.
Banking crises are not a new economic phenomenon, and similarly are not the only source of financial crises. Over the course of
the past two centuries there have been a surprisingly large number of financial crises, as demonstrated in the attached figure. In
understanding banking crises over time, it is useful to identify the causes in context with historic examples of banking collapses.
Financial Crises Globally since 1800: This chart is an interesting take on the relatively consistent frequency in which financial
crises occur across the globe. It is interesting to note both the efficacy of Bretton Woods alongside the increasing risk of financial
collapse in modern times.
Causes of Banking Crises

Banks can fail for several different reasons:
Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank
is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand. This can quickly induce panic
in the public, driving up withdrawals as everyone tries to get their money back from a system that they are increasingly
skeptical of. This leads to a bank panic which can result in a systemic banking crisis, which simply means that all of the free
capital in the banking system is withdrawn.
Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a similar positive feedback
loop effect in the stock markets, which was a much more dynamic factor in more recent banking crises (i.e. 2007-2009 sub-
prime mortgage disaster). John Maynard Keynes once compared financial markets to a beauty contest, where investors are
merely trying to pick what is attractive to other investors. There is a profound truth to this, creating an interdependent and
potentially self-fulfilling investment thought process. This can create dramatic rises and falls (bubbles and crashes), which in
turn can throw banks with poorly designed leverage into huge losses.
Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of governmental oversight. As noted
above, banks often leverage themselves to capture gains despite extremely high risks (such as over-dependence on derivatives).
Contagion: Due to globalization and international interdependence, the failure of one economy can create something of a
domino effect. In 2008, when the U.S. economy collapses, the reduced buying power and economic output from that economy
dramatically damaged all economies dependent upon it (which includes most of the world). This is called contagion.
The Great Depression

The Great Depression highlights how bank runs caused a banking crisis, which ultimately became a global economic crisis.The
Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market
crash (Black Tuesday) and subsequent bank runs. As fear began to grip consumers across the United States, people became
protective of their assets (including their cash). This caused a large number of people to the banks to withdraw, which in turn
motivated others to go to the banks and get their capital out also. Since banks lend out some of their deposits, they did not have
enough cash on hand to meet the immediate withdrawal requests (they became illiquid) and therefore went bankrupt. Within a few
weeks this resulted in a systemic banking crisis.
1929 Stock Market Crash: As the market falls, investors create a positive feedback loop and self-fulfilling prophecy due to a lack
of confidence that drives it down even further.
Consequences of Banking Crises

Banking crises have a range of short-term and long-term repercussions, domestically and globally, that reduce economic output and
growth.
Explain consequences of banking crises on the broader economy
Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis
in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that
underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most
useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily
through investment and lending.
Domestic Consequences
Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate
and economy’s savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously
funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse
individual and economic consequences within the system.
First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the
capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally,
sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving
down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact
that they have less capital to invest and returns to acquire.
This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall
in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer
confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to
these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.
Global Consequences
While these domestic consequences are expected and, in many ways, intuitive, the global dependency upon foreign trade in modern
markets has exacerbated these effects. Imports and exports play an increasingly large role in the health of most developed
economies, and as a result the relative well-being of trade partners plays an increasingly critical role in the success of domestic
economies.
A good example of this is to look at the way in which the U.S. (and to some extent, European) banking disasters in 2008 and 2009
led to a complete global financial meltdown, destroying economies not involved in the irresponsible investing practices executed
by banks in these specific regions. identifies the critical importance of economic well-being in trading partners, as the U.S. banking
and financial crises spread rapidly (within the course of just one year) across a substantial portion of the globe (though there are
certainly other factors that contributed to the financial crisis and its consequences). The domestic reduction of capital for
businesses, income for consumers and tax revenue for governments ultimately results in a reduction of trade and economic activity
for other economies.
2009 GDP Growth Rates: This figure shows the growth in GDP for world economies in 2009. The slow and negative growth
demonstrates all of the economic losses that resulted in part from the U.S. financial crisis, highlighting the dependency of global
economies.
Key Points
A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in
investments, the bank’s liquidity will sometimes fail to meet the consumer demand.
Due to the mass interdependence of economies across the globe, a banking crisis in one nation is likely to dramatically affect
other international economies.
The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock
market crash (Black Tuesday) and subsequent bank runs.
Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists
predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists
predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
Banks play a critical role in economic growth, primarily through investment and lending.
After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle
to raise the capital required to execute upon their operations.
The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces
investor and consumer confidence.
Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-
being of trade partners plays an increasingly critical role in the success of domestic economies.
Key Terms
Bank Run: A large number of customers withdraw their deposits from a financial institution at the same time due to a loss of
confidence in the banks.
leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and
earn an expected higher return, but usually at high risk.
Economic crisis: A period of economic slowdown characterised by declining productivity and devaluing of financial
institutions often due to reckless and unsustainable money lending.
liquidity: The degree to which an asset can be easily converted into cash.
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Causes and Immediate Impacts of the Crisis
Banks, consumers, and the government all contributed to improper borrowing and lending, which in turn created a downward
spiraling economy.
Summarize the causes that led to the 2007 banking crisis
The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a
series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners
into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective homeowners who could not afford to
repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as
highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This
created an economic meltdown, starting with the United States, that spread across the global markets.
The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context.
It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case
study for many of the critical concepts of economic theory.
How Did This Happen?

The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there
are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various
stakeholders and their contributions:
Inputs to the Mortgage Crisis: This graph outlines two of the three parties in the collapse (excludes government), as the banks
and the buyers both took on ridiculous amounts of risk.
Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy
homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back.
Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as
extremely safe derivative investments. They were not safe.
Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought
homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had
to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses
that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective
home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage
payments. Without such verification, it became easier for people to get mortgages they could not afford.
Combining these factors, the problem largely revolved around irresponsible lending and borrowing which was then turned into
derivatives that were labeled safe despite their massive risks. This resulted in an economic realization of loans that could not be
repaid, which spread through the banking system and turned into large scale obligations that could not be met.
Economic Impact
What happened next is well captured in the diagram below. In short, the banks eventually failed due to their investments. In order
to prevent the entire financial system from collapsing, some of the banks (and other financial institutions) were bailed out.
2008 Crisis Flow Chart: This chart embodies critical checkpoints in the economic decline reactions to poor mortgage management
by the banks. Understanding the implications of each point on this diagram will greatly enhance the larger understanding of the
short term effects of this economic collapse.
Of course the negative effects did not stop there. The U.S. stock market lost confidence in financial institutions and some of the
companies connected to them and subsequently crashed. The NYSE fell by half, drastically reducing the value of the U.S.
economy. This was then telegraphed into a loss of consumer confidence and business access to investment. Within a few months,
there were job cuts, bankruptcies, and reduced spending, as the crisis spread throughout the economy (both domestically and
globally).
Recovery
The objective of economic recovery when in crisis is to stabilize the economy and recapture the value lost using economic stimulus
strategies.
Discuss the characteristics of the recovery from the 2007 crisis
The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a
result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce
recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The
objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic
stimulus strategies while addressing the factors which contributed to the collapse in the first place.
Stimulus Package
One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act
of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen
substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the
inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a
Keynesian perspective).
The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places, totaling
$831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and
companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely
based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and
driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as
Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure
demonstrates that it was likely a strategic reaction to the economic crisis.
ARRA Efficacy Projections: This graph points out the economic opportunity cost of not utilizing the ARRA, which would likely
have left the U.S. (and subsequently, the global) economy in significantly worse shape than it is now.
Stimulus Investments (U.S.) of ARRA: This graphic demonstrates the different silos receiving government aid within the
domestic economy, as a direct result of the American Recover and Reinvestment Act (ARRA).
Troubled Asset Relief Program (TARP)

Perhaps more debatable still, is the reaction to the inevitable and deserved bankruptcy of the banks and insurers involved in the
toxic mortgage-backed securities (i.e. CDO’s) that drove the economy into disaster were bailed out by the government. These
companies, such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the required capital
by the government to offset their massive losses due to undue risk and poor leveraging. This was in the form of the government
utilizing tax money to purchase these securities, removing the toxic assets from the books of the companies involved (who were
deemed ‘too big to fail’). This move saved the economic decline and restored consumer confidence through direct government
intervention.
TARP was also largely criticized, with a high number of seemingly reasonable objections. The first, and most intuitive, is that these
businesses deserved to go under. Bad business practice, poor investment, and grossly unethical behavior deserves bankruptcy.
Instead, the government demonstrated that, as long as certain fiscal influence is achieved, these competitive rules are negligible.
Secondly, and slightly more complex, is the implementation of the TARP act (which necessitated SIG-TARP, an oversight group
ensuring that TARP money went out to those who it was intended for). It was noted on many occasions that TARP money was ill-
used.
Outcomes
While the long-term outcomes of these practices cannot yet be predicted, the progress made so far is worth analyzing economically.
First and foremost, job numbers have improved, although not as much as had been hoped or expected (see ). While this is positive,
it does not capture the large number of people who are underemployed or the individuals who have abandoned the search for
employment. GDP growth has inched along to positive numbers, as has the profitability of many businesses and industries.
Interestingly enough, as of the end of 2013, the stock market has not only recovered but expanded beyond 2007 levels.
U.S. Job Gains and Losses: This graph demonstrates the negative affect that the collapse had on jobs as well as the pacing of
economic recovery in the short-term.
Global Impacts
The 2007-2009 economic collapse was damaging not only to the U.S. but also global markets, driving the global economy into
recession.
Analyze the extent to which the 2007 crisis was global
Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being
will have a dramatic impact on national economic well-being and vice versa. As a result, the 2007-2009 economic collapse had
large effects not only at the origin (in the United States), but also on a global scale. The speed in which the market decline spread
across the globe underlines just how far globalization and international interdependence has come, with GDP growth numbers in
2009 already demonstrating substantial losses across the map (see ).
2009 Global GDP Growth and Decline): As this map illustrates, many international markets fell rapidly into decline as a direct
result of the U.S. sub-prime mortgage disaster.
Recession: Domestic to Global

In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth (over two
consecutive quarters). This recessionary period spread rapidly around the map, creating a global recession in Q3 and Q4 in 2008
and Q1 of 2009 (defined as a contraction in global GDP growth during that time) as is represented in this figure. To provide
additional context to the global adverse effects of the sub-prime mortgage crisis, of 65 countries that record and report GDP only 11
escaped a recessionary period between 2006 and today.
World GDP Growth: It is quite clear in this graphic, the global GDP growth dropped dramatically following the U.S. crisis,
pitching the entire global economy into a recession.
Even countries where double-digit economic growth had been a consistent trend going into 2008, such as China, began to
experience growth reductions due to reduced consumer purchasing power on a global scale. China has seen reductions towards the
7%-8% economic GDP growth (year on year), from clear double-digits in previous years.
Political Instability
Another indirect global impact that occurred as a result of the economic collapse is political instability, primarily due to the
inability of developed nations to pursue social welfare investments and global poverty reduction processes during recessionary
times. Indeed, these instabilities are not only isolated to developing nations. Countries in the EU, such as Greece, Spain and Italy,
have seen dramatic GDP decreases and unemployment numbers reaching or exceeding 20% in some cases. This instability has
placed a great deal of pressure on government officials to solve these huge economic problems in the short-term. The United States
has also seen an incredible reduction in governmental efficacy with the least effective house of representatives for nearly a century
alongside dramatic polarization of public opinion towards left-wing and right-wing ideas.
Global Responses
Positively, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence
in the future. Reducing interest rates to drive up borrowing and investment, providing tax benefits to the unemployed and
underemployed, and subsidizing new business have created positive steps towards meaningful recovery globally.
There have also been a series of banking and financial regulatory changes across the world.These global safety nets and prevention
policies are setting the tone for future strategies to avoid economic crises and minimize the prospective damage that occurs as a
result of these unethical practices.
Key Points
The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, began with the failure of a
series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to home-
owners into a falsely ‘safe’ investment.
Banks offered loans to debtors that couldn’t afford them, and then bundles these debt instruments and sold them.
The banking crisis spread into a broader financial crisis as companies were negatively affected by the crisis in financial
institutions to which they were connected.
The government did not regulate the housing market at all, as a result of the elimination of two critical clauses: verification of
income and a 20% down payment.
The U.S. stock market, realizing the scale of errors of the banks, lost all investment confidence. This cut the NYSE in half,
drastically reducing the value of the U.S. economy.
One of the key components to the crisis recovery in the United States is an act called the American Recovery and Reinvestment
Act of 2009 (ARRA). It invests money in the economy to drive spending and recovery.
ARRA is largely based on the Keynesian macro-environmental concept of driving spending through enabling spending, in turn
driving up demand, creating jobs, and driving spending up further.
The Troubled Asset Relief Program (TARP) was another recovery strategy, buying toxic assets off the banks to prevent them
from failing.
TARP was criticized for protecting banks who behaved unethically and with a lack of strategic intelligence as businesses,
essentially implying that they should have failed.
While the stock market has recovered and the banks are in better shape now than before the collapse, the average American is
still less likely to have a job or to be underemployed.
Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-
being will have a dramatic impact on national economic well-being and vice versa.
In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth, which This
spread rapidly around the map to create a global recession in Q3 and Q4 in 2008 and Q1 of 2009.
Another indirect global impact that occurred as a result of the economic collapse was political instability, primarily due to the
inability of developed nations to pursue altruistic investments and global poverty reduction processes during recessionary times.
On the upside, many global organizations and countries are actively employing policies to minimize the likelihood of a re-
occurrence in the future.
Key Terms
CDO: A type of asset-backed security and structured credit product constructed from a portfolio of fixed-income assets.
Sub-prime: Designating a loan (typically at a greater than usual rate of interest) offered to a borrower who is not qualified for
other loans (e.g. because of poor credit history).
stimulus: Anything that may have an impact or influence on a system. In 2009, it is the monetary investments in the economy
to recover from the collapse.
Economic crises: A period of economic slowdown characterized by declining productivity and devaluing of financial
institutions often due to reckless and unsustainable money lending.
recession: A significant decline in economic activity spread across the economy, lasting more than a few months, normally
visible in real GDP, real income, employment, and industrial production.
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CHAPTER OVERVIEW
34: Interest and Profit

Topic hierarchy
34.1: Interest
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34.1: Interest
Defining Capital
In economics, capital references non-financial assets used in the production of goods and services.
Define and explain capital.
Capital
In economics, capital (also referred to as capital goods, real capital, or capital assets ) references non-financial assets used in the
production of goods and services. Capital is important because it is a significant factor in the creation of wealth.
Capital goods are used in the production process and may depreciated through accounting practice to incorporate utilization, though
they are not consumed. It is possible for capital goods to be maintained or regenerated depending on the type of capital.
Classifications of Capital
In a broad sense, capital can be divided into two categories:
Physical Capital: capital that must be produced by human labor before it can become a factor of production (also referred to as
manufactured capital). Examples include machinery and buildings.
Natural Capital: a factor of production that occurs naturally in the environment; for example, land or minerals.
Fundamentally, capital is any product that is produced and has the ability to enhance a person’s power to perform work that is
economically useful. For example, roads are capital for individuals who live in a city.
Capital is directly impacted by both interest and profit. Interest is a fee that is paid by a borrower of assets. It is a form of
compensation for the use of the assets. Commonly, it is the price that is paid for the use of borrowed money. Profit is the
accumulation of capital, which is the driving force behind economic activity. Interest allows capital to be obtained, while profit is
the accumulation of the capital.
Features of Capital
There are certain features that determine whether a good is considered capital. These features include:
1. the good can be used in the production of other goods (this makes it a factor of production),
2. the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and
3. the good was produced.
Modern Types of Capital

There are detailed classifications of capital which include the following types:
Financial Capital is capital that is liquidated as money for trade, and owned by legal entities. It is a form of capital assets that is
traded in financial markets. The value of financial capital is based on the market perception of expected revenues and risk.
Natural Capital is capital that occurs naturally in the environment and is protected because it supports human life. Examples of
natural capital include land and water.
Social Capital is capital that is captured as goodwill or brand value. It is the general concept of inter-relationships between
humans have money-like value that motivates actions.
Instructional Capital is capital that is defines as the aspect of teaching knowledge and transferring knowledge that is not
inherent in individual or social relationships.
Human Capital is capital that includes social, instructional, and individual human talent combined together. As a term, it is used
to define balanced growth where the goal is to improve human capital and economic capital equally.
Interest Rates and Economic Rationale

Economic rationale, the reasons or thought processes that impact economic decisions, is influenced substantially by the interest
rate.
Define and explain the relationship between interest rates and economic rationale.
Economic Rationale
Rationale is defined as an explanation of the basis or fundamental reasons for something. In economics, rationale are the reasons or
thought processes that impact economic decisions. The interest rate is one of the primary influences on economic rationale.
Interest Rate
The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
It is the percent of principal paid a certain amount of times per period.
Impact of the Interest Rate

The interest rate guides economic rationale because it is a vital tool of monetary policy. The interest rate is taken into account when
dealing with economic variables such as investment, inflation, and unemployment. Central banks usually reduce the interest rate to
increase investment and consumption in the country’s economy. The interest rate directly impacts economic choices such as
spending, investment, and consumption.
Interest Rates: This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. The interest rates reached 14% in
1969 and lowered to 2% by 2003. The interest rate in an economy directly impacts economic choices including spending,
investment, and consumption.
Interest rates also influence inflationary expectations. People form an expectation of what will happen to inflation in the future. The
current and projected interest rates are influential in these economic expectations. Investments are made based on the nominal
interest rate and the degree of risk involved. Low interest rates are enticing, but can be problematic if an economic bubble forms.
For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market. When
these bubbles pop, the investments fail, resulting in large unpaid debts and financial bankruptcy for individuals and banking
institutions.
When interest rates increase, investments decrease, which causes the national income to fall. High interest rates do encourage more
savings, which over time leads to more investment and higher levels of employment to meet production needs. Higher rates
discourage economically unproductive lending such as consumer credit and mortgage lending.
The interest rate also directly impacts money and inflation because the government can affect the markets and alter the total of
loans, bonds, and shares that are issued. When the interest rate is lower, it usually increases the broad supply of money. An increase
in the money supply leads to inflation.
Key Points
Fundamentally, capital is any product that is produced and has the ability to enhance the power of an individual to perform
economically useful work.
Capital is directly impacted by both interest and profit. Interest allows capital to be obtained, while profit is the accumulation of
the capital.
Features that determine whether a good is capital include: 1) the good can be used in the production of other goods (this makes
it a factor of production ), 2) the good is not used up immediately in the process of production, unlike intermediate goods or raw
materials, and 3) the good was produced.
Types of capital include: physical, financial, natural, social, instructional, and human.
The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender
(creditor).
The interest rate guides economic rationale because it is a vital tool of monetary policy.
The interest rate directly impacts economic choices such as spending, investment, and consumption.
When interest rates decrease, investment and spending increase. When interest rates increase, investments decrease which
causes the national income to fall.
Key Terms
depreciate: To reduce in value over time.
Capital (economics). Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Capital_(economics). License: CC BY-SA:
Economic profit. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Economi...conomic_profit. License: CC BY-
Interest. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Interest. License: CC BY-SA: Attribution-ShareAlike
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CHAPTER OVERVIEW
35: Health Care Economics

Topic hierarchy
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Defining Health, Health Care, and Medical Care
Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in health care services.
List the parties involved in the healthcare system in the United States
Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in medical care and
health care services and issues. The study of health care, from an economic perspective, requires taking a broad lens on a complex
system with a wide variety of stakeholders. In 1963, Kenneth Arrow differentiated health care economics from other economics
due to the wide range of unique considerations involved. Health care, due to the severity of the need/demand, wide variety of
externalities, government intervention, and role of doctors as third-parties (making critical purchasing decisions for other people),
cannot be considered from the same perspective as other industries.
Defining Health Care

Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers,
and non-profits. It is a vast economic system with many internal players and externalities. Understanding the basic factors
involved, both logistically and economically, will provide useful context in defining health care and the medical care services.
The chart below outlines who is involved, and in what fashion.
Health Care System Flow Chart: This flow chart does an excellent job of outlining the various stakeholders and influences in the
broader health care system context.
Health (Box B): Health metrics for health attributes from a value of life and overall utility-based perspective.
Demand for Health Care (Box C): The overall health care demand, which is a complex array of inputs that can be summarized
as health care seeking behaviors, and what factors influence them (i.e. externalities, price, time, perspectives, etc.).
Supply of Health Care Costs (Box D):The supply of health care in most systems is quite complex, inclusive of direct inputs
such as drugs, medical suppliers, and diagnostics to insurance companies (third parties) to health care professionals (doctors,
nurses, etc.) to research.
Evaluation of the Whole System (Box F): This is where the government factors in, particularly in countries with a more
socialized system for health care, alongside the comparisons both internally and externally.
This process flow is what defines health care and the medical industry from an economic standpoint, and the relative influence of
each of these components, and the interdependence between them, is worth studying to determine where higher degrees of
efficiency and efficacy can be found.
Health Care System in the U.S.

With this in mind, it is useful to also outline the inputs and outputs of the U.S. health care system, particularly during this
transitional time. At the time of this writing (2013), the Affordable Care Act (often referred to as ‘Obamacare’) will be coming into
play shortly. While the details and implications of this are beyond the scope of this discussion, it is useful to understand what the
basic construct that exists in the United States currently.
At the moment, health care is largely privatized with the exception of medicaid and medicare, the former being for low income
groups and the latter for retirees. For most of us, health care insurance is generally purchased on a capital market by a policy-holder
(who may be a company the beneficiary works for or the beneficiary themselves, depending upon the profession and contractual
obligations of an employer). This health insurance plan offers a construct for what will be covered under an umbrella of monthly
health care payments, and what is considered outside of the plan. There are many large health care insurance providers out there,
offering this service to prospective beneficiaries.
Now, either the insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their
particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices. These institutions are also
quite complicated, and require their own insurances against liability due to the high consequences in the field. Doctors and nurses
provide a service, either actively performing a recommended approach (e.g. surgery) or recommending a treatment (e.g drugs).
These medical professionals are largely overseen by the government from a quality control perspective (various standardized test
and degree requirements), adding an additional line of complexity to the operation.
Overall, this system of healthcare in the U.S. is quite convoluted. There are many players involved and the stakes are extremely
high. Picture a demand curve for a treatment for a deadly disease, what would the price point be? Considering the consequences,
healthcare services often fall outside of standard macroeconomic concepts, defying supply and demand frameworks due to the
nature of the business (i.e. life and death, the well-being of people). This underlines a social issue: how can we improve healthcare
economics to maximize value and minimize costs?
Where a Dollar Spent on Health Care Goes: Introducing the Inputs to Health Care
Health care has many inputs and a variety of incumbents, namely insurance providers, administrators, governments, and
pharmaceuticals.
Discuss the factors that affect the cost of and access to healthcare
Healthcare has many inputs and a wide variety of interested parties profiteering. Understanding what drives the need for health care
(and what prevents it), what is included in the cost, and the overall accessibility of this essential service is critical to understanding
economics issues in healthcare. A dollar spent on health care can find it’s way to insurance providers, medical service providers,
pharmaceutical companies, governments, administrative bodies (managing these businesses), and laboratories. Understanding what
individuals pay for and why, alongside what is available, is important data for navigating this market.
Where the Money Goes

While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a
complex system, it is safe to say that quite a few players contribute to the constantly rising price of even simple procedures and
doctor’s visits. A breakdown of the critical players illuminates this further:
Health Care Providers: On the surface, this is who a beneficiary feels like they are paying. This is their doctors, nurses,
psychologists, dietitians, technologists, chiropractors, surgeons, and a wide range of other hands on and customer facing roles.
These individuals are further differentiated by the fact that they often act as references as opposed to direct suppliers, making
them both a direct to consumer provider and a third party provider.
Pharmaceutical Companies: Drugs are playing an increasingly large role in health care, and likely will continue to do so in
the future. The constant development of new drugs, alongside the distribution of established medications, is an enormous part of
the market.
Insurance Providers: There is a divider between most medical service consumers and their providers, and this is the insurance
company. For those who are covered by their full-time jobs (or dependents of these individuals), this is largely a matter of who
their business purchases from. For others not covered, insurance issues are a complex and highly expensive issue, and getting
coverage is quite difficult (this is being addressed in the U.S. by new legislation, and is not an issue in most other developed
nations). The insurance companies command a huge profit and represent a substantial part of the medical price tag.
Government: The role of government in health care is fiercely debated in the United States, but in most of the developed world
the government is essentially the provider of health care plans (using social services models to consolidate tax revenues to be
allocated for this service). In the U.S., this is only done for medicaid and medicare. The government also takes tax revenues
from involved parties in this industry, driving prices up further.
Administration: This is the hospital itself, or the doctors office, where the management team attempts to run a largely
profitable business in the medical industry. Administration pays the health care providers and the government, taking income
from direct consumers, the government, and the insurance companies to cover the cost of business (and often turn substantial
profits).
With these group of incumbents in mind, it becomes quite clear why the costs are rising exponentially and are so unsustainable.
The constant struggle between these large and powerful players coupled with an essentially infinite demand has left the consumer
as an extremely weak player in the market. Indeed, with this in mind, the graph displays the trajectory of health care spending due
to excess costs in the long term.
Health Care Costs: This graph illustrates the danger of continuing down path of using the excessively high cost-structure U.S.
health care incumbents have dictated in the context of spending as a % of GDP.
Accessibility
One of the most discussed topics in health care is accessibility. Due to the fact that health care represents the ability for an
individual to maintain a healthy and happy life, it seems intuitive that accessibility must as unlimited as possible. Of course, in a
capitalistic system, this will not be the case. Economics dictates that price points will be determined based on supply and demand,
and the demand in this industry is often essentially infinite. As a result, accessibility and profitability do not always align from an
economic perspective. The U.S. employs medicaid and medicare to provide for low-income and elderly citizens that would
otherwise be excluded from the market, while other countries have healthcare systems with more government intervention to
address market failure.
One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing
nations often do not have access to the skills or suppliers required to run modern hospitals and doctors offices, nor the ability to act
preventatively (i.e. eating healthy, getting exercise, check ups, etc.). This creates enormous inefficiency in the system and reduces
the economic viability of operating in these countries for insurance providers. Addressing this concern is one of the central issues
for the United Nations (UN) and other nongovernmental organizations.
Different Health Care Systems Around the World
Health care systems differ from nation to nation depending upon the level of economic development and the political system in
place.
Identify different types of healthcare systems
Health care differs from nation to nation, sometimes substantially depending upon the level of economic development and the
political system in place. Health care systems, on the global scale, is best defined via the World Health Organization’s definition:
“A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health.
This includes efforts to influence determinants of health as well as more direct health-improving activities. A health system is
therefore more than the pyramid of publicly owned facilities that deliver personal health services. ” This definition is important
when observing international health care systems, as it captures both developed and developing nations within this context.
Comparisons: Developed Nations

The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking
system for health care on a global scale. While this has seen some objections, primarily due to the selection of attributes which
weigh into this ranking, it is designed to measure critical success factors which are easily comparably across borders (apples to
apples). These measured attributes include health of the population, fair financial contributions, responsiveness of the system,
preventable deaths, affordability and a range of other considerations.
The countries which perform the highest on these metrics are primarily located in Europe (generally northern Europe, see ), where
social systems are well designed at a governmental level to ensure prices remain accessible and care remain available. Interestingly,
the U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at
similar economic levels. Two good examples are provided in the media relative to the overall capital costs and the subsequent
returns on these costs, on being costs to hospital beds per capita and the other costs to physicians per capita. By these measures,
European nations capture more value and efficiency within their systems. The most notable difference between these systems is
that the US is that, of these countries, the US is the only country without universal healthcare.
Capital Costs and Physicians: Similar to the graph representing costs vs. beds, this chart illustrates the number of physicians
available (relative to the population) in the context of capital expenditures. Once again the United States is a clear outlier, where the
number of physicians is low and the cost quite high.
Capital Costs and Hospital Beds: This graph demonstrates the apparent correlation between beds (per 1000 people) and the costs
involved in healthcare overall. This demonstrates that, on a per capita basis, the U.S. is spending a great deal without capturing
much in return relative to available space for patients.
Economic Efficiency of Global Health Care Systems: Healthcare spending per capita is on the left y-axis and life expectancy is
on the right. Country differences are apparent, especially when comparing the US to others.
Let us explore further through an example of health care in German (though not all European countries are the same). Germany has
consistently demonstrated reductions in cost of health care per capita relative to GDP growth. German health care is regulated by
the Federal Joint Commission, a public health organization which leverages governmental health reform bills to generate new
regulations. This system also includes a total of 85% of the population on the government offered standardized health care plan,
which covers a variety of health care needs across the board. The remaining 15% of the population has opted for private health
insurance options, which provide unique niche benefits for specific groups. This system has been highly effective and affordable in
providing health care to German citizens.
Developing Nations
With fewer resources, developing nations struggle to compete provide the same access to health care as do developed nations.
China is an interesting case study. China has a great deal of variance in quality and accessibility, with hospital wait times for the
poor (depending on severity) taking many hours (sometimes days) compared to the rich, who are admitted immediately.
Transitioning towards a system that provides care to the rich and the poor alike is the primary challenge in these developing
regions.
Externalities in the Health Care Market
Health care can impact people beyond the person receiving and the person providing the care, causing positive and negative
externalities.
Describe externalities in the healthcare market
Defining Externalities
An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction. That
is to say, an externality is something that affects other people outside of the particular parties involved in an exchange.
Externalities: The basic premise of an externality is captured in this diagram, where external factors affect the internal economic
system for a product or service.
A classic example of externalities is the automobile. Cars consistently produce air pollution whenever they are driven, slowly
eroding the health of our ecosystem. This cost is shouldered not only by the driver of the vehicle, but also by every living thing on
the planet. This is an example of parties not involved in the transaction (selling or buying the vehicle) being impacted, in this case
negatively.
Health Care Externalities

In health care, the critical externality in most systems is the care provided to others. You benefit from others being healthy because
it reduces the likelihood of you catching their illness (assuming it’s contagious). You benefit from a positive externality of others
receiving health care.
Your health care costs are also affected by others choosing to purchase health care. The healthy pay more to the insurance company
than they receive in treatment, while the opposite is true for the sick. Insurance fundamentally operates by taking the money from
healthy people to pay for the procedures required by sick people.
Taxpayers should also be concerned with the state of the healthcare system not only because they pay for Medicare and Medicaid,
but also because healthcare is a huge part of the US economy. In 2011, the US spent 17.2% of GDP on healthcare, more than any
other country. Reducing the cost of health care can clearly increase the amount that the US can consume or invest.
Other negative externalities include:
Infectious Disease: One of the largest reasons why health care is so critical is the fact that disease are infectious. Untreated
disease will result higher population vulnerability to that disease due to increased exposure.
Environmental Degradation: Health care produces a great deal of chemical waste, requires a great deal of emissions
(ambulances, etc.) and alters the natural ecological environment of bacteria.
Antibiotic Resistance: An interesting byproduct of the newer solutions to medical dilemmas is the slowly growing resistance
of antibiotics in bacteria. Due to the way in which the health care industry has been operating, bacteria are dramatically altering
to resist our solutions.
Positive externalities include:
Health Affects Wealth: Healthy workers are absent from work less and are more productive workers. A health care market that
effectively helps workers can lead to positive economic gains.
Technology and Information: The study of health care, and the research involved in generating new solutions, has
dramatically increased the knowledge and technological capacity of society in general. This has affected other industries, as
research and development in health care affects the technological efficacy in other markets.
Vaccinations: An interesting new development in health care is the advent of vaccines. Vaccination results in herd immunity, or
essentially the fact that many individuals will become immune and thus reduce the likelihood that everyone in the population
will contract certain diseases.
Current Issues in Health Care

Current issues in the U.S. health care system largely revolve around the significant policy changes resulting from the Affordable
Care Act.
Explain the main parts of the Affordable Care Act and the current American healthcare system
Current issues in the U.S. health care system largely revolve around the significant policy changes imposed by the Affordable Care
Act (ACA, or Obamacare), which attempts to provide health insurance coverage for all citizens. This legislation was designed to
respond to many flaws in the current U.S. system of healthcare. It is also important to understand the criticisms of this change, as
many voters in the U.S. disagree with proposed changes to the system.
U.S. House Votes for the Affordable Health Care Act: This map outlines the voting distribution in 2009 when the Affordable
Health Care Act was brought to the floor.
U.S. Health Care Currently

The U.S., despite having some of the greatest technological advances and medical professionals, has consistently struggled to
provide affordable, effective health care to everyone. The costs alone, on a per capita basis, underline the way in which the U.S.
system has struggled to meet international standards in providing affordable care. illustrates the costs incurred by each individual in
the system based on a country to country comparison. As it illustrates, consumers in the U.S. are faced with much higher (and
growing) costs than international counterparts.
Health Costs Per Capita: This chart illustrates the costs incurred by each individual in the system based on a country to country
comparison. As is demonstrated, consumers in the U.S. are faced with much higher costs (and consistently growing higher) than
international counterparts.
Most Americans with private health insurance have it provided by their employers. There are also social welfare programs such as
Medicaid and Medicare. The insurers negotiate rates with hospitals for different procedures. Patients then go into the hospital and
get procedures recommended by doctors. The doctors are then paid by hospitals. This is a classic case of moral hazard: the two
parties deciding for the transaction to occur- patients and doctors- are not the same two exchanging money.
Healthcare has a demand curve that fluctuates wildly based upon the extent of the issue – consumers who are facing serious health
problems will likely demand healthcare at almost any price, allowing medical providers to take advantage of the inelastic demand.
Further issues include the fact that doctors represent a third party (recommending drugs and procedures) and that insurance
companies have the power to deny coverage to individuals who need it most.
The Affordable Health Care Act

In December of 2009, the Senate passing a bill called Patient Protection and Affordable Care Act. The Affordable Care Act is a
complex piece of legislation, but a number of bullets from the bill are highly useful to understand:
Pre-existing Conditions: Individuals with pre-existing conditions are much more likely to be expensive clients, and thus are
not profitable to insure. This results in insurers refusing to insure these patients. The Affordable Care Act addresses this through
legislation, saying providers cannot refuse coverage.
Changing Insurance Rates: As a complement to the analysis above, insurance agencies also cannot alter rates based on pre-
existing conditions or gender. This levels the playing field for the consumer, who historically had limited buyer power.
Antitrust: Previously, insurance companies were immune to antitrust laws. This means they could generate monopolies
geographically and exploit consumers. This immunity has been repealed.
Standards: Obamacare also closes loopholes regarding to quality standards, ensuring that insurance providers do not reduce
what is provided to clients in an effort to cut costs.
Healthcare.gov: This is a way to enable consumers in finding health care insurers in a way that promotes capitalistic
competition between providers. Previously, discussing pricing and plans with insurers was highly complex for many individuals
(designed for businesses, not individual consumers).
Medicaid and Medicare: Overall, medicare has been reduced while medicaid has been expanded. Medicare spending has been
increasing dramatically. This has been cut by $400 billion, which is a source of discontent for many individuals. Medicaid has
been expanded to 133% of the poverty level, covering more people.
Criticisms
The ACA will only work if both healthy and sick people alike buy insurance: if the healthy choose to pay the fine for not having
insurance and only the sick buy insurance, then costs will increase. There is also a political critique of the ACA. Some feel that the
government should not mandate that private citizens purchase insurance in the first place. They feel that the government is
overstepping its bounds.
Many individuals also believe that this new legislation will increase costs for small businesses that are now required to buy
insurance for their employees, and will motivate ‘freeloaders’, or individuals who take government handouts. Overall, while the
goal is to enable more people to health care more affordably, many people believe this new approach will do not accomplish that.
Key Points
Kenneth Arrow, in 1963, differentiated health care economics from other economics due to the wide range of unique
considerations involved (i.e. infinite demand, wide range of stakeholders, etc. ).
Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers,
researchers, and non-profits. These parties determine the supply, demand, oversight, and externalities of the system.
Currently, U.S. health care is largely privatized with the exception of medicaid and medicare, the former being for low income
groups and the latter for retirees. This is unlike many developed nations, who have socialized support in place.
The insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular
procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices.
Overall, this system of health care in the U.S. is quite convoluted. There are many players involved and the stakes are extremely
high.
While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a
complex system, it is safe to say that quite a few players contribute to the constantly rising price.
In short, the dollar value of health care is largely provided by beneficiaries to insurance companies (or governments), and paid
out to administrative systems who employ and pay health care providers.
One of the most discussed topics in health care is accessibility. Governments and insurers provide economics means for this in
developed nations.
One of the larger issues in accessibility is nations without the infrastructure required to support health care industries.
Developing nations often do not have access to the skills or suppliers required.
A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health.
This includes efforts to influence determinants of health as well as more direct health-improving activities.
The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking
system for health care on a global scale.
The countries which perform the highest on these metrics are primarily located in Europe, where social systems are well
designed at a governmental level to ensure prices remain accessible and care remain available.
The U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed
at similar economic levels.
Developing nations struggle to compete and compare apples to apples to developed nations, primarily due to the required
infrastructure and capital requirements.
An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction.
Negative externalities include tax costs, infectious disease, anti-biotic resistance and environmental degradation. The negative
components impact others despite their participation in the system.
Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases
in technology and knowledge.
Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases
in technology and knowledge.
U.S. citizens pay substantially more per capita for health care than do residents of other countries, and many people lack access
to affordable health care.
Patients have procedures performed by doctors, by the actual exchange of money occurs between the patient’s insurance
provider and the doctor’s employer.
The Affordable Care Act addresses issues like pre-existing conditions, anti-trust, unfair rates based on gender, universal
standards and a range of other considerations.
Many individuals believe that this new legislation will increase costs for small businesses, and will motivate ‘freeloaders’, or
individuals who take government handouts.
Key Items
Health care: The prevention, treatment, and management of illness or the preservation of mental and physical well-being
through the services offered by the medical, nursing, and allied health professions.
Medicare: The system of government subsidies for health care for the elderly and disabled.
Medicaid: U.S. government system for providing medical assistance to persons unable to afford medical treatments.
Beneficiary: One who benefits or receives an advantage.
World Health Organization: The World Health Organization (WHO) is a specialized agency of the United Nations (UN) that
is concerned with international public health.
Universal healthcare: A system where every citizen is guaranteed access to a certain basic level of health services.
Determinants: A determining factor; an element that determines the nature of something
Vaccinations: Inoculation with a vaccine in order to protect a particular disease or strain of disease
Affordable Care Act: The ACA was enacted with the goals of increasing the quality and affordability of health insurance.
Pre-existing Conditions: A pre-existing condition is a risk with extant causes that is not readily compensated by standard,
affordable insurance premiums.
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CHAPTER OVERVIEW
36: Natural Resource Economics

Topic hierarchy
This page titled 36: Natural Resource Economics is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by
Boundless.
Types of Natural Resources
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
Analyze natural resource economics and explain the types of natural resources that exist.
Natural Resource Economics

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. It’s goal is to gain a
better understanding of the role of natural resources in the economy. Learning about the role of natural resources allows for the
development of more sustainable methods to manage resources and make sure that they are maintained for future generations.The
goal of natural resource economics is to develop an efficient economy that is sustainable in the long-run.
Importance of the Environment: This diagram illustrates how society and the economy are subsets of the environment. It is not
possible for societal and economic systems to exist independently from the environment. For this reason, natural resource
economics focuses on understanding the role of natural resources in the economy in order to develop a sufficient and sustainable
economy that protects natural resources.
Types of Natural Resources

Natural resources are derived from the environment. Some of the resources are essential to survival, while others merely satisfy
societal wants. Every man-made product in an economy is composed of natural resources to some degree.
There are numerous ways to classify the types of natural resources, they include the source of origin, the state of development, and
the renewability of the resources.
In terms of the source of origin, natural resources can be divided into the following types:
Biotic: these resources come from living and organic material, such as forests and animals, and include the materials that can be
obtained them. Biotic natural resources also include fossil fuels such as coal and petroleum which are formed from organic
matter that has decayed.
Abiotic: these resources come from non-living and non-organic material. Examples of these resources include land, fresh water,
air, and heavy metals (gold, iron, copper, silver, etc.).
Natural resources can also be categorized based on their stage of development including:
Potential resources: these are resources that exist in a region and may be used in the future. For example, if a country has
petroleum in sedimentary rocks, it is a potential resource until it is actually drilled out of the rock and put to use.
Actual resources: these are resources that have been surveyed, their quantity and quality has been determined, and they are
currently being used. The development of actual resources is dependent on technology.
Reserve resources: this is the part of an actual resource that can be developed profitably in the future.
Stock resources: these are resources that have been surveyed, but cannot be used due a lack of technology. An example of a
stock resource is hydrogen.
Natural resources are also classified based on their renewability:
Renewable natural resources: these are resources that can be replenished. Examples of renewable resources include sunlight, air,
and wind. They are available continuously and their quantity is not noticeably affected by human consumption. However,
renewable resources do not have a rapid recovery rate and are susceptible to depletion if they are overused.
Non-renewable natural resources: these resources form extremely slow and do not naturally form in the environment. A
resource is considered to be non-renewable when their rate of consumption exceeds the rate of recovery. Examples of non-
renewable natural resources are minerals and fossil fuels.
There is constant worldwide debate regarding the allocation of natural resources. The discussions are centered around the issues of
increased scarcity (resource depletion) and the exportation of natural resources as a basis for many economies (especially
developed nations). The vast majority of natural resources are exhaustible which means they are available in a limited quantity and
can be used up if they are not managed correctly. Natural resource economics aims to study resources in order to prevent depletion.
Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how
resources must be used and they monitor the availability and status of the resources. An example of natural resource protection is
the Clean Air Act. The act was designed in 1963 to control air pollution on a national level. Regulations were established to protect
the public from airborne contaminants that are hazardous to human health. The act has been revised over the years to continue to
protect the quality of the air and health of the public in the United States.
Wind: Wind is an example of a renewable natural resource. It occurs naturally in the environment and has the ability to replenish
itself. It has also been used as a form of energy development through wind turbines.
Basic Economics of Natural Resources

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources to create a more efficient
economy.
Explain basic natural resource economics
Natural Resource Economics
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. The main objective of
natural resource economics is to gain a better understanding of the role of natural resources in the economy. By studying natural
resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for
future generations. Economists study how economic and natural systems interact in order to develop an efficient economy.
As a field of academic research, natural resource economics addresses the connections and interdependence between human
economies and natural ecosystems. The focus is how to operate an economy within the ecological constraints of the earth’s natural
resources.
Natural Resource Economics: This diagram illustrates that society and the economy are subsets of the environment. It is not
possible for social and economic systems to exist independently from the environment. Natural resource economics focuses on the
demand, supply, and allocation of natural resources to increase sustainability.
Areas of Study
Economists study the commercial and recreational use and exploitation of resources. Traditionally, natural resource economics
focused on fishery, forestry, and mineral models. However, in recent years many more topics have become increasingly important,
including air, water, and the global climate. Natural resource economics is studied on an academic level, and the findings are used
to shape and direct policy-making for environmental issues.
Examples of areas of study in natural resource economics include:
welfare theory
pollution control
resource exhaustibility
environmental management
resource extraction
non-market valuation
environmental policy
Additionally, research topics of natural resource economists can include topics such as the environmental impacts of agriculture,
transportation and urbanization, land use in poor and industrialized countries, international trade and the environment, and climate
change.
Impact of Natural Resource Economics

The findings of natural resource economists are used by governments and organizations to better understand how to efficiently use
and sustain natural resources. The findings are used to gain insight into the following environmental areas:
Extraction: the process of withdrawing resources from nature. Extractive industries are a basis for the primary sector of the
economy. The extraction of natural resources substantially increases a country’s wealth. Economists study extraction rates to
make sure that resources are not depleted. Also, if resources are extracted too quickly, the sudden inflow of money can cause
inflation. Economists seek to maintain a sense of balance within extraction industries.
Depletion: the using up of natural resources, which is considered to be a global sustainable development issue. Many
governments and organizations have become increasingly involved in preserving natural resources. Economists provide data to
determine how to balance the needs of societies now and preserve resources for the future.
Protection: the preservation of natural resources for the future. The findings of economists help governments and organization
develop measures of protection to sustain natural resources. Protection policies state the necessary actions internationally,
nationally, and individually that must take place to control natural resource depletion that is a result of human activity.
Management: the use of natural resources taking into account economic, environmental, and social concerns. This process
deals with managing natural resources such as land, water, soil, plants, and animals. Particular focus is placed on how the
preservation of natural resources impacts the quality of life now and for future generations.
Externalities and Impacts on Resource Allocation

Production and use of resources can have a positive or negative effect on the allocation of the natural resources.
Examine externalities and how they the impact resource allocation of natural resources.
Resource Allocation
Resource allocation is division of goods for the use of production within the economy. The needs and wants of society as well as
industries impact what is produced. Suppliers focus on producing the varieties of goods and services that will yield the greatest
satisfaction to consumers. In the long run, externalities directly impact resource allocation. It must be determined whether the
production, as well as the process of production, creates more benefits that costs for the producers, consumers, and society as a
whole.
Externalities
An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit. In regards to natural resources,
production and use of resources can have a positive or negative effect on the allocation of the resources.
External Costs
A negative externality, also called the external cost, imposes a negative effect on a third party to an economic transaction. Many
negative externalities impact natural resources negatively because of the environmental consequences of production and use. For
example, air pollution from factories and vehicles can cause damage to crops. Likewise, water pollution has a negative impact of
plants and animals.
Negative externality: Air pollution from vehicles is an example of a negative externality. It affects other than those who drive the
vehicle and those who sell the gas.
In the case of negative externalities, the marginal private cost of consuming a good is less than the marginal social or public cost.
The marginal social benefit should equal the marginal social cost (i.e. production should only be increased when the marginal
social benefit exceeds the marginal social cost). When external costs are present, the use of natural resources is inefficient because
the social benefit is less than the social cost. In other words, society and the natural resources involved would have been better off
if the natural resources had not been used at all.
Developed countries use more natural resources and must enact sustainable development plan for the use of resources. Human
needs must be met, but the environment and natural resources must be preserved. Examples of resource depletion include mining,
petroleum extraction, fishing, forestry, and agriculture.
External Benefits
Positive externalities, also referred to as external benefits, impose a positive effect on a third party. An example of a positive
externality is when crops are pollinated by bees from a neighboring bee farm. In order to achieve the socially optimal equilibrium,
the marginal social benefit should equal the marginal social cost (i.e. production should be increased as long as the marginal social
benefit exceeds the marginal social cost). Assuming that natural resources are used and also sustained, the external benefits of
goods produced by natural resources impacts the majority of the public in a positive way.
Key Points
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
Every man-made product in an economy is composed of natural resources to some degree.
Natural resources can be classified as potential, actual, reserve, or stock resources based on their stage of development.
Natural resources are either renewable or non-renewable depending on whether or not they replenish naturally.
Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine
how resources must be used and they monitor the availability and status of the resources.
As a field of academic research, natural resource economics addresses the connections and interdependence between human
economies and natural ecosystems.
By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that
they are maintained for future generations.
Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for
environmental issues. These issues include resource extraction, depletion, protection, and management.
Natural resource economics findings impact policies for environmental work including issues such as extraction, depletion,
protection, and management.
An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit.
A negative externality, also called the external cost, imposes a negative effect on a third party.
When external costs are present, the market equilibrium use of natural resources is inefficient because the social benefit is less
than the social cost. In other words, society would have been better off if fewer natural resources had been used.
Positive externalities, also referred to as external benefits, imposes a positive effect on a third party.
Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources
impacts the majority of the public in a positive way.
Key Terms
natural resource: Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.
Renewable: Sustainable; able to be regrown or renewed; having an ongoing or continuous source of supply; not finite.
depletion: The consumption of a resource faster than it can be replenished.
sustainable: Able to be sustained for an indefinite period without damaging the environment, or without depleting a resource.
Boundless. Provided by: Boundless Learning. Located at: www.boundless.com//political-...tion/renewable. License: CC BY-
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CHAPTER OVERVIEW
37: Agriculture Economics

Topic hierarchy
This page titled 37: Agriculture Economics is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
The Agricultural Market Landscape
The agricultural market landscape is the economic system that produces, distributes, and consumes agricultural products and
services.
Outline the evolution of the agriculture market over time
Agriculture, in many ways, has been the fundamental economic industry throughout history. The production and exchange of food
laid the groundwork for all bartering, making it likely to be the oldest market in history. The production of food in modern times in
developed nations is oddly taken for granted, as surpluses tend to define the market in pursuit of providing options.
Developing nations view agriculture quite differently, where famines and low yield years can dramatically affect the overall food
supply in a given region. Due to the critical importance of food production, the agricultural market landscape is one of the most
studied and evolved economic segments.
The History of Agriculture

The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions,
climates, cultures, and technological approaches. Over 10,000 years ago, tribes began executing forest gardening. This evolved in
the Fertile Crescent region into the domestication of animals (i.e. cattle, sheep, goats, pigs), growing of wheat and barley in Jordan
Valley and the growth of cereal in Syria (all still about 10,000 years ago).
As population expanded dramatically over time (see ), so did the efficiency of agriculture economics. This began with agricultural
improvements such as the hoe and the plow (2500 B.C.), irrigation via canals, and biological pest control as early as the bronze and
iron ages. This evolved further in the middle ages with the advent of fertilizers, three field techniques, draft horses, and improved
international exchange. Indeed, until the Industrial Revolution (18th and 19th centuries) the vast majority of the human population
labored long hard days to generate enough food to feed the masses.
Human Population Growth: This chart illustrates the way in which human population growth evolved over time, underlining the
difficulty in maintaining supplies to fill the needs of such a large population.
The modern era of farming is increasingly defined by selective breeding, crop rotation, economies of scale, electronic machinery,
genetic modification, pesticides, and a host of other solutions that have rapidly expanded the overall potential capacity in farming.
Agricultural Economics
This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated to
observing and predicting trends within the agriculture market landscape. Basic macro and micro-economic principles apply to
farming, as do the existence of externalities such as climate change and nutritional health. Agricultural economics is defined as the
economic system that produces, distributes, and consumes agricultural products and services. This represents a large interconnected
supply chain on a global scale.
Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs for
the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress greatly reducing the
need for human labor in the production of agricultural goods, weighting the costs more heavily on the human resources side of the
equation.
The politics and economics of agriculture are also relevant issues on the global scale. US agricultural subsidies have had a large
impact on international trade flows. The subsidies make US agricultural products artificially cheap, too cheap for developing
nations to compete with. Developing nations, which may rely more heavily on agriculture in their economy than developed nations,
argue that the US should reduce its agriculture subsidies. This tension is perhaps the biggest cause of the failure of the Doha
Round, a World Trade Organization push for more open global trade, to make any progress since its initiation in 2001.
Subsidies and Income Supports

An agricultural subsidy is a government grant paid to incumbents in the industry to reduce costs and influence the supply of
commodities.
Analyze the positive and negative affects of subsidies on agricultural economics.
When governments want to ensure their citizens have access to healthy foods at reasonable prices, a variety of governmental
supports are provided to the industry to ensure it maintains low costs of production and high output. This is generally in the form of
subsidy and income supports, which alleviate some competitive dynamics and operating expenses to maintain reasonable price
points in the market economically.
Subsidies
An agricultural subsidy is defined as a government grant paid to farmers to supplement income and influence the overall cost and
supply of certain commodities. In this industry, subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice,
peanuts, tobacco, soybean, cotton, lamb, beef, chicken and pork. illustrates the governmental priorities, based upon subsidies
provided, for specific agricultural goods in the United States. These subsidies play a large role in enabling higher supply at lower
price points, supporting the domestic agricultural industry.
Agriculture Subsidies in the U.S. (2005): This chart illustrates the governmental priorities, based upon subsidies provided, for
specific agriculture goods in the United States.
Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and
clothes, which are considered necessities and thus should be provided at the lowest costs possible. These consumer-based subsidies
are another governmental attempt to enable citizens in the country to purchase basic food stuffs required to survive. Food stamps
are a similar concept, used to empower low income individuals and ensure they have access to these basic foods as well (food
stamps are often limited to milk, eggs, bread and other core foods).
Impacts of Subsidies
While these subsidies above are designed to have a positive effect on consumers looking to purchase foods, there are externalities
to this process that can have a damaging affect on other groups:
Global Effects: While domestic subsidies are good for driving up production domestically, it suppresses competition in the
context of international trade. Government assistance in an industry is argued to provide an unfair competitive advantage for
those companies, artificially lowering their costs of production, sometimes below the feasible level for countries (especially
developing nations) not receiving these supports.
Developing Nations: A complement to the above discussion is the effect on poverty and developing nations without the
infrastructure to provide subsidies for their own farmers. The International Food Policy Research Institute has estimated a total
loss of economic growth in developing nations at $24 billion in 2003, all of which translate to lost income for individuals who
desperately need it.
Nutrition: Another interesting side effect of subsidies and the artificially reduced price of food is obesity and overeating. Some
argue that these low prices provide the incentive to buy more food than is necessary, and this over consumption has resulted in a
highly unhealthy culture (particularly in the U.S.).
Environmental Implications: As food prices reduce distribution increases, thus driving an environmental externality which
already existed even further. The cost, environmentally, of transporting a high quantity of agricultural goods across the globe
has resulted in high degrees of pollution and waste.
Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to
subsidies as well. Politics must find a way to mitigate the negative consequences while increasing the positive effects, allowing for
balanced and healthy consumption across all demographics.
Price Supports
Price supports are subsidies or price controls used by the government to artificially increase or decrease prices in the agriculture
market.
Assess the way in which price controls affect supply, demand, and equilibrium pricing in agricultural economics.
The agriculture industry is a critical component of any national economy because it represents both a substantial portion of gross
domestic product and it is a core necessity for citizens within the system. Due to the fact that these goods are necessities, it is also
important to keep in mind the way in which supply and demand would operate if there was a limited supply (required for survival,
and thus potential demand upsides could be boundless). Due to these factors, governments enact a variety of price controls on the
agriculture business, both in the U.S. and abroad.
Defining Price Supports

Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease
prices, and thus alter the supply consumed/quantity demanded by individuals within the system. Understanding the effects of
subsidies and price controls is critical in industries with a high degree of government involvement, and agriculture is one of the
most affected industries.
is simply a supply and demand curve that demonstrates the consumer surplus and producer surplus opportunities in basic supply
and demand chart. In this scenario, without external governmental intervention, the price equilibrium will remain in the center of
the graph. However, the government may implement price supports that artificially consume some of the consumer surplus (in, this
is 200 units). This drives the price upwards to $6 per unit despite the fact that the consumer is not gaining additional quantity (it is
artificial quantity, as purchased by the government).
Consumer Surplus with Price Support: This graph is a complement to the first graph. It demonstrates the effect of implementing
a price support on a basic supply and demand chart. The overall consumption will decrease as the government buys up consumer
surplus. This demonstrates a price control on behalf of the government.
Consumer Surplus: This chart, in conjunction with the one below, illustrates the way in which price supports can alter supply and
overall consumption. It demonstrates the consumer surplus and producer surplus opportunities on a basic supply and demand chart.
This can happen in reverse as well in the form of subsidies. Subsidies are the reduction of costs for producers, generally in the form
of governmental grants provided to suppliers. In this scenario, prices are artificially reduced, allowing for an outward shift of the
supply curve along the demand line, which creates a higher amount of consumption by consumers as a result of the reduced price.
This is illustrated in, where the governmental subsidy allows for increased consumption power on behalf of the consumers in that
market.
Subsidies and Supply: This chart shows how subsidies and price controls affect supply and demand. A subsidy, as illustrated here,
will reduce the price and extend the overall supply demanded and consumed by individuals within the system. This is the most
relevant chart to agricultural economics specifically.
Applying Price Supports to Agricultural Economics

The United States currently pays out around $20 billion annually to farmers and producers in agriculture in the form of subsidies
via farm bills in order to artificially reduce prices and shift the supply curve outward to ensure the overall supply in the market is
high enough to satisfy all prospective consumers. It is important to note how dramatically the recipients of farming subsidies have
changed over time in the United States. In 1925, there were around 6,000,000 small farms of which 25% of the nation resided. By
1997, 72% of farm sales come from 157,000 large farms and only 2% of the U.S. population resides there. This is an interesting
economic factor in farm subsidies, as these subsidies are largely going to corporations of substantial size, as opposed to small
farmers.
The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a
significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce at the
level of goods desired by the U.S. government. Agricultural economics is a highly complicated market as a result of these price
supports and controls, particularly from the perspective of subsidization and price control.
Supply Reduction
Agricultural aggregate supply can be reduced through external capacity potential or governmental interventions.
Identify factors resulting in global reductions in agricultural supply levels.
Agricultural economics is largely bound by concepts of climate and overall world food producing capacity (i.e. farmlands and
infrastructure), while simultaneously being enabled by government policy, technological advances, and the continued growth of
developing nations. Understanding the reductions in aggregate supply in this industry, as a result of governmental policy or
economic limits, is a critical component in understanding agricultural economics. We will look at both the governmental
components and the climatic/aggregate demand components contributing to overall supply in this industry.
Governmental Policy
Government policy has a large impact on the agriculture market. Both subsidies and price ceilings are common and affect the
overall supply and demand equilibrium points in the market. Governmental policy to reduce supply also exists and is executed
often from a global trade perspective. One of the largest risks in this industry, due to the high degree of subsidization, is ‘ dumping.
‘ Dumping is the process of selling undervalued goods in another market, upsetting price points and equilibrium. In this scenario,
government policies may set quotas, or import limits, to reduce supply.
A second reduction in supply that is quite common in developed nations is utilizing surplus for foreign aid. Many developing
nations lack the requisites to generate the appropriate supply of agriculture to feed the population. In this scenario, the leveraging of
the surplus in one country can benefit the other country via aid, and in turn correct the supply/demand equilibrium in the donating
country to the desired level.
Climate Change
Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming has been
slowly increasing temperatures as the ozone layer erodes due to a variety of pollutants, altering the ecosystem averages outside of
the evolutionary environment in which many agricultural products historically grew. Climate changes means a different growing
environment for plants, which are not used to it. illustrates the reduction in yield as a result of altering climatic environments. Shifts
in climate drastically reduce aggregate supply.
Climate Change Affecting Agriculture: This chart illustrates the reduction in yield as a result of altering climatic environments.
Essentially, deviations outside of the normal temperature ranges drastically reduce aggregate supply.
Other concerns revolve around dramatic soil damage due to short-term yield increasing strategies, growing immunity to pesticides,
loss of rural space for farming (due to urbanization), and availability of clean water for irrigation. All of these factors may reduce
the aggregate supply and thus drive up prices. demonstrates rising food prices, perhaps from a number of the supply reduction
factors discussed in this atom (or potentially unidentified factors). Controlling supply is a critical component of ensuring everyone
has access to affordable food, and maintaining our ecosystem will clearly play a critical role in the years ahead.
Food Price Increases Over Time: Food prices over time, particularly in recent years, are demonstrating a trend upwards that may
reflect a reduction in overall efficiency of agricultural production or reductions in supply.
Evaluating Policies
Agriculture requires a vast support system and a great deal of oversight, addressing industry threats and utilizing policy-based
tools.
Evaluate the economics of agriculture policies.
The political frame of the agriculture market is hugely complex, with a wide range of critical concerns that need to be addressed
both domestically and internationally. Agricultural policy differs from nation to nation, but has a number of key questions and
considerations that occur across the board. The purpose of this atom is to outline the various trends in agricultural economic policy,
and how these governmental policies can be evaluated for efficacy in their respective markets.
Policy Concerns
Agriculture requires a vast support system and a great deal of oversight, as the consumption of grown foods poses a huge safety
threat alongside a critical need for the health and survival of a civilization. Below is a list of core questions to keep in mind when
evaluating agricultural policy:
Biosecurity: The ability of a country to consistently provide enough food for its citizens is a major concern. Pests and diseases
are a significant threat to yield rates and must be closely observed and regulated.
International Trading Environment: Global agricultural trade is a complex issue, with quality control, pricing (dumping), and
import/export tariffs. The dangers of biosecurity, or lack thereof, in particular are quite stringent.
Infrastructure: Transporting goods, irrigation facilities, land utilization, and a variety of other logistics concerns are required
by the government to enable effective economic trade (domestically and internationally).
Technology: This is a critical driving force in increasing yield and lowering costs in the agriculture business. Enabling
technological progress is a critical investment and something governments must provide incentives for.
Water: Access to clean, potable water is a basic necessity to which not everyone has access.Effective sewage systems for
irrigation and effective water treatment for sanitation are a required input, and must be provided via governmental centralized
infrastructure.
Resource Access: Ensuring access to land and biodiversity is another important component to a successful agricultural
industry. Protection of environmental land and the overall ecosystem is an important policy consideration.
Policy Tools
With the above concerns in mind, it is also useful to understand some of the tools leveraged by governments to enable this industry:
Subsidies: The government can utilize subsidies to reduce price points and increase the overall supply within a system. The use
of subsidies in developed nations has been a major point of international contention, since they may force developing nations
out of the global agriculture market.
Price Floors/Ceilings: Price floors provide a minimum price point for a given product while price ceilings create a maximum
price point. These are used to ensure appropriate pricing in a given industry (see ), and are often used in agriculture to control
price points.
Import Quotas: Policy makers often implement quotas in agriculture to retain more control over prices and protect domestic
incumbents. Quotas, like other forms of trade protection, benefit the local industry.
Aid: When aggregate supply is too high in a home country or there is a crisis in another, governments can provide their surplus
to nations in need of food. This is both a way to provide utilitarian value while reducing aggregate supply.
Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns and
activities of the respective government in a given economy. This is useful in controlling food prices, reducing waste, enabling
efficiency and avoiding biosecurity issues.
Key Points
The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions,
climates, cultures, and technological approaches.
The roots of agriculture are derived over 10,000 years ago, with tribes executing forest gardening alongside the domestication
of animals in the Fertile Crescent region.
As population expanded dramatically over time (see, so did the efficiency of agriculture economics. This began with
agricultural improvements such as the hoe and is represented today with genetic engineering, robotics, irrigatiion, etc.
This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated
to observing and predicting trends within the agriculture market landscape.
Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs
for the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress.
Subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice, peanuts, tobacco, soybean, cotton, lamb,
beef, chicken and pork.
Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and
clothes, which are considered necessities and thus should be provided at the lowest costs possible.
In the context of international trade, government assistance in industry provides an unfair competitive advantage for those
companies receiving the support.
subsidies as well.
subsidies as well. Politics must find a way to mitigate the negative externalities.
Governments enact a variety of price controls on the agriculture business, both in the U.S. and abroad, to ensure desired supply
and prices for specific necessities.
Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease
prices, and alter the supply consumed/quantity demanded by individuals within the system.
The government may artificially increase prices through purchasing a portion of the consumer surplus or artificially increase
quantity through offering subsidies to producers. This allows the government control over the established equilibrium in
agriculture.
The United States currently pays out around $20 billion annually to farmers and producers in agriculture in the form of
subsidies via farm bills in order to artificially reduce prices and shift the supply curve.
The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a
significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce.
Government policy has a large impact on the agriculture market, usually in the form of subsidies and price ceilings, by
controlling the overall supply and demand equilibrium points in the market.
Governments may reduce supply through utilizing quotas (limiting imports ) or providing foreign aid (actively reducing
domestic demand).
Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming
(increased average temperatures) has demonstrated a negative effect on overall plant yield for certain products.
Other concerns reducing supply revolve around dramatic soil damage due to short-term yield increasing strategies, growing
immunity to pesticides, loss of rural space for farming (due to urbanization), and availability of clean water for irrigation.
The political frame of the agriculture market is complex, with a wide range of critical concerns that need to be addressed both
domestically and internationally.
Concerns to keep in mind revolve around the international markets, bio-security, infrastructure, technology, water, and resource
allocation to enable effective agricultural markets.
Governments can use import quotas, subsidies, price floors, price ceilings, and aid to control their domestic market supply,
demand, and equilibrium price point.
Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns
and activities of the respective government in a given economy.
Key Terms
Agricultural Economics: The study of the production, distribution, and consumption of goods and services related to food.
subsidy: Government assistance to a business or economic sector.
externalities: Impacts, positive or negative, on any party not involved in a given economic transaction or act.
Price support: A subsidy or a price control with the intended effect of keeping the market price of a good higher or the quantity
consumer higher within a market.
Subsidies: Financial support or assistance, such as a grant.
Dumping: Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.
Quotas: A restriction on the import of a good to a specific quantity.
infrastructure: The basic facilities, services, and installations needed for the functioning of a community or society.
Biosecurity: The protection of plants and animals against harm from disease or from human exploitation.
Agriculture in the United States. Provided by: Wikipedia. Located at: en.Wikipedia.org/wiki/Agricul..._United_States.
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CHAPTER OVERVIEW
38: Immigration Economics

Topic hierarchy
This page titled 38: Immigration Economics is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Boundless.
Dimensionalizing Immigration: Numbers of Immigrants around the World
Annually, millions of people around the world decide to emigrate to another country, and this rate is expected to increase over time.
Describe trends of global immigration
Immigration
Immigration is defined as the movement of people from their home country or region to another country, of which they are not
native, to live. There are specific economic factors that contribute to immigration, including the desire to obtain higher wage rates,
improve the standard of living, have better job opportunities, and gain an education. Non-economic factors are also significant and
include leaving a home country due to persecution, ethnic cleansing, genocide, war, natural disasters, and political control (for
example, dictatorship). Throughout history, with improved transportation and technology, immigration has become increasingly
common worldwide. Immigration numbers impact both the home country and the host country.
Immigration Statistics
In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide, which accounted for
about 3% of the world population. This represented an increase in the number of immigrants by about 26 million since 1990. It is
estimated that 60% of the immigrants moved to developed countries.
Country Immigrant Populations in 2005: The darker the color, the higher the percent immigrants in the population. The darkest
blue indicates more than 50% of the population are immigrants. There is no data for countries in grey.
In 2006, the International Organization for Migration estimated the number of immigrants to be more than 200 million globally.
Europe, the United States, and Asia were found to host the largest number of immigrants at 70 million, 45 million, and 25 million.
Moreover, it is predicted that immigration rates will continue to increase over time. A 2012 survey that was conducted by Gallup
determined that nearly 640 million adults would want to immigrate if they had the chance. About one quarter of those surveyed
(23%, or 150 million adults) stated that they would choose to immigrate to the United States. Seven percent (45 million adults)
stated that they would choose to immigrate to the United Kingdom. Other top countries listed in the survey included Canada,
France, Saudi Arabia, Australia, Germany, and Spain.
Net Immigration Rate: This graph shows the worldwide net immigration rate in 2011. The blue shows positive rates, the orange is
negative, green is stable, and gray represents no data available. It is predicted that global immigration rates will continue to
increase in the future.
Regional Factors for Immigration

Regional factors contribute to immigrants’ selection of a specific host country. The prospects for employment, wage rate, standard
of living, and immigration laws all contribute to relocation decisions. Examples of immigration patterns in certain countries help to
illustrate how specific factors influence immigration numbers worldwide.
Europe: Immigrants helped to rebuild and repopulate Europe after World War II. In 2005 Europe experienced an overall net
gain of 1.8 million people from immigration. This accounted for almost 85% of Europe’s total population growth that year. In
2010, according to Eurostat, there were 47.3 million immigrants living throughout Europe, which accounted for 9.4% of the
total population; Germany, France, the United Kingdom, Spain, Italy, and the Netherlands experienced the highest immigration
rates.
Japan: Japan had strict immigration policies, but in the early 1990’s, issues such as low birth rates and an aging work force
caused the country to reevaluate its laws. It is estimated that the number of foreign residents living in Japan in 2008 was more
than 2.2 million. The largest groups of immigrants were from Korea, China, and Brazil.
Mexico: Mexico does experience large numbers of immigrants crossing over the Guatemalan border, but many of these
individuals enter illegally and get deported. There were an estimated 200,000 undocumented immigrants in Mexico in 2005
alone. Mexico is also the leading country for migrants moving to the United States. The tighter immigration laws have made
immigrating to the U.S. from Mexico very challenging. Many Mexican immigrants enter and live in the U.S. illegally.
United States: Factors that influence immigration to the U.S. include family reunification, employment opportunities, and
humanitarian needs. When President Bill Clinton was in office, the U.S. Commission on Immigration Reform sought to limit
legal immigration to about 550,000 people a year. Immigration has remained a heavily debated issue since then. U.S. borders
have tightened in recent years to help control illegal immigration. It was documented in 2010 that 1 million immigrants
obtained legal permanent resident status for that year.
Impact of Immigration on the Immigrant

Immigrants move to another country with the intent to improve their life; however, immigration presents both benefits and
challenges for immigrants.
Assess the impact that immigration has on immigrants
Immigration
Immigration involves the movement of people from their home country to a host country or region, to which they are not native, to
live. There are many reasons why immigrants choose to leave their home countries, including economic issues, political issues,
family reunification, and natural disasters. In general, no matter what the reasoning is, immigrants move to another country to
improve their life. Immigration presents both benefits and challenges for immigrants.
Benefits of Immigration
There are many benefits associated with immigration. Primarily, immigrants choose to leave their home country in order to
improve their quality of life. Economic reasons for immigrating include seeking higher wage rates, better employment
opportunities, a higher standard of living, and educational opportunities. It is also common for immigrants to leave their home
country to escape from poverty, religious persecution, oppression, ethnic cleansing, genocide, wars, or a political structure (e.g.
repressive dictatorship). No matter what the reasoning is behind immigration, it provides the immigrant with a new start on life and
more growth opportunities than were previously available. Success in a new country is not guaranteed and often requires hard work
and sacrifices, but many immigrants are willing to take risks for the possibility of a better future for themselves.
Immigration: This picture shows a group of North African immigrants on a boat near the island of Sicily. When most immigrants
choose to leave their home country, the intent is to move in order to obtain a higher quality of life in the host country.
Challenges of Immigration
One of the initial challenges faced by immigrants is the cost of immigrating. Many immigrants are seeking better economic
conditions in a new country, so the cost of moving can be substantial for them. It is not uncommon for immigrants to liquidate their
assets, potentially at a substantial loss, to be able to afford to move. Also, during immigration many individuals are without work
and must find work once they get settled.
The majority of challenges associated with immigration deal with assimilating into life in the host country. Many immigrants take
low wage jobs until they can adjust to society, gain housing, and obtain an education. Immigrants must learn a new way of life and
become familiar with the language and laws of the host country. While many immigrants leave their home country to escape
persecution, it is possible that they could face discrimination or even racism in the host country. The process of immigrating is not
easy, but for many individuals staying in their home country does not provide them with a promising future. Most immigrants are
willing to take risks and work hard to build a solid future even though the process can be challenging.
Impact of Immigration on the Host and Home Country Economies

Immigration has both positive and negative effects on the host and home countries including population totals, employment, and
production.
Explain how immigration impacts the host country and the home country of immigrants
Immigration
Immigration involves the movement of people from their home country to a host country, of which they are not native, to settle and
live. People immigrate for many reasons; some of which include economic or political reasons, family reunification, natural
disasters, or the desire to change one’s surroundings.
In 2006, the International Organization for Migration estimated the number of foreign migrants worldwide to be more than 200
million. Europe, North America, and Asia host the largest number of immigrants totaling 70 million, 45 million, and 25 million in
2005, respectively.
Immigration Rates: This map shows the migration rates worldwide in 2011. The blue countries experienced positive rates, orange
indicates negative rates, green shows stable rates, and the gray shows where no data was available. Immigration involves
individuals moving from their home country to live in a non-native country. In 2005, Europe, the United States, and Asia had the
highest levels of immigration worldwide.
Impacts on the Host Country

A host country experiences both advantages and challenges as a result of immigration. At certain times throughout history, larger
migrations have taken place which created huge population surges. The higher population numbers placed strain on the
infrastructure and services within the host country. When immigrants move to a new country, they are faced with many unknowns,
including finding employment and housing, as well as adjusting to new laws, cultural norms, and possibly a new language. It can
be a challenge for a host country to assimilate immigrants into society and provide the necessary support.
Immigration does cause an increase in the labor force. This can impact great quantities of them if the immigrants are generally the
same type of worker (e.g. low-skilled) and immigrate in large enough numbers so as to significantly expand the supply of labor.
Immigration is still a heavily debated topic in many host countries. Some believe that immigration brings many advantages to a
country both for the economy and society as a whole. Others believe that high immigration numbers threaten national identity,
increase dependence on welfare, and threaten national security (through illegal immigration or terrorism). Another argument is that
high immigration rates cheapens labor. Empirically, research has shown this may be partially true. The Brookings Institute found
that from 1980 to 2007, immigration only caused a 2.3% depression in the wages of the host country. The Center for Immigration
Studies found a 3.7% depression in wages during 1980 to 2000.
Impacts on the Home Country

The home country also faces specific challenges in regards to immigration. In many cases, immigrants move to another country to
provide positive changes for their future. Reasons to immigrate can include the standard of living not being high enough, the value
of wages being too low, a slow job market, or a lack of educational opportunities. A home country must analyze immigration
statistics to determine and address why citizens are moving to other countries. In the long-run, large amounts of immigration will
weaken the home country by decreasing the population, the level of production, and economic spending. If a country is losing
citizens due to economic reasons, the situation will not improve until economic changes are made.
At times, citizens of a country may leave because of non-economic reasons such as religious persecution, ethnic cleansing,
genocide, war, or to escape the government (for example, a dictatorship). In these cases, it is not uncommon for the citizens to
return to the home country at some point once the threat is no longer present. While a citizen is living in another country, if they
receive an education and create a solid life, their individual success can also be beneficial to the home country, if they use their
acquired skills to make a difference. Many individuals do not forget their home country and continue to support family members
financially through the income from the country they migrate to.
Key Points
It is predicted that immigration rates will continue to increase over time. A 2012 Gallup survey determined that nearly 640
million adults would want to immigrate if they had the chance to.
In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide; about 3% of the
world population. In 2006, Europe, the United States, and Asia were found to host the largest number of immigrants at 70
million, 45 million, and 25 million, respectively.
Regional factors contribute to immigrants selecting a specific host country. The prospects for employment, wage rate, standard
of living, and immigration laws all contribute the immigrants’ decision of where to relocate.
Some reasons immigrants choose to leave their home countries include economic issues, political issues, family reunification,
or natural disasters. Economic reasons include seeking higher wages, better employment opportunities, a higher standard of
living, and educational opportunities.
No matter the reasons behind an immigration decision, immigration provides the immigrant with a new start on life and more
growth opportunities than were previously available.
One of the initial challenges faced by immigrants is the cost of immigrating. However, the majority of challenges associated
with immigration deal with assimilating into life in the host country.
One of the initial challenges faced by immigrants is the cost of immigrating. It is not uncommon for immigrants to liquidate
their assets, potentially at a substantial loss, to be able to afford to move.
The majority of challenges associated with immigration deal with assimilating into life in the host country.
People immigrate for many reasons, some of which include economic or political reasons, family reunification, natural
disasters, or the desire to change one’s surroundings.
Immigration can represent an expansion of the supply of labor in the host country.
Host countries are faced with a variety of challenges due to immigration including population surges, support services,
employment, and national security.
Reasons to immigrate can include the standard of living not being high enough, the value of wages being low, a slow job
market, or a lack of educational opportunities.
In the long run, large amounts of immigration will weaken the home country by decreasing the population, the level of
production, and economic spending.
Key Terms
immigration: The act of coming into a country for the purpose of permanent residence.
immigrant: A person who comes to a country from another country in order to permanently settle in the new country.
assimilate: To absorb a group of people into a community.
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CHAPTER OVERVIEW
4: Economic Surplus
Topic hierarchy
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1
Explain the relationship between price and quantity demanded
Willingness to Pay and the Demand Curve

In general as the price of a good increases, the quantity demanded of that good decreases.
A demand curve is the graphical depiction of the relationship between the price of a certain commodity and the amount of it that
consumers are willing and able to purchase at that price. Demand curves are used to estimate behaviors in competitive markets and
are often used with supply curves to estimate the market equilibrium price, or the price at which sellers are willing to sell the same
amount of a product as the market’s buyers are willing purchase. A demand graph can reflect the preferences of a single consumer,
a group of consumers or an entire market. For demand graphs that reflect a group, the individual demands at each price are added
together.
Demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances. It is defined by three
elements:
Individual Utility: An item’s utility is based on its ability to satisfy an individual’s needs or wants. Some utility is universal;
every human needs water to survive so it has high utility for everyone. Some utility is based on personal preference; some
people prefer Coke over Pepsi so for them Coke has the higher utility. The more people that find utility in the good the greater
the market demand; the greater the individual utility in the product the greater the individual demand.
Purchasing Power: Demand is measured based on a person’s willingness to buy under the prevailing circumstances. If an
individual lacks the money to purchase the product, she can’t demand it because she cannot afford it.
Ability to Decide: The individual must be able to choose to make a purchase. Sometimes circumstances may prevent a person
from purchasing something they might desire, even if they have the necessary money. For example, an underaged person may
not be permitted by law to purchase cigarettes. That person might want the cigarettes and can afford to purchase them, but since
it is against the law for him to purchase it, there is no demand.
For the vast majority of goods and services, an increase in price will lead to a decrease in the quantity demanded. There are two
exceptions to this general rule.
Supply and demand graph: The downward sloping demand curve reflects the fact that as price increases, consumers willing to
purchase less of the good or service.
Veblen Goods
Veblen goods are expensive luxury products, such as designer handbags and high-end cars. In these rare circumstances, decreasing
the price actually decreases the demand for the good. The reason for this is because part of the value of the good is exclusivity.
These items are status symbols and lowering the price diminishes the status.
Giffen Goods
Giffen goods are another example where rising prices can lead to increased demand for a product. Giffen goods are very rare and
are defined by three characteristics:
It is an inferior good, or a good for which demand decreases as consumer income rises,
There must be a lack of substitute product,
The good must constitute a substantial percentage of the buyer’s income, but not such a substantial percentage of the buyer’s
income that none of the associated normal goods are consumed.
For example, imagine a significant portion of a family’s grocery bill is bread. Bread is a staple and it is the cheapest option out of
the food available. If bread prices rise, the family will need to cut back on other groceries to make up the difference. However,
since the family still need to eat a certain amount of calories each day and bread is still the cheapest option, they will purchase
more bread to make up for the food they aren’t purchasing and consuming. In this instance, bread is a giffen good.
The Demand Curve and Consumer Surplus

Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay.
Illustrate consumer surplus with the demand schedule and demand curve
Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. If a
consumer would be willing to pay more than the current asking price, then they are getting more benefit from the purchased
product than they spent to buy it. Consumer surplus plus producer surplus equals the total economic surplus in the market.
This chart graphically illustrates consumer surplus in a market without any monopolies, binding price controls, or any other
inefficiencies. The price in this chart is set at the pareto optimal. This means that the price could not be increased or decreased
without one of the parties being made worse off. The consumer surplus, as marked in red, is bound by the y-axis on the left, the
demand curve on the right, and a horizontal line where y equals the equilibrium price. This area represent the amount of goods
consumers would have been willing to purchase at a price higher than the pareto optimal price. Generally, the lower the price, the
greater the consumer surplus.
Price
Supply curve
Consumer
Market price
surplus
Equilibrium
Producer
surplus
Demand
curve
Equilibrium quantity Quantity
Consumer Surplus: Consumer surplus, as shown highlighted in red, represents the benefit consumers get for purchasing goods at
a price lower than the maximum they are willing to pay.
Another way to define consumer surplus in less quantitative terms is as a measure of a consumer’s well-being. Some goods, like
water, are valuable to everyone because it is a necessity for survival. But the utility, or “usefulness,” of most goods vary depending
on a person’s individual preferences. Since the utility a person gets from a good defines her demand for it, utility also defines the
consumer surplus an individual might get from purchasing that item. If a person has no use for a good, there is no consumer’s
surplus for that person in purchasing the good no matter the price. However, if a person finds a good incredibly useful, consumer
surplus will be significant even if the price is high. An individual’s customer surplus for a product is based on the individual’s
utility of that product.
Impacts of Price Changes on Consumer Surplus

Consumer surplus decreases when price is set above the equilibrium price, but increases to a certain point when price is below the
equilibrium price.
Explain how shifting a price away from pareto optimal will impact consumer surplus
Consumer surplus is defined, in part, by the price of the product. Recall that the consumer surplus is calculating the area between
the demand curve and the price line for the quantity of goods sold. Assuming that there is no shift in demand, an increase in price
will therefore lead to a reduction in consumer surplus, while a decrease in price will lead to an increase in consumer surplus.
Consumer Surplus: An increase in the price will reduce consumer surplus, while a decrease in the price will increase consumer
surplus.
Below are two scenarios that illustrate how changes in price can affect consumers’ surplus. It is important to note that any shift
from the good’s pareto optimal price will result in a decrease in the total economic surplus. The total economic surplus equals the
sum of the consumer and producer surpluses.
Price Ceiling
A binding price ceiling is one that is lower than the pareto efficient market price. This means that consumers will be able to
purchase the product at a lower price than what would normally be available to them. It might appear that this would increase
consumer surplus, but that is not necessarily the case.
For consumers to achieve a surplus they have to be able to purchase the product, which means that producers have to make enough
to be purchased at a price. If a good’s price drops below the market equilibrium for whatever reason, manufacturing the product
will be less profitable for the producers. So while more consumers will want to purchase the product because of its low price, they
will not be able to. This means the market will have a shortage for that good. This shortage will create a deadweight loss, or a
market wide loss of efficiency and value that neither producer nor consumers obtain.
So any increase in consumer surplus due to the decrease in price may be offset by the fact that consumers that want the good cannot
purchase it. At some point the benefit from the drop in price will be outweighed by the decrease in the good’s availability.
Price Floor
When a price floor is set above the equilibrium price, consumers will have to purchase the product at a higher price. Therefore,
fewer consumers will purchase the product because some will decide that the utility they get from the good is not worth the price.
Necessarily, this reflects a drop in consumer surplus.
Key Points
Demand is the willingness and ability of a consumer to purchase a good under certain circumstances.
Demand curves are used to estimate behaviors in competitive markets and are often used with supply curves to estimate the
market equilibrium price, or the price at which sellers are willing to sell the same amount of a product as the market’s buyers
are willing purchase.
An individual’s demand is defined by her utility, purchasing power, and ability to make a purchasing decision.
On a supply and demand chart, consumer surplus is bound by the y-axis on the left, the demand curve on the right, and a
horizontal line where y equals the current market price.
Another way to define consumer surplus in less quantitative terms is as a measure of a consumer’s well-being.
An individual’s customer surplus for a product is based on the individual’s utility of that product.
Consumer surplus will only increase as long as the benefit from the lower price exceeds the costs from the resulting shortage.
Consumer surplus always decreases when a binding price floor is instituted in a market above the equilibrium price.
The total economic surplus equals the sum of the consumer and producer surpluses.
Price helps define consumer surplus, but overall surplus is maximized when the price is pareto optimal, or at equilibrium.
Key Terms
demand curve: The graph depicting the relationship between the price of a certain commodity and the amount of it that
consumers are willing and able to purchase at that given price.
price floor: A mandated minimum price for a product in a market.
Price ceiling: A government-imposed price control or limit on how high a price is charged for a product.
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Market Power
Market power is a measure of a firm’s economic strength that affects its pricing and supply decisions.
Summarize the relationship between market power and a firm’s supply decision
Market power is a measure of the economic strength of a firm. It is the ability of a firm to influence the quantity or price of goods
and services in a market. A firm is said to have significant market power when price exceeds marginal cost and long run average
cost, so the firm makes economic profits. Such firms are often referred to as “price makers.” In contrast, firms with limited to no
market power are referred to as “price takers.”
Determinants of Market Power

A firm usually has market power by virtue of controlling a large portion of the market. However, market size alone is not the only
indicator of market power. Other factors that affect a firm’s market power include:
Number of producers
Size of firms in the market
The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product
flows. However, being a large firm does not necessarily equal market power. For example, while conglomerates may be very large,
they may play only small roles in many different markets and have no ability to influence prices in any of them.
Barriers to entry
Barriers to entry determine how contestable the market is. Even highly concentrated markets may be contestable markets if there
are no barriers to entry or exit, which limits a firm’s ability to raise its price above competitive levels.
Common barriers to entry include control of a scarce resource, increasing returns to scale, technological superiority, and
government-imposed barriers.
Availability of substitute goods
Greater availability of substitute goods will weaken a firm’s market power.
Relationship between Market Power and Firm Behavior

A firm’s market power influences its behavior. For example, market power gives firms the ability to engage in unilateral anti-
competitive behavior. Some of the behaviors that firms with market power are accused of engaging in include predatory pricing,
product tying, and creation of overcapacity or other barriers to entry. If no individual participant in the market has significant
market power, then anti-competitive behavior can take place only through collusion, or the exercise of a group of participants’
collective market power.
Google Logo: In 2012, the U.S. Federal Trade Commission opened an antitrust probe against Google’s search practices. Google
allegedly used its market dominance to promote its own products over competitors’ products in web searches.
A monopoly, a price maker with market power, can raise prices and retain customers because the monopoly has no competitors. If a
customer has no other place to go to obtain the goods or services, they either pay the increased price or do without.
An oligopoly may also be a price maker with market power, as firms may be able to collude and control the market price or
quantity demanded.
A perfectly competitive firm, a price taker with no market power, cannot raise its price without losing its customers.
Measurement of Market Power

Measurement of market power is often accomplished with concentration ratios or the Herfindahl-Hirschman Index (HHI).
Concentration Ratios
The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). This
measure of market power relates the size of firms to the size of the market. For monopolies, the four firm concentration ratio is 100
percent, while the ratio is zero for perfect competition.
Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry, and an indicator of the amount
of competition among them. The HHI is calculated by summing the squares of the percentage market shares of all participants in
the market. The HHI for perfect competition is zero; for a monopoly, it is 10,000.
For example, if a market consists of five firms with market shares of 40, 20, 20, 15, and 5 percent each, the HHI is 2650.
(40 + 20 + 20 + 15 + 5 = 2650) .
2 2 2 2 2
Measurement Problems
The use of the concentration ratio or the HHI to measure market power is not perfect. A high concentration ratio or large firm size
is not the only way to achieve market power. Many smaller firms acting in unison can achieve the same result. Additionally, the
measurements do not convey the extent to which market power may be concentrated in a local market.
Defining Producer Surplus

Producer surplus is the difference between the amount producers get for selling a good and the amount they want to accept for that
good.
Define producer surplus
Producer surplus is the difference between what price producers are willing and able to supply a good for and what price they
actually receive from consumers. It is the extra money, benefit, and/or utility producers get from selling a product at a price that is
higher than their minimum accepted price, as shown by the supply curve.
Price
Supply curve
Consumer
Market price
surplus
Equilibrium
Producer
surplus
Demand
curve
Economic Surplus: Producer surplus is the shaded area directly above the supply curve, up to the equilibrium point. Consumer
surplus is the shaded area directly under the demand curve, up to the equilibrium point.
For example, above, the equilibrium price is P '. However, at P , the producers are willing to sell one unit of a commodity for a
1
price that is lower than P '. The resulting rectangle from P on the y -axis, to its intersection with the supply curve, up to the level
1
of P ' is the producer surplus at price level P .

1
Similarly, at P , the producers are willing to sell two units of a commodity at a price that is still lower than P '. The rectangle from
2
P on the y -axis, to its intersection with the supply curve, up to the level of P ' is the new producer surplus at price P . The total
2 2
producer surplus at P is the first rectangle at the P price, plus the new rectangle from the P price.
2 1 2
This process is repeated for every price level up to the equilibrium price. To find the resulting total producer surplus, all of the
rectangles for the individual price levels are added together, and the total area is the total producer surplus. Below, the total
producer surplus is made of all three pink rectangles – the surpluses at price levels of P , P , and P – added together.
1 2 3
Producer surplus: In the figure, producer surplus at different prices is represented by the pink rectangles.
Impact of Changing Price on Producer Surplus

Producer surplus is affected by changes in price, the demand and supply curve, and the price elasticity of supply.
Examine producer surplus in terms of changes in demand, supply, price, and price elasticity
Producer surplus is affected by many different factors. Changes in the price level, the demand and supply curves, and price
elasticity all influence the total amount of producer surplus, other things held constant.
Changes in Price
Changes in price are directly associated with the amount of surplus a producer will receive. Graphically, the producer surplus is
directly above the supply curve, but below the price. Other things equal, as equilibrium price increases, the amount of potential
producer surplus and the number of goods supplied increases. Lower prices result in lower potential producer surplus and goods
supplied: with a lower equilibrium price, the producer surplus triangle will be smaller.
Price
Supply curve
Consumer
Market price
surplus
Equilibrium
Producer
surplus
Demand
curve
Economic Surplus: The producer surplus is directly above the supply curve and is shaded in blue.
Demand Curve
Shifts in the demand curve are directly related to the amount of producer surplus. If demand decreases, and the demand curve shifts
to the left, producer surplus decreases. Conversely, if demand increases, and the demand curve shifts to the right, producer surplus
increases.
At an initial demand represented by the “Demand (1)” curve, producer surplus is the blue triangle made of P , A , and B . When 1
demand increases, represented by the “Demand (2)” curve, producer surplus is the larger gray triangle made of P , A , and C . 2
Producer Surplus and the Demand Curve: If the demand curve shifts out, producer surplus increases, as seen by size of the gray
triangle.
Supply Curve
Similarly, shifts in the supply curve are also directly related to the amount of potential surplus. Decreases in the supply curve will
cause decreases in producer surplus. Increases in the supply curve will cause increases in producer surplus.
At an initial supply represented by the “Supply (1)” curve, producer surplus is the blue triangle made of P , A , and 1 C . If supply
increases, represented by the “Supply (2)” curve, producer surplus is the larger gray triangle made of P , B , and D. 2
Price Elasticity of Supply

Price elasticity of supply is the relationship between price and quantity changes. It measures how quantity supplied is affected by
changes in price. When supply is elastic, producers can increase production without much price or cost change. When supply is
inelastic, producers cannot change production easily.
When supply is perfectly elastic, it is depicted as a horizontal line. Producer surplus is zero because the price is not flexible.
Producers cannot provide a higher price than market price.
When supply is perfectly inelastic, it is depicted as a vertical line. Producer surplus is infinite because the price is completely
flexible.
Key Points
Firms with market power are said to be “price makers.” They can raise prices and change the quantity supplied of goods and
services without hurting profits. Market power often exists when there is a monopoly or oligopoly.
Firms with limited to no market power are said to be “price takers.” They cannot raise their prices or change the quantity
supplied of goods and services without hurting profits. Perfectly competitive firms are examples of price takers with no market
power.
Market power is determined by the number of producers in the market, the size of each firm, barriers to entry in the market, and
availability of substitute goods. Firm size and market size alone do not dictate market power.
Market power is often measured with concentration ratios or the Herfindahl-Hirschman Index, but these are not perfect
measures.
Producer surplus can be thought of as the extra money, utility, or benefits the producer receives by selling a product at a price
that is higher than its minimum acceptable price.
The minimum acceptable price for producers is represented by the supply curve.
Graphically, producer surplus is the shaded region just above the supply curve, but below the equilibrium price level.
Changes in the equilibrium price are directly related to producer surplus, other things equal. As the equilibrium price increases,
the potential producer surplus increases. As the equilibrium price decreases, producer surplus decreases.
Shifts in the demand curve are directly related to producer surplus. If demand increases, producer surplus increases. If demand
decreases, producer surplus decreases.
Shifts in the supply curve are directly related to producer surplus. If supply increases, producer surplus increases. If supply
decreases, producer surplus decreases.
Price elasticity of supply is inversely related to producer surplus. If supply is completely elastic, it is drawn as a horizontal line,
and producer surplus is zero. If supply is completely inelastic, it is shown as a vertical line, and producer surplus is infinite.
Key Terms
Herfindahl-Hirschman Index: A measure of the size of firms in relation to the industry and an indicator of the amount of
competition among them.
concentration ratio: The proportion of total industry output produced by the largest firms (usually the four largest).
contestable market: An imperfectly competitive industry subject to potential entry if prices or profits increase.
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.
price elasticity of supply: A numerical measure of the responsiveness of the quantity supplied of a product to a change in the
price of the product alone.
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CHAPTER OVERVIEW
5: Consumer Choice and Utility

Topic hierarchy
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1
Defining Utility
Utility is an economic measure of how valuable, or useful, a good or service is to a consumer.
Define Utility
Utility is a term used by economists to describe the measurement of “useful-ness” that a consumer obtains from any good or
service. Utility may measure how much one enjoys a movie or the sense of security one gets from buying a deadbolt. The utility of
any object or circumstance can be considered. Some examples include the utility from eating an apple, from living in a certain
house, from voting for a specific candidate, or from having a given wireless phone plan. In fact, every decision that an individual
makes in their daily life can be viewed as a comparison between the utility gained from pursuing one option or another.
Apples and Oranges: Utility allows you to compare apples and oranges based on which you prefer.
Utility may be positive or negative with no effect on its interpretation. If one option gives −15−15utility and another gives −12−12,
selecting the second is not, as it might seem, the “lesser of two evils,” but can only be interpreted as the better option.
Utility can be measured in one of two ways:
Ordinal utility ranks a series of options in order of preference. This ranking does not show how much more valuable one option
is than another, only that one option is preferable over another. An example of a statement reflecting ordinal utility is that “I
would rather read than watch television.” Generally, ordinal utility is the preferred method for gauging utility.
Cardinal utility also ranks a series of options in order of preference, but it also measures the magnitude of the utility differences.
An example of a statement reflecting cardinal utility is “I would enjoy reading three times more than watching television.”
Given how difficult it is to precisely measure preference, cardinal utility is rarely used.
Theory of Utility
The theory of utility states that, all else equal, a rational person will always choose the option that has the highest utility.
Explain the Theory of Utility
The theory of utility is based on the assumption of that individuals are rational. Rationality has a different meaning in economics
than it does in common parlance. In economics, an individual is “rational” if that individual maximizes utility in their decisions.
Whenever an individual is to choose between a group of options, they are rational if they choose the option that, all else equal,
gives the greatest utility. Recalling that utility includes every element of a decision, this assumption is not particularly difficult to
accept. If, when everything is taken into account, one decision provides the greatest utility, which is equivalent to meaning that it is
the most preferred, then we would expect the individual to take that most preferred option. This should not necessarily be taken to
mean that individuals who fail to quantify and measure every decision they make are behaving irrationally. Rather, this means that
a rational individual is one who always selects that option that they prefer the most.
Consumer making a decision: When making an economically rational purchasing decision, a consumer must consider all of their
personal preferences.
It is important to emphasize how rationality relates to a person’s individual preferences. People prioritize different things. For
example one person may prioritize flavor while another person may value making healthy choices more. As a result the first person
may choose a sugary cereal while the second may choose granola. Based on their preferences, both made the economically rational
choice.
The rationality assumption gives a basis for modeling human behavior and decision making. If we could not assume rationality, it
would be impossible to say what, when presented with a set of choices, an individual would select. The notion of rationality is
therefore central to any understanding of microeconomics.
Marginal Utility
Marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service.
Define Marginal Utility
In economic terms, marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of
that good or service. The idea of marginal value is an important consideration when making production or purchasing decisions. A
person should produce or purchase an additional item when the marginal utility exceeds the marginal cost.
Marginal Utility of Housing: The marginal utility of owning a second house is likely less than the marginal utility of owning the
first house.
Marginal utility is measured on a per unit basis. When evaluating the marginal utility of any item, it is important to know in what
unit utility is measured. The unit is based on the type of activity that you are trying to measure. If you are a consumer of potato
chips, you might measure utility based on whether to buy another bag or have another hand full with your lunch. If you are a
producer of potato chips, your marginal value might be defined by a pallet of potato chips. In general, marginal value should be
measured based on the smallest unit of consumption or production related to the product in question.
It is also important to remember that utility is difficult to quantify since preferences vary based on the individual. Utility is rarely
measured in terms of magnitude; utility is normally just about determining which option is the best choice. Since utility is rarely
measured using cardinal means, it may seem difficult to determine a product’s marginal value. Economists get around this by
substituting dollar values. While this may fail to capture a specific individual’s preferences and utility, it offers a good
approximation based on everyone’s collective preferences as defined by the market.
Principle of Diminishing Marginal Utility

The principle of diminishing marginal utility states that as more of a good or service is consumed, the marginal benefit of the next
unit decreases.
Explain diminishing marginal utility
The principle of diminishing marginal utility states that as an individual consumes more of a good, the marginal benefit of each
additional unit of that good decreases.
The concept of diminishing marginal utility is easy to understand since there are numerous examples of it in everyday life. Imagine
it is a hot summer day and you are hungry, so you get some ice cream. The first bite is great and so is the second. But with each
spoonful, your hunger decreases and you become cooler. So while the last bite might still be good, it is probably not as satisfying as
the first. This is a simple illustration of diminishing marginal utility.
Total and marginal utility: As you can see in the chart, the more of a good you consume, the further its marginal utility decreases.
Negative Marginal Utility

While there are some circumstances where there will always be some marginal utility to producing or consuming more of a good,
there are also circumstances where marginal utility can become negative. For example, while some antibiotics may be useful in
curing diseases. However, if you take too much you can become sick or resistant to the drugs which could lead to future illnesses
being incurable. So it is important to remember that “diminishing” does not necessarily mean to zero; you can have too much of a
good thing.
Exceptions to the General Rule

This concept suggests a uniform steady decline of marginal utility, but that may not always be the case. There can be situations in
which one might gain more utility from consuming a later unit of a good than from earlier consumption. If you are going on a date,
for example, getting one ticket to a concert will have some utility but the second arguably has more because it enhances the value
of the first.
Generally these exceptions occur when what is being consumed is a component of a larger whole. While utility may increase for a
period, there is usually a “tipping point” where afterwards marginal utility decreases. Getting a third ticket for your date will have
low marginal utility than the second.
Key Points
Utility is measured by comparing multiple options.
Utility can be positive and negative.
Ordinal utility ranks a series of preferences without measuring how much more valuable one option is than another. Cardinal
utility measures how much more preferable one option is in comparison to another.
Ordinal utility is generally the preferred method of measuring utility.
The rationality assumption gives a basis for modeling human behavior and decision making.
Utility includes every element of a decision.
Rationality is dependent on a person’s individual preferences. Therefore, what might be a rational decision for one person may
not be a rational decision for another.
Marginal utility is measured on a per unit basis.
Since an individual’s utility is rarely measured using cardinal means, calculating a product’s marginal value for an individual
may be difficult.
Instead of trying to calculate a product’s marginal value for an individual, economists assign dollar values to products based on
their market price. This allows economists to estimate a product’s marginal value based on all the consumer’s preferences.
The idea of marginal value is an important consideration when making production or purchasing decisions. A person should
produce or purchase an additional item when the marginal utility exceeds the marginal cost.
If you consume too much, the marginal utility of a good or service can become negative.
In some circumstances, the marginal utility of producing or consuming an additional unit will increase for a short period of
time. Generally there will be a “tipping point” at which marginal utility will then decrease.
Generally these exceptions occur when what is being consumed is a component of a larger whole.
Key Terms
ordinal: Of a number, indicating position in a sequence.
cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number
indicating relative position.
Rational individual: A person who chooses the option that, all else equal, gives the greatest utility.
marginal: Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number
indicating relative position.
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.
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Introducing the Budget Constraint
Budget constraints represent the plausible combinations of products and services a buyer can purchase with the available capital on
hand.
Discuss the role of the budget set and indifference curve in determining the choice that gives a consumer maximum satisfaction
The concept of budget constraints in the field of economics revolves around the idea that a given consumer is limited in
consumption relative to the amount of capital they possess. As a result, consumers analyze the optimal way in which to leverage
their purchasing power to maximize their utility and minimize opportunity costs. This is achieved through using budget constraints,
which represent the plausible combinations of products and/or services a buyer is capable of purchasing with their capital on hand.
Trade-offs
To expand upon this definition further, the business concept of opportunity cost via trade-offs is a central building block in
understanding budget constraints. An opportunity cost is defined as the foregone value of the next best alternative in a given action.
To apply this to a real-life situation, pretend you have $100 to spend on food for the month. You have a wide variety of options, but
some will provide you with higher opportunity costs than others. You could purchase enough bread, rice, milk and eggs to feed
yourself for the full month or you could buy premium cut steak and store-prepared dinners by the pound (which would last about
one week). The opportunity cost of the former is the high quality foods which have the convenience factor of already being
prepared for you while the opportunity cost of the latter is having enough food to feed yourself for the entire month. In this
circumstance the decision is easy, and the trade off will be sacrificing convenience and high quality food for the ability to have
enough food on the table over the course of the whole month.
Budget Curves and Indifference Curves

Understanding these trade-offs underlines the true function of budget constraints in economics, which is identifying which
consumer behaviors will maximize utility. Consumers are inherently equipped with an infinite demand and a finite pool of
resources, and therefore must make budgetary decisions based on their preferences. The way economists demonstrate this
arithmetically and visually is through generating budget curves and indifference curves.
Budget curves: This indicates the relationship between two goods relative to opportunity costs, which defines the value of each
good relative to one another. For example, on the figure provided a quantity of 5 for ‘good yy‘ is identical in price (economic
value) as a quantity of 7 for ‘good xx‘. This demonstrates the trade-off ratio between the two available products or services. It is
important to keep in mind that prices and valuations of goods are constantly changing, and that the ratio between any two goods is
not fixed over the long-term for most products/services.
Good Y
A (0,5)
B (7,0)
Good X
Budget Curve: A budget curve demonstrates the relationship between two goods relative to opportunity costs, essentially deriving
the relative value of each good based on quantity and utility. Keep in mind that moving from one point on the in to another is
trading off ‘xx‘ amount of one good for ‘yy‘ amount of another.
Indifference curves: Indifference curves underline the way in which a given consumer interprets the value of each good relative to
one another, demonstrating how much of ‘good xx‘ is equivalent in utility to a certain quantity of ‘good yy‘ (and vice versa). Any
point along the indifference curve will represent indifference to the consumer, or simply put equivalent preference for one
combination of goods or the other. In the figure it is clear that the budget curve has been included in conjunction with the
indifference curves, which allows insight as to the ideal actual quantity of each good is optimal for this specific consumer.
I1 I2 I3
Good Y
Qy
Qx Good X
Indifference Curves: Indifference curves are designed to represent an equal perception of overall value in a given basket of goods
relative to a specific consumer. That is to say that each point along the curve is considered by the consumer of equivalent value
despite alterations in the quantity of each good, as these trade-offs are consider of equal value and thus indifferent.
Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall
utility based upon their budget constraints.
Mapping Preferences with Indifference Curves

Economists mapping consumer preferences use indifference curves to illustrate a series of goods that represent equivalent utility.
Describe the indifference curves for goods that are perfect substitutes and complements
A critical input to understanding consumer purchasing behaviors and the general demand present in a given market or economy for
specific goods and services is the identification of consumer preferences. Consumer preference varies substantially from individual
to individual and market to market, requiring comprehensive economic observation of consumer choices and behaviors. One of the
primary tools leveraged by economists mapping consumer preferences is the indifference curve, which illustrates a series of
bundled goods in which a consumer is indifferent. A consumer would be just as happy with any combination of Good X and Good
Y on the curve. This could synonymous to saying baskets of goods that provide the same utility.
I1 I2 I3
Good Y Good X
Indifference Curve: A consumer will be just as happy with any combination of Good X and Y on indifference curve I1, though
s/he will prefer any bundle on indifference curve I2 or I3.
These indifference curves, when mapped graphically alongside other curves, is called an indifference map. A key consideration in
creating any indifference map is what relative preferences should be isolated. While it is possible to create a complex array of
preference maps to compare more than two products/services, each specific standard indifference map will be about creating a
benchmark between two. For example one could compare relatively similar goods/services (i.e. apples vs. oranges) or dramatically
different goods/services (i.e. university training vs. automobile purchasing). These two items being compared represent the x and y
axis of a indifference map. A consumer will always prefer to be on the indifference curve farthest from the origin.
Implications of Indifference Maps

After constructing the required inputs to generate a comprehensive indifference map, an economist can derive conclusions based
upon the properties of the illustration. In framing these implications it is useful to identify the two potential extremes that can be
outlined via with indifference curves:
Perfect Substitutes: To understand what a indifference curves will look like when products are perfect substitutes, please see
the graph below. These lines are essentially perfectly straight, and that demonstrates that the relative utility of ‘Good X’
compared to that of ‘Good Y’ is equivalent regardless of the amount in question. It is reasonable to assume in this scenario that
purchasing all of one or all of the other will not decrease the overall satisfaction of the consumer. Perfect substitutes are often
homogeneous goods. A consumer with no preference between Burger King and McDonald’s, for example, might consider them
perfect substitutes and be indifferent to spending all of their fast food money on one or the other.
Perfect Complements: The opposite of a perfect substitute is a perfect complement, which is illustrated graphically through
curves with perfect right angles at the center. These right angles, and the subsequent straight horizontal and vertical lines,
demonstrate that ‘Good X’ and ‘Good Y’ are inherently tied to one another and that the consumption of one is dependent upon
the consumption of the other. An example of complementary goods might be university tuition and academic textbook
purchases, an automobile and automobile insurance, or a cable and a television.
Combining an understanding of these inputs with the extremes demonstrated an indifference map, economists are able to draw
meaningful conclusions regarding consumer choices and purchasing behaviors in the context of two goods. The comparison
between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when
posed with a decision between various products and services.
Good Y
I2 I3
I1
Good X
Perfect Substitute Indifference Curve: In this particular series of indifference curves it is clear that ‘Good X’ and ‘Good Y’ are
perfect substitutes for one another. That is to say that the utility of one is identical to the utility of the other across all quantities
represented on the map.
Good Y
I3
I2
I1
Good X
Perfect Complement Indifference Curve: The perfect right angle in this series of indifference curves implies that the utility of
‘Good X’ and ‘Good Y’ are entirely interdependent. This is to say that in order to enjoy one good it is necessary to also have the
other.
Properties of Indifference Curves

Almost all indifference curves will be negatively sloped, convex, and will not intersect.
Analyze the properties that are common to many indifference curves
Indifference curves trace the combination of goods that would give a consumer a certain level of utility. The indifference curve
itself represents a series of combinations of quantities of goods (generally two) that a consumer would be indifferent between, or
would value each of them equally in regards to overall utility. Indifference curves allow economists to predict consumer purchasing
behaviors based upon utility maximization for a bundle of goods within the context of a given consumer’s budget constraints and
preferences.
Properties of Indifference Curves

The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the
purchase of groupings of goods, with a series of key properties that define the process of mapping these curves:
Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right).
This assumes that negative quantities are meaningless – one can’t consume a negative amount of a good.
Indifference curves are always negatively sloped. This is based on the assumption that a consumer is always better off
consuming more of a good, so as quantity consumed of one good increases, total satisfaction would increase if not offset by a
decrease in the quantity consumed of another good. This also assumes that the marginal rate of substitution is always positive.
All curves projected on the indifference map must also be transitive to ensure that if AA is preferred to BBand BB is preferred
to CC, CC is not also preferred to AA. This is manifested in indifference curves that never intersect.
Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left). This demonstrates that
increasingly high quantities of one good over another have a cost in respect to their overall utility per unit (diminishing returns).
It is technically possible for indifference curves to be perfectly straight as well, which would imply that the two goods are
identical (perfect substitutes).
Combining these various properties, one can highlight a number of critical implications of consumer purchasing behavior and the
concept of utility. Consumers naturally desire a bundle of goods that is varied (hence the convex curves for most comparisons) in
order to maximize their utility. Similarly, all indifference curves will naturally identify diminishing rates of substitution as the
quantity increases for a certain good compared to another, and can create demand projections of prospective supply.
Impact of Income on Consumer Choices

One of the central considerations for a consumer’s consumption choice is income or wage levels, and thus their budgetary
constraints.
Break down changes in consumption into the income effect and the wealth effect
Consumer choices are predicated on various economic circumstances, and recognizing the relationship between these
circumstances and an individual’s purchasing behavior allows economists to recognize and predict consumer choice trends. One of
the central considerations for a consumer in deciding upon their purchasing behaviors is their overall income or wage levels, and
thus their budgetary constraints. These budgetary constraints, when applied to a series of products and services, can be optimized to
capture the most utility for the consumer based on their purchasing power.
Income from a Consumer Theory Perspective

The simplest way to demonstrate the effects of income on overall consumer choice, from the viewpoint of Consumer Theory, is via
an income-consumption curve for a normal good. The basic premise behind this curve is that the varying income levels (as
illustrated by the green income line curving upwards) will determine different quantities and balanced baskets along the provided
indifference curves for the two goods being compared in this graph. These differences in quantity reflect the increase or decrease an
a given individual’s purchasing power, thus the income effect could be summarized as the increase in relative utility captured by a
consumer with more monetary power.
X²
income
consumption
curve
X⁰ I⁴
I³
X″
I²
X′
I¹
X*
X⁺ I⁵
B1 B2 B3
X¹
Income-Consumption Curve: Simply put, increases or decreases in income will alter the optimal quantity (and thus relative
utility) of a given basket of goods for a specific consumer.
The wealth effect differs slightly from the income effect. The wealth effect reflects changes in consumer choice based on perceived
wealth, not actual income. For example, if a person owns a stock that appreciates in price, they perceive that they are wealthier and
may spend more, even though they have not realized those gains so their income has not increased.
Effects of Income on Different Goods

Income effects on consumer choice grow more complex as the type of good changes, as different product and services demonstrate
different properties relative to both other products/services and a consumers preferences and utility. As a result, it is useful to
outline the differences in income effects on normal, inferior, complementary and substitute goods:
Normal: A normal good is a good with incremental increases or decreases in utility as quantity changes, demonstrating a
predictable and simple linear relationship as income increases or decreases. demonstrates a graphical representation of the
effects of income changes upon preference map.
Inferior: Inferior goods, or goods that are less preferable, will demonstrate inverse relationships with income compared to
normal goods. That is to say that an increase in income will not necessarily result in an increase in quantity for the inferior
good, as the consumer derives minimal utility in purchasing the inferior good compared to other goods. Inferior goods are often
sacrificed as income rises and consumers gain more choice/options. This can be represented in.
Complementary: Complementary goods are goods that are interdependent in consumption, or essentially goods that require
simultaneous consumption by the consumer. An example of this would be like purchasing an automobile and car insurance, the
consumption of one requires the consumption of the other. As income increases, these will increase relative to one another (as a
ratio). demonstrates this concept in graphical form.
Substitutes: Perfect substitutes are essentially interchangeable goods, where the consumption of one compared to another has
no meaningful impact on the consumer’s utility derived. Substitutes are goods that a consumer cannot differentiate between in
terms of the need being filled and the satisfaction obtained. Income increases will thus affect the consumption of these goods
interchangeably, resulting in increase in the quantity of either or both.
In merging Consumer Theory and consumer choices with income level, the primary takeaway is that an increase in income will
increase the prospective utility that consumer can acquire in the market. Understanding how this applies in a general fashion,
alongside the specific circumstances dictating specific types of goods, it becomes fairly straight-forward to predict consumer
purchasing behaviors at differing income levels.
X²
X′
X²₂ I²
income
consumption
curve
X*
X²₁ I¹
X¹₂ X¹₁ B1 B2
X¹
Income Levels and Inferior Goods: This graph demonstrates the inverse relationship between income and the consumption of
inferior goods. As income rises, the quantity consumed of ‘X1’ decreases. This illustrates increased variance in consumer choice as
income rises.
X²
income
consumption
curve
I³
X″
I²
X′
I¹
X*
B1 B2 B3
X¹
Income Effect on Complementary Goods: In this graphical depiction of income increases, the consumption of these two goods
are complementary and thus interdependent.
Impact of Price on Consumer Choices

The demand curve shows how consumer choices respond to changes in price.
Construct the demand curve using changes in consumption due to price changes
In almost all cases, consumer choices are driven by prices. As price goes up, the quantity that consumers demand goes down. This
correlation between the price of goods and the willingness to make purchases is represented clearly by the generation of a demand
curve (with price as the y-axis and quantity as the x-axis). The construction of demand, which shows exactly how much of a good
consumers will purchase at a given price, is defining of consumer choice theory.
Deriving Overall Demand

The generation of a demand curve is done by calculating what price consumers are willing to pay for a given quantity of a good or
service. For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will
generally increase as the price on the y-axis decreases (and vice versa). The quantity demanded may change in response to both to
shifts in demand (and the creation of a new demand curve, as demonstrated in ) and movements along the established demand
curve. A demand shift usually takes place when an external factor increases or decreases demand across the board, while a
movement upwards or downwards on the curve is indicative of a change in the good’s price.
P
D1 D2 S
P2
P1
Q1 Q2 Q
Demand Shifts: This graph demonstrates a shift in overall demand in the market, where the generation of a new parallel demand
curve is required to accurately represent consumer choices.
As the demand curve implies, price is often the central driving force behind a decision to purchase a given product or service.
Consumers must weigh the overall utility they can capture by making a purchase and benchmark that against their overall monetary
resources to optimize their purchasing decisions. This practice regulates the price companies can set for their products and services,
as the income effects and the prospective substitutions (substitution effect) will drive consumer purchase towards purchases that
create the most value for themselves.
Price Elasticity
A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive demand is
to a change in price. Price elasticity is essentially a measurement of how much any deviations in price will drive the overall
quantity purchased up or down, underlining to what extent consumer purchasing decisions will be dictated by pricing. The figure
pertaining to price elasticity shows how the slope of the demand curve will change depending on the degree of price sensitivity in
the marketplace for a good. A highly elastic good will see consumers much less likely to purchase when prices are high and much
more likely to purchase when prices are low, while a good with low elasticity will see consumers purchasing the same quantity
regardless of small price changes.
Price Elasticity: As this graph demonstrates, the slope of the demand curve will vary as a direct result of how elastic consumer
purchasing behaviors will be compared to price changes.
Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.
Deriving the Demand Curve

The law of demand pursues the derivation of a demand curve for a given product that benchmarks the relative prices and quantities
desired.
Explain how Giffen goods violate the law of demand
The law of demand in economics pertains to the derivation and recognition of a consumer’s relative desire for a product or service
coupled with a willingness and ability to pay for or purchase that good. Consumer purchasing behavior is a complicated process
weighing varying products/services against a constantly evolving economic backdrop. The derivation of demand is a useful tool in
this pursuit, often combined with a supply curve in order to determine equilibrium prices and understand the relationship between
consumer needs and what is readily available in the market.
Deriving Demand Curves

Despite a wide array of prospective goods and services in a constantly altering economic environment, the law of demand pursues
the derivation of a demand curve for a given product that benchmarks the relative prices and quantities desired by consumers in a
given marketplace. The inherent relationship between the price of a good and the relative amount of that good consumers will
demand is the fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.
Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa. The derivation of
demand curves for normal goods is therefore relatively predictable in respect to the direction of the slope on a graph. The
downward slope represented in this figure underline the critical principle that a given price point will reflect a given quantity
demanded by a given marketplace, allowing suppliers and economists to measure the value of a product/service based on a
price/quantity analysis of consumer purchasing behaviors.
Deriving the Demand Curve (Normal Goods): This illustration demonstrates the way in which economists can identify a series
of prices and quantities for goods demanded, which ultimately represents the overall demand curve for a given product/service.
One important consideration in demand curve derivation is the differentiation between demand curve shifts and movement along
the curve itself. Movement along the curve itself is the identification of what quantity will be purchased at different price points.
This means that the factors that underlie consumer desire for the product remains constant and consistent, but the quantity or price
alters to a new point along the established curve. Alternatively, sometimes external factors can shift the actual demand for a given
good, pushing the demand curve outwards to the right and up or inwards down and left. This represents a substantial change in the
actual demand for that product, as opposed to a quantity or price shift at a fixed demand level.
Exceptions: Giffen Goods and Neutral Goods

With the concept of general demand curves in mind, it is important to recognize that some goods do not conform to the traditional
assumption that higher prices will always demonstrate lower demand. Giffen goods and neutral goods break this rule, with the
former demonstrating an increase in demand as a result of a price rise and the latter demonstrating indifference to price in regards
to the quantity demanded (illustrated as a completely vertical demand curve):
Demand Curve for Giffen Goods: Giffen goods are essentially goods that demonstrate an increase in demand as a result of an
increase in price, generally considered counter-intuitive in traditional economic models. This graph illustrates the derivation of a
demand curve for these goods.
Giffen Goods – Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in
demand despite a rise in price. Goods such as high-end luxury items like expensive fashion often demonstrate this type of
counter-intuitive trend, where the high price of an item is attractive to the consumer for the sake of displaying wealth.
Neutral Goods – Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumers
will pay any price to get a fixed quantity. These goods are often necessities, defying the standard law of demand due to the fact
that they must be purchased regardless of price/situation. A good example of this is water or healthcare, where not getting what
is required will have dramatic consequences.
Applications of Principles on Consumer Choices

The income effect and substitution effect combine to create a labor supply curve to represent the consumer trade-off of leisure and
work.
Explain the labor-leisure tradeoff in terms of income and substitution effects
Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt to
maximize the utility obtainable within their income range. Central principles to analyzing consumer actions and choices are income
effect and the substitution effect, which ultimately generate a labor supply to illustrate the labor-leisure trade-off for consumers.
Income Effect
The income effect needs two simple inputs: the average price of goods and the consumer’s income level. This creates a relative
buying power, which will play a substantial role in the quantity of goods purchased. Predicting consumer choice requires inputs on
consumer purchasing power and the goods in which they are deciding between. In we are comparing ‘Good X’ and ‘Good Y’ to
identify how a change in income will alter the overall amount of each good would likely be purchased along a series of indifference
curves. This graphical representation of a consumer’s income (I) and budget constraints (BC) underlines the variance in quantity of
‘Good X’ and ‘Good Y’ that will be demanded dependent upon income circumstance. Naturally, a higher income will result in a
shift towards increase in quantity for many consumable goods/services.
Good X
X3
X2
X1
I3
I2
BC3
BC1 BC2 I1
Y1 Y2 Y3
Good Y
Income Effects on Consumption and Budget Constraints: This graphical representation of a consumers income(I) and budget
constraints (BC) underlines the variance in quantity of ‘Good X’ and ‘Good Y’ that will be demanded dependent upon income
circumstance. Naturally, a higher income will result in a shift towards increase in quantity for many consumable goods/services.
Substitution Effect
The substitution effect is closely related to that of the income effect, where the price of goods and a consumers income will play a
role in the decision-making process. In the substitution effect, a lower purchasing power will generally result in a shift towards
more affordable goods (substituting cheaper in place of more expensive goods) while a higher purchasing power often results in
substituting more expensive goods for cheaper ones. This shows the relationship between two graphs, pointing out how the
substitution effect identifies the relationship between the price of a given good and the quantity purchased by a given consumer. As
the bottom half of the figure implies, a higher price will dictate a lower quantity consumer for ‘Good Y’, while a lower price will
create a higher quantity. This translates to the graph above as the consumer makes choices to maximize utility when comparing the
price of different goods to a given income level, substituting cheaper goods and more expensive goods dependent upon purchasing
power.
Good X
X1
X2
X3
I3
I2
BC3
BC1 BC2 I1
Y1 Y2 Y3
Good Y
Price Y
P1
P2
P3
Y1 Y2 Y3 Quantity Good Y
Substitution Effect: This two-part graphical representation of the substitution effect identifies the relationship between the price of
a given good and the quantity purchased by a given consumer. As the bottom half effectively highlights, a higher price will dictate
a lower quantity consumer for ‘Good Y’, while a lower price will create a higher quantity. This translates to the graph above as the
consumer makes choices to maximize utility when comparing the price of different goods to a given income level.
Types of Goods
One additional important component of consumer choice is the way in which different goods demonstrate different reactions to
income alterations and price changes:
Income Changes: When income changes rises or falls, consumption of certain types of goods will have a positive or negative
correlation with these changes. With normal goods, an increase of income will correlate with a higher quantity of consumption
while a decrease in income will see a decrease in consumption. Inferior goods, on the other hand, will demonstrate an inverse
relationship. A rise in income will cause a decrease in their consumption and vice versa.
Price Changes: When price rises or falls, consumption of certain types of good will either demonstrate positive or negative
correlations to these shifts in regard to quantity consumed. Ordinary goods will demonstrate the intuitive situation, where a rise
in price will result in a decrease in quantity consumer. Inversely, Giffen goods demonstrate a positive relationship, where the
price rises will result in higher demand for the good and high consumption.
Labor Supply Curve

These concepts of income versus required monetary inputs (prices) for goods/services generates a relationship between how much
an individual will choose to work and how much an individual can take in terms of leisure time. Simply put, desired labor and
leisure time are dependent upon income and prices for goods. The relationship between the number of hours worked and the overall
wage levels results in something of a boomerang effect, with hours worked as the x-axis and wages as the y-axis.
Graphically represented, the labor supply curve looks like a backwards-bending curve, where an increase in wages from W1 to W2
will result in more hours being worked and an increase from W2 to W3 will result in less. This is primarily due to the fact that there
is a certain amount of capital attained by consumers where they will be satisfied with their monetary utility, at which point working
more has diminishing returns on their satisfaction. A rational consumer will begin to work less hours after meeting their
consumption requirements in order to capture the value of leisure (and enjoy their income in a meaningful way).
W3
Wage rate
W2
W1
L1 L3 L2
Hours worked
Labor Supply Curve: The concept of labor supply economics is most efficiently communicated via the following graphical
representation. This graph demonstrates the relationship between hours work and overall wage rates, demonstrating the shift in
utility as wages increase.
To apply this to the concept of different types of goods above, one can view wage rates and leisure time as consumer goods.
Depending on which point on the backwards-bending curve we are on, the trade-offs and thus the consumer decision will change. If
a worker choose to work more when the wage rate rises, leisure is an ordinary good.
Key Points
Consumers analyze the optimal way in which to leverage their purchasing power to maximize their utility and minimize
opportunity costs through employing trade -offs.
The way economists demonstrate this arithmetically and visually is through generating budget curves and indifference curves.
Budget curves indicate the relationship between two goods relative to opportunity costs, which defines the value of each good
relative to one another.
Indifference curves underline the way in which a given consumer interprets the value of each good relative to one another,
demonstrating how much of ‘good xx‘ is equivalent in utility to a certain quantity of ‘good yy‘ (and vice versa).
Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall
utility based upon their budget constraints.
Indifference curves illustrate bundles of goods that provide the same utility.
An economist can derive conclusions based upon the properties of the illustration. In framing these implications it is useful to
identify the two potential extremes of substitute goods and complementary goods.
The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which
consumers will act when posed with a decision between various products and services.
The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which
consumers will act when posed with a decision between various products and services.
The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the
purchase of groupings of goods, with a series of key properties that define the process of mapping these curves.
Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right).
Indifference curves are always negatively sloped. Essentially this assumes that the marginal rate of substitution is always
positive.
All curves projected on the indifference map must not intersect in order to ensure transitivity.
Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left).
The basic premise behind the income effect is that varying income levels will determine different quantities and balanced
baskets along the provided indifference curves for any two goods being compared.
These differences in quantity reflect the increase or decrease an a given individual’s purchasing power, thus the income effect
could be summarized as the increase in relative utility captured by a consumer with more monetary power.
Income effects on consumer choice grow more complex as the type of good changes, as different product and services
demonstrate different properties relative to both other products/services and a consumers preferences and utility.
The four key types of goods to consider are normal goods, inferior goods, complements and substitutes.
For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will
generally increase as the price on the y-axis decreases (and vice versa).
As the demand curve implies, price is the central driving force behind a decision to purchase a given product or service.
A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive
demand is to a change in price.
Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.
The quantity demanded may change in response to both to shifts in demand (and the creation of a new demand curve, as
demonstrated in and movements along the established demand curve.
The derivation of demand is a useful tool in this pursuit, often combined with a supply curve in order to determine equilibrium
prices and understand the relationship between consumer needs and what is readily available in the market.
The inherent relationship between the price of a good and the relative amount of that good consumers will demand is the
fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.
Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa.
Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in demand despite a
rise in price.
Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumer swill pay any
price to get a fixed quantity.
Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt
to maximize the utility obtainable within their income range.
The income effect says that a consumers overall income level will have an effect on the quantities of goods that consumer will
purchase.
The substitution effect, similar to the income effect, identifies ways in which consumer purchasing power will alter the relative
quantities of goods/services purchased by consumers at varying income levels and budgetary constraints.
Combining the substitution effect and the income effect, one can derive an overall labor -leisure trade-off based on a given
consumers purchasing power (income) relative to the price of necessary bundles of goods (substitution effect).
A rational consumer will begin to work less hours after meeting their consumption requirements in order to capture the value of
leisure (and enjoy their income in a meaningful way).
Key Terms
Trade-offs: Any situation in which the quality or quantity of one thing must be decreased for another to be increased.
substitute: A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of
another is increased.
Complement: A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of
another good is decreased.
Transitive: Having the property that if an element x is related to y and y is related to z, then x is necessarily related to z.
Inferior goods: A good that decreases in demand when consumer income rises; having a negative income elasticity of demand.
Income Effect: The change in consumption choices due to changes in the amount of money available for an individual to
spend.
Wealth Effect: The change in an individual’s consumption choices due to changes in perception of how rich s/he is.
elasticity: The sensitivity of changes in a quantity with respect to changes in another quantity.
Giffen good: A good which people consume more of as only the price rises; Having a positive price elasticity of demand.
Derivation: The operation of deducing one function from another according to some fixed law, called the law of derivation, as
the of differentiation or of integration.
substitution effect: The change in demand for one good that is due to the relative prices and availability of substitute goods.
Income Effect: The change in consumption resulting from a change in real income.
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CHAPTER OVERVIEW
6: Elasticity and its Implications

Topic hierarchy
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Boundless.
1
Define the price elasticity of demand.
The price elasticity of demand (PED) is a measure that captures the responsiveness of a good’s quantity demanded to a change in
its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all
other determinants of demand are held constant.
The formula for the coefficient of PED is:
% change in quantity demanded
P ED = (6.1.1)
% change in price
The law of demand states that there is an inverse relationship between price and demand for a good. As a result, the PED
coefficient is almost always negative. However, economists tend to ignore the sign in everyday use. Only goods that do not
conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.
The numerical values for the PED coefficient could range from zero to infinity. In general, the demand for a good is said to be
inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a less than
proportional effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its
PED is greater than one. In this case, changes in price have a more than proportional effect on the quantity of a good demanded.
A PED coefficient equal to one indicates demand that is unit elastic; any change in price leads to an exactly proportional change in
demand (i.e. a 1% reduction in demand would lead to a 1% reduction in price). A PED coefficient equal to zero indicates perfectly
inelastic demand. This means that demand for a good does not change in response to price.
Perfectly Inelastic Demand: When demand is perfectly inelastic, quantity demanded for a good does not change in response to a
change in price.
Finally, demand is said to be perfectly elastic when the PED coefficient is equal to infinity. When demand is perfectly elastic,
buyers will only buy at one price and no other.
Perfectly Elastic Demand: When the demand for a good is perfectly elastic, any increase in the price will cause the demand to
drop to zero.
Measuring the Price Elasticity of Demand

The price elasticity of demand (PED) is calculated by dividing the percentage change in quantity demanded by the percentage
change in price.
Calculate the own-price elasticity of demand
he price elasticity of demand (PED) captures how price-sensitive consumers are for a given product or service by measuring the
responsiveness of quantity demanded to changes in the good’s own price. This is in contrast to measuring the responsiveness of the
good’s demand to a change in price for some other good (a complement or substitute), which is called the cross-price elasticity of
demand. The own-price elasticity of demand is often simply called the price elasticity.
The following formula is used to calculate the own-price elasticity of demand:
%Change in Quantity Demanded
Elasticity = (6.1.2)
%Change in Price
The formula above usually yields a negative value because of the inverse relationship between price and quantity demanded.
However, economists often disregard the negative sign and report the elasticity as an absolute value. For example, if the price of a
good increases by 5 percent and the quantity demanded decreases by 5 percent, then the elasticity at the initial price and quantity is
-5%/5% = -1. This number is likely to be reported simply as 1.
Sale: There is an inverse relationship between price and quantity demanded, so the elasticity coefficient is almost always negative.
There are a few other important points to note about the coefficient value provided by this formula. First, the elasticity coefficient is
a pure number, meaning that it does not have units of measurement associated with it. Second, the coefficient value can range from
zero to negative infinity. Finally, the result provided by the formula will be accurate only when the changes in price and quantity
are small. The result will be less accurate when the changes are large.
Since PED is based off of percent changes, the starting nominal quantity and price matter. At low prices and high quantities, the
PED is therefore more inelastic. For example, a drop in the price of $1 from a starting price of $100 is a 1% drop, but if the starting
price is $10, it is a 10% drop. Similarly, at high prices and low quantities, PED is more elastic.
Price Elasticity of Demand and Revenue: PED is based off of percent changes, so the starting nominal values of price and
quantity are significant.
Interpretations of Price Elasticity of Demand

The price elasticity of demand (PED) explains how much changes in price affect changes in quantity demanded.
Describe the relationship between price elasticity and the shape of the demand curve.
The price elasticity of demand (PED) is a measure of the responsiveness of the quantity demanded of a good to a change in its
price. It can be calculated from the following formula:
% change in quantity demanded
(6.1.3)
% change in price
When PED is greater than one, demand is elastic. This can be interpreted as consumers being very sensitive to changes in price: a
1% increase in price will lead to a drop in quantity demanded of more than 1%.
When PED is less than one, demand is inelastic. This can be interpreted as consumers being insensitive to changes in price: a 1%
increase in price will lead to a drop in quantity demanded of less than 1%.
The effect of price changes on total revenue PED may be important for businesses attempting to distinguish how to maximize
revenue For example, if a business finds out its PED is very inelastic, it may want to raise its prices because it knows that it can sell
its products for a higher price without losing many sales. Conversely, if a business finds that its PED is very elastic, it may wish to
lower its prices. This would allow the business to dramatically increase the number of units sold without losing much revenue per
unit.
There are two notable cases of PED. The first is when demand is perfectly elastic. Perfectly elastic demand is represented
graphically as a horizontal line. In this case, any increase in price will lead to zero units demanded.
Perfectly Elastic Demand: Perfectly elastic demand is represented graphically by a horizontal line. In this case the PED value is
the same at every point of the demand curve.
The second is perfectly inelastic demand. Perfectly inelastic demand is graphed as a vertical line and indicates a price elasticity of
zero at every point of the curve. This means that the same quantity will be demanded regardless of the price.
Perfectly Inelastic Demand: Perfectly inelastic demand is graphed as a vertical line. The PED value is the same at every point of
the demand curve.
Since PED is measured based on percent changes in price, the nominal price and quantity mean that demand curves have different
elasticities at different points along the curve. Elasticity along a straight line demand curve varies from zero at the quantity axis to
infinity at the price axis. Below the midpoint of a straight line demand curve, elasticity is less than one and the firm wants to raise
price to increase total revenue. Above the midpoint, elasticity is greater than one and the firm wants to lower price to increase total
revenue. At the midpoint, E1, elasticity is equal to one, or unit elastic.
Elasticity and the Demand Curve: The price elasticity of demand for a good has different values at different points on the
demand curve.
Determinants of Price Elasticity of Demand

A good’s price elasticity of demand is largely determined by the availability of substitute goods.
Explain how a good’s price elasticity of demand may be different in the short term than in the long term
The price elasticity of demand (PED) is a measure of how much the quantity demanded changes with a change in price. The PED
for a given good is determined by one or a combination of the following factors:
Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity.
When several close substitutes are available, consumers can easily switch from one good to another even if there is only a small
change in price. Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.
Proportion of the purchaser’s budget consumed by the item: Products that consume a large portion of the purchaser’s
budget tend to have greater elasticity. The relative high cost of such goods will cause consumers to pay attention to the purchase
and seek substitutes. In contrast, demand will tend to be inelastic when a good represents only a negligible portion of the
budget.
Degree of necessity: The greater the necessity for a good, the lower the elasticity. Consumers will attempt to buy necessary
products (e.g. critical medications like insulin) regardless of the price. Luxury products, on the other hand, tend to have greater
elasticity. However, some goods that initially have a low degree of necessity are habit-forming and can become “necessities” to
consumers (e.g. coffee or cigarettes).
Duration of price change: For non-durable goods, elasticity tends to be greater over the long-run than the short-run. In the
short-term it may be difficult for consumers to find substitutes in response to a price change, but, over a longer time period,
consumers can adjust their behavior. For example, if there is a sudden increase in gasoline prices, consumers may continue to
fuel their cars with gas in the short-run, but may lower their demand for gas by switching to public transportation, carpooling,
or buying more fuel-efficient vehicles over a longer period of time. However, this tendency does not hold for consumer
durables. The demand for durables (cars, for example) tends to be less elastic, as it becomes necessary for consumers to replace
them with time.
Breadth of definition of a good: The broader the definition of a good, the lower the elasticity. For example, potato chips have
a relatively high elasticity of demand because many substitutes are available. Food in general would have an extremely low
PED because no substitutes exist.
Brand loyalty: An attachment to a certain brand (either out of tradition or because of proprietary barriers) can override
sensitivity to price changes, resulting in more inelastic demand.
Key Points
The PED is the percentage change in quantity demanded in response to a one percent change in price.
The PED coefficient is usually negative, although economists often ignore the sign.
Demand for a good is relatively inelastic if the PED coefficient is less than one (in absolute value).
Demand for a good is relatively elastic if the PED coefficient is greater than one (in absolute value).
Demand for a good is unit elastic when the PED coefficient is equal to one.
PED captures the change in quantity demanded in response to a change in the good’s own price (as opposed to the price of some
other good).
The formula for price elasticity yields a value that is negative, pure, and ranges from zero to negative infinity.
The result provided by the formula will be accurate only if the changes in price and quantity demanded are small.
Elastic PED can be interpreted as consumers being very sensitive to changes in price.
Inelastic PED can be interpreted as consumes being insensitive to changes in price.
Firms use PED to figure out how to change their prices in order to increase revenue.
PED varies along a straight demand curve.
A good with more close substitutes will likely have a higher elasticity.
The higher the percentage of a consumer’s income used to pay for the product, the higher the elasticity tends to be.
For non-durable goods, the longer a price change holds, the higher the elasticity is likely to be.
The more necessary a good is, the lower the price elasticity of demand.
Key Terms
elastic: Demand for a good is elastic when a change in price has a relatively large effect on the quantity of the good demanded.
Unit Elastic: Demand for a good is unit elastic when the percentage change in quantity demanded is equal to the percentage
change in price.
inelastic: Demand for a good is inelastic when a change in price has a relatively small effect on the quantity of the good
demanded.
Own-price elasticity of demand: Responsiveness of quantity demanded to a change in the good’s own price
Cross-price elasticity of demand: Measures the responsiveness of the demand for a good to a change in the price of another
good.
Price elasticity of demand: The percent change in quantity demanded due to a 1% change in price.
Substitute Good: A good that fulfills a consumer need in a way that is similar to another good.
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Cross-Price Elasticity of Demand
The cross-price elasticity of demand measures the change in demand for one good in response to a change in price of another good.
Use the cross elasticity of demand to describe a good
The cross-price elasticity of demand shows the relationship between two goods or services. More specifically, it captures the
responsiveness of the quantity demanded of one good to a change in price of another good. Cross-Price Elasticity of Demand
(EA,B) is calculated with the following formula:
%Change in Quantity Demanded for Good A
EA,B = (6.2.1)
%Change in Price of Good B
The cross-price elasticity may be a positive or negative value, depending on whether the goods are complements or substitutes. If
two products are complements, an increase in demand for one is accompanied by an increase in the quantity demanded of the other.
For example, an increase in demand for cars will lead to an increase in demand for fuel. If the price of the complement falls, the
quantity demanded of the other good will increase. The value of the cross-price elasticity for complementary goods will thus be
negative.
Complements: Two goods that complement each other have a negative cross elasticity of demand: as the price of good Y rises, the
demand for good X falls.
A positive cross-price elasticity value indicates that the two goods are substitutes. For substitute goods, as the price of one good
rises, the demand for the substitute good increases. For example, if the price of coffee increases, consumers may purchase less
coffee and more tea. Conversely, the demand for a substitute good falls when the price of another good is decreased. In the case of
perfect substitutes, the cross elasticity of demand will be equal to positive infinity.
Substitutes: Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for
good X rises.
Two goods may also be independent of each other. In this instance, if the price of one good changes, demand for the other good
will stay constant. For independent goods, the cross-price elasticity of demand is zero: the change in the price of one good with not
be reflected in the quantity demanded of the other.
Independent: Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for
good X stays constant.
Income Elasticity of Demand

The income elasticity of demand measures the responsiveness of the demand for a good or service to a change in income.
Analyze the characteristics of the income elasticity of demand.
The income elasticity of demand (YED) measures the responsiveness of demand for a good to a change in the income of the people
demanding that good, ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in
income:
%change in quantity demanded
Y ED = (6.2.2)
%change in real income
If an increase in income leads to an increase in demand, the income elasticity of that good or service is positive. A positive income
elasticity is associated with normal goods. In contrast, if a rise in income leads to a decrease in demand, the good or service has a
negative income elasticity of demand. A negative income elasticity is associated with inferior goods.
In all, there are five types of income elasticity of demand:
Income Elasticity of Demand: Income elasticity of demand measures the percentage change in quantity demanded as income
changes.
High income elasticity of demand (YED>1): An increase in income is accompanied by a proportionally larger increase in
quantity demanded. This is typical of a luxury or superior good.
Unitary income elasticity of demand (YED=1): An increase in income is accompanied by a proportional increase in quantity
demanded.
Low income elasticity of demand (YED<1): An increase in income is accompanied by less than a proportional increase in
quantity demanded. This is characteristic of a necessary good.
Zero income elasticity of demand (YED=0): A change in income has no effect on the quantity bought. These are called sticky
goods.
Negative income elasticity of demand (YED<0): An increase in income is accompanied by a decrease in the quantity
demanded. This is an inferior good (all other goods are normal goods). The consumer may be selecting more luxurious
substitutes as a result of the increase in income.
Calculating Elasticities
The basic elasticity formula has shortcomings which can be minimized by using the midpoint method or calculating the point
elasticity.
Calculate price elasticity of demand with the midpoint method
The basic formula for the price elasticity of demand (percentage change in quantity demanded divided by the percentage change in
price) yields an accurate result when the changes in quantity and price are small. As the difference between the two prices or
quantities increases, however, the accuracy of the formula decreases. This happens because the price elasticity of demand often
varies at different points along the demand curve and because the percentage change is not symmetric. Instead, the percentage
change between any two values depends on which is chosen as the starting value. For example, when the quantity demanded
increases from 10 units to 15 units, the percentage change is 50%. If the quantity demanded decreases from 15 units to 10 units, the
percentage change is -33.3%. Two alternative elasticity measures can be used to avoid or minimize the shortcomings of the basic
elasticity formula.
The midpoint method calculates the arc elasticity, which is the elasticity of one variable with respect to another between two given
points on the demand curve. This measure requires just two points for quantity demanded and price to be known; it does not require
a function for the relationship. The midpoint method uses the midpoint rather than the initial point for calculating percentage
change, so it is symmetric with respect to the two prices and quantities demanded. The arc elasticity is obtained using this formula:
Arc Elasticity: To calculate the arc elasticity, you need to know two points on the demand curve. The calculation does not require a
function for the relationship between price and quantity demanded.
(Q2 − Q1)/[(Q2 + Q1)/2]
Price Elasticity of Demand = (6.2.3)
(P 2 − P 1)/[(P 2 + P 1)/2]
Suppose that the price of hot dogs changes from $3 to $1, leading to a change in quantity demanded from 80 to 120. The formula
provided above would yield an elasticity of 0.4/(-1) = -0.4. As elasticity is often expressed without the negative sign, it can be said
that the demand for hot dogs has an elasticity of 0.4.
The point elasticity is the measure of the change in quantity demanded to a tiny change in price. It is the limit of the arc elasticity as
the distance between the two points approaches zero, and hence is defined as a single point. In contrast to the midpoint method,
calculating the point elasticity requires a defined function for the relationship between price and quantity demanded. The point
elasticity can be calculated with the following formula:
P ΔQd
Point − Price Elasticity = × (6.2.4)
Qd ΔP
In the formula above, dQ/dP is the partial derivative of quantity with respect to price, and P and Q are price and quantity,
respectively, at a given point on the demand curve.
Key Points
Complementary goods have a negative cross- price elasticity: as the price of one good increases, the demand for the second
good decreases.
Substitute goods have a positive cross-price elasticity: as the price of one good increases, the demand for the other good
increases.
Independent goods have a cross-price elasticity of zero: as the price of one good increases, the demand for the second good is
unchanged.
The income elasticity of demand is the ratio of the percentage change in demand to the percentage change in income.
Normal goods have a positive income elasticity of demand (as income increases, the quantity demanded increases).
Inferior goods have a negative income elasticity of demand (as income increases, the quantity demanded decreases).
When changes in price and quantity are big, the arc elasticity or point elasticity formulas provide a more accurate elasticity
coefficient than the basic elasticity formula.
The arc elasticity captures the responsiveness of one variable to another between two given points.
The midpoint method can be used if just two points on the demand curve are known. You do not need to know the function
relating price and quantity demanded to use this method.
The point elasticity captures the change in quantity demanded to a tiny change in price. To calculate the point elasticity, you
must have a function for the relationship between price and quantity.
Key Terms
Complement: A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of
another good is decreased.
substitute: A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of
another is increased.
Necessary Good: A type of normal good. An increase in income leads to a smaller than proportional increase in the quantity
demanded.
Superior Good: A type of normal good. Demand increases more than proportionally as income rises.
Point elasticity: The measure of the change in quantity demanded to a very small change in price.
Arc elasticity: The elasticity of one variable with respect to another between two given points.
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Definition of Price Elasticity of Supply
The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good.
Differentiate between the price elasticity of demand for elastic and inelastic goods
In economics, elasticity is a summary measure of how the supply or demand of a particular good is influenced by changes in price.
Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:
%Change in quantity
Elasticity = (6.3.1)
%Change in price
The price elasticity of supply (PES) is the measure of the responsiveness in quantity supplied (QS) to a change in price for a
specific good (% Change QS / % Change in Price). There are numerous factors that directly impact the elasticity of supply for a
good including stock, time period, availability of substitutes, and spare capacity. The state of these factors for a particular good will
determine if the price elasticity of supply is elastic or inelastic in regards to a change in price.
The price elasticity of supply has a range of values:
PES > 1: Supply is elastic.
PES < 1: Supply is inelastic.
PES = 0: The supply curve is vertical; there is no response of demand to prices. Supply is “perfectly inelastic.”
PES = ∞∞ (i.e., infinity): The supply curve is horizontal; there is extreme change in demand in response to very small change in
prices. Supply is “perfectly elastic.”
Inelastic goods are often described as necessities. A shift in price does not drastically impact consumer demand or the overall
supply of the good because it is not something people are able or willing to go without. Examples of inelastic goods would be
water, gasoline, housing, and food.
Elastic goods are usually viewed as luxury items. An increase in price for an elastic good has a noticeable impact on consumption.
The good is viewed as something that individuals are willing to sacrifice in order to save money. An example of an elastic good is
movie tickets, which are viewed as entertainment and not a necessity.
The price elasticity of supply is determined by:
Number of producers: ease of entry into the market.
Spare capacity: it is easy to increase production if there is a shift in demand.
Ease of switching: if production of goods can be varied, supply is more elastic.
Ease of storage: when goods can be stored easily, the elastic response increases demand.
Length of production period: quick production responds to a price increase easier.
Time period of training: when a firm invests in capital the supply is more elastic in its response to price increases.
Factor mobility: when moving resources into the industry is easier, the supply curve in more elastic.
Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied. If cost rise rapidly the stimulus to
production will be choked off quickly.
The result of calculating the elasticity of the supply and demand of a product according to price changes illustrates consumer
preferences and needs. The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively
inelastic, or perfectly inelastic.
Price elasticity over time: This graph illustrates how the supply and demand of a product are measured over time to show the price
elasticity.
Perfectly Inelastic Supply: A graphical representation of perfectly inelastic supply.
Measuring the Price Elasticity of Supply

The price elasticity of supply is the measure of the responsiveness of the quantity supplied of a particular good to a change in price.
Calculate elasticities and describe their meaning
The price elasticity of supply (PES) is the measure of the responsiveness of the quantity supplied of a particular good to a change in
price (PES = % Change in QS / % Change in Price). The intent of determining the price elasticity of supply is to show how a
change in price impacts the amount of a good that is supplied to consumers. The price elasticity of supply is directly related to
consumer demand.
Elasticity
The elasticity of a good provides a measure of how sensitive one variable is to changes in another variable. In this case, the price
elasticity of supply determines how sensitive the quantity supplied is to the price of the good.
Calculating the PES

When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic.
The percentage of change in supply is divided by the percentage of change in price. The results are analyzed using the following
range of values:
PES > 1: Supply is elastic.
PES < 1: Supply is inelastic.
PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices change.
PES = infinity: Supply is perfectly elastic. An decrease in prices will lead to zero units produced.
Factors that Influence the PES
There are numerous factors that impact the price elasticity of supply including the number of producers, spare capacity, ease of
switching, ease of storage, length of production period, time period of training, factor mobility, and how costs react.
The price elasticity of supply is calculated and can be graphed on a demand curve to illustrate the relationship between the supply
and price of the good.
Applications of Elasticities
In economics, elasticity refers to how the supply and demand of a product changes in relation to a change in the price.
Give examples of inelastic and elastic supply in the real world
In economics, elasticity refers to the responsiveness of the demand or supply of a product when the price changes.
The technical definition of elasticity is the proportionate change in one variable over the proportionate change in another variable.
For example, to determine how a change in the supply or demand of a product is impacted by a change in the price, the following
equation is used: Elasticity = % change in supply or demand / % change in price.
The price is a variable that can directly impact the supply and demand of a product. If a change in the price of a product
significantly influences the supply and demand, it is considered “elastic.” Likewise, if a change in product price does not
significantly change the supply and demand, it is considered “inelastic.”
For elastic demand, when the price of a product increases the demand goes down. When the price decreases the demand goes up.
Elastic products are usually luxury items that individuals feel they can do without. An example would be forms of entertainment
such as going to the movies or attending a sports event. A change in prices can have a significant impact on consumer trends as
well as economic profits. For companies and businesses, an increase in demand will increase profit and revenue, while a decrease
in demand will result in lower profit and revenue.
For inelastic demand, the overall supply and demand of a product is not substantially impacted by an increase in price. Products
that are usually inelastic consist of necessities like food, water, housing, and gasoline. Whether or not a product is elastic or
inelastic is directly related to consumer needs and preferences. If demand is perfectly inelastic, then the same amount of the product
will be purchased regardless of the price.
Economists study elasticity and use demand curves in order to diagram and study consumer trends and preferences. An elastic
demand curve shows that an increase in the supply or demand of a product is significantly impacted by a change in the price. An
inelastic demand curve shows that an increase in the price of a product does not substantially change the supply or demand of the
product.
Inelastic Demand: For inelastic demand, when there is an outward shift in supply and prices fall, there is no substantial change in
the quantity demanded.
Elastic Demand: For elastic demand, when there is an outward shift in supply, prices fall which causes a large increase in quantity
demanded.
Key Points
Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:
%Change in quantity
Elasticity =
%Change in price
The impact that a price change has on the elasticity of supply also directly impacts the elasticity of demand.
Inelastic goods are often described as necessities, while elastic goods are considered luxury items.
The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly
inelastic.
The price elasticity of supply = % change in quantity supplied / % change in price.
When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or
inelastic.
PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: if the supply curve is vertical, and there is no response to
prices. PES = infinity: if the supply curve is horizontal.
To determine the elasticity of a product, the proportionate change of one variable is placed over the proportionate change of
another variable (Elasticity = % change of supply or demand / % change in price ).
For elastic demand, a change in price significantly impacts the supply and demand of the product.
For inelastic demand, a change in the price does not substantially impact the supply and demand of the product.
Economists use demand curves in order to document and study elasticity.
Key Terms
luxury: Something very pleasant but not really needed in life.
constant.
mobility: The ability for economic factors to move between actors or conditions.
capacity: The maximum that can be produced on a machine or in a facility or group.
inelastic: Not sensitive to changes in price.
constant.
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CHAPTER OVERVIEW
7: Market Failure: Externalities

Topic hierarchy
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1
Market Failure
Identify common market failures and governmental responses
Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume
a good. The market will fail by not supplying the socially optimal amount of the good.
Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the
marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the
good.
The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to
inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party
which is caused by the production or consumption of a good or service.
Air pollution: Air pollution is an example of a negative externality. Governments may enact tradable permits to try and reduce
industrial pollution.
During market failures the government usually responds to varying degrees. Possible government responses include:
legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For
example, by supplying high amounts of education, parks, or libraries.
taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on
tobacco products, and subsequently increasing the cost of tobacco consumption.
subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition
because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive
externalities.
tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade
permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to
reduce of pollution.
extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a
market for pollution. Then, individuals get fined for polluting certain areas.
advertising – encourages or discourages consumption.
international cooperation among governments – governments work together on issues that affect the future of the environment.
Causes of Market Failure

Market failure occurs due to inefficiency in the allocation of goods and services.
Explain some common causes of market failure
Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the
costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the
supply of the good that is socially optimal – it will be over or under produced. To fully understand market failure, it is important to
recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result,
most markets are not successful and require forms of intervention.
Reasons for market failure include:
Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production
of a good or service. A positive externality is a positive spillover that results from the consumption or production of a good or
service. For example, although public education may only directly affect students and schools, an educated population may
provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example,
secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
Environmental concerns: effects on the environment as important considerations as well as sustainable development.
Lack of public goods: public goods are goods where the total cost of production does not increase with the number of
consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or
one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to
provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This
problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the
free rider problem.
Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive
externalities. For example, education, healthcare, and sports centers are considered merit goods.
Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative
externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.
When a market fails, the government usually intervenes depending on the reason for the failure.
Introducing Externalities
An externality is a cost or benefit that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit.
Give examples of externalities that exist in different parts of society
In economics, an externality is a cost or benefit resulting from an activity or transaction, that affects an otherwise uninvolved party
who did not choose to be subject to the cost or benefit. An example of an externality is pollution. Health and clean-up costs from
pollution impact all of society, not just individuals within the manufacturing industries. In regards to externalities, the cost and
benefit to society is the sum of the value of the benefits and costs for all parties involved.
Externality: An externality is a cost or benefit that results from an activity or transaction and that affects an otherwise uninvolved
party who did not choose to incur that cost or benefit.
Negative vs. Positive
A negative externality is an result of a product that inflicts a negative effect on a third party. In contrast, positive externality is an
action of a product that provides a positive effect on a third party.
Negative Externality: Air pollution caused by motor vehicles is an example of a negative externality.
Externalities originate within voluntary exchanges. Although the parties directly involved benefit from the exchange, third parties
can experience additional effects. For those involuntarily impacted, the effects can be negative (pollution from a factory) or
positive (domestic bees kept for honey production, pollinate the neighboring crops).
Economic Strain
Neoclassical welfare economics explains that under plausible conditions, externalities cause economic results that are not ideal for
society. The third parties who experience external costs from a negative externality do so without consent, while the individuals
who receive external benefits do not pay a cost. The existence of externalities can cause ethical and political problems within
society.
In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases,
internalizing the costs is not financially possible. Governments may step in to correct such market failures.
Externality Impacts on Efficiency

Economic efficiency is the use resources to maximize the production of goods; externalities are imperfections that limit efficiency.
Analyze the effects of externalities on efficiency
Economic Efficiency
In economics, the term “economic efficiency” is defined as the use of resources in order to maximize the production of goods and
services. An economically efficient society can produce more goods or services than another society without using more resources.
A market is said to be economically efficient if:
No one can be made better off without making someone else worse off.
No additional output can be obtained without increasing the amounts of inputs.
Production proceeds at the lowest possible cost per unit.
Externalities
An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur
the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party. An example
of a negative externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding
areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution. An
example of a positive externality would be an individual who lives by a bee farm. The third parties’ flowers are pollinated by the
neighbor’s bees. They have no cost or investment in the business, but they benefit from the bees.
Externality: This diagram shows the voluntary exchange that takes place within a market system. It also shows the economic costs
that are associated with externalities.
Externalities and Efficiency

Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics states that the existence of
externalities results in outcomes that are not ideal for society as a whole. In the case of negative externalities, third parties
experience negative effects from an activity or transaction in which they did not choose to be involved. In order to compensate for
negative externalities, the market as a whole is reducing its profits in order to repair the damage that was caused which decreases
efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social welfare is improved, but
the providers of the benefit do not make any money from the shared benefit. As a result, less of the good is produced or profited
from which is less optimal society and decreases economic efficiency.
In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional
funds in order to make up for damages incurred. Benefits are also internalized because they are viewed as goods produced and used
by third parties with no monetary gain for the market. Internalizing costs and benefits is not always feasible, especially when the
monetary value or a good or service cannot be determined.
Externalities directly impact efficiency because the production of goods is not efficient when costs are incurred due to damages.
Efficiency also decreases when potential money earned is lost on non-paying third parties.
In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing
externalities. When market imperfections exist, the efficiency of the market declines.
Key Points
Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects
the marginal benefit of consumption.
The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due
to inefficient producers, externalities, environmental concerns, and lack of public goods.
Government responses to market failure include legislation, direct provision of merit goods and public goods, taxation,
subsidies, tradable permits, extension of property rights, advertising, and international cooperation among governments.
A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good.
When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under
produced.
Due to the structure of markets, it may be impossible for them to be perfect.
Reasons for market failure include: positive and negative externalities, environmental concerns, lack of public goods,
underprovision of merit goods, overprovision of demerit goods, and abuse of monopoly power.
In regards to externalities, the cost and benefit to society is the sum of the benefits and costs for all parties involved.
Market failure occurs when the price mechanism fails to consider all of the costs and benefits necessary for providing and
consuming a good.
In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many
cases, internalizing the costs is not feasible. When externalities exist, it is possible that the particular industry will experience
market failure.
In many cases, the government intervenes when there is market failure.
An economically efficient society can produce more goods or services than another society without using more resources.
An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to
incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.
Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a
whole.
In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing
externalities. When market imperfections exist, the efficiency of the market declines.
In order for economic efficiency to be achieved, one defining rule is that no one can be made better off without making
someone else worse off. When externalities are present, not everyone benefits from the production of the good or service.
Key Terms
merit good: A commodity which is judged that an individual or society should have on the basis of some concept of need,
rather than ability and willingness to pay.
intervene: To interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder an action.
efficient: Making good, thorough, or careful use of resources; not consuming extra. Especially, making good use of time or
energy.
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Negative Externalities
Negative externalities are costs caused by an activity that affect an otherwise uninvolved party who did not choose to incur that
cost.
Describe the impact of a negative externality on society
A negative externality is a cost that results from an activity or transaction and that affects an otherwise uninvolved party who did
not choose to incur that cost.
Reasons for Negative Externalities

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in
calculating the costs of production. Production decisions are generally based on financial data and most social costs are not
measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents accrue
by drinking water from a river the factory polluted. As a result, a product that shouldn’t be produced, because the total expenses
exceed the return, are made because social costs were not considered.
In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than
societal marginal costs, which also capture the true costs of the negative externalities. As a result, producers will overestimate the
ideal quantity of the good to produce.
Negative Externality: Graphically, negative externalities occur when social costs are lower than private costs, and firms produce
more units than is socially optimal. The ideal equilibrium quantity that reflects negative externalities is Qs, but firms may produce
at Qp.
Government Solutions for Negative Externalities

In these cases, government intervention is necessary to help “price” negative externalities. Governments can either use regulation
(e.g. outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by
private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things.
First, these regulations recover funds to help fix the damage caused by negative externalities. Second, these acts help put a financial
price on social costs. With that information, businesses can arrive at a more accurate figure for the costs of production. Businesses
can then avoid producing products whose financial and social costs exceed the financial return.
Cigarette smoke: Secondhand smoke is an example of a negative externality; a person chooses to smoke, but others who do not
choose to smoke are harmed.
Positive Externalities
Positive externalities are benefits caused by activities that affect an otherwise uninvolved party who did not choose to incur that
benefit.
Use an example to discuss the concept of a positive externality
Positive externalities are benefits caused by transactions that affect an otherwise uninvolved party who did not choose to incur that
benefit. Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use
of common resources that are shared with parties are not involved with the exchange. The use of these resources, in turn, impacts
the uninvolved parties.
In the case of positive externalities, a transaction has positive side effects for non-related parties. Let’s take a look at some example:
A homeowner keeps his house maintained, the neighborhood benefits through higher home values. The homeowner’s neighbors
benefit from a positive externality.
A person may keep bees for her own enjoyment, but gardeners in the area benefit because their flowers are pollinated. The
beekeeper’s transaction of purchasing bees ends up positively affecting parties who are not involved in the transaction.
A person becomes inoculated against a disease, those around him benefit because they cannot catch the disease from him. There
was an exchange between the doctor and the patient, but others also benefit.
In each of these cases, the people taking action are presumably not doing it for the sake of the community, but for their own
purposes. The people taking the action may also enjoy the additional benefits described above, but initiators of actions are not
considered beneficiaries of externalities.
The problem with positive externalities is that the people who create these advantages cannot charge the beneficiaries; the
beneficiaries can “free ride,” or benefit without paying. For example, assume everyone in a community, except one person, got a
flu shot. That one person could choose to abstain from receiving the shot; since everyone else got inoculated, he can’t get the
disease from the others because they can’t catch the flu. That person would be a free rider since he would benefit from inoculations
without incurring any cost.
Since parties that create the externality aren’t compensated, they do not have any incentive to create more. This results in a
suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.
Key Points
The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included
in calculating the costs of production.
Government intervention is necessary to help ” price ” negative externalities. They do this through regulations or by instituting
market-based policies such as taxes, subsidies, or permit systems.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative
externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative
externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of
common resources that are shared with parties are not involved with the exchange. The use of these resources in turn impacts
the uninvolved parties.
The problem with positive externalities is that the people who create the externality cannot charge the beneficiaries; the
beneficiaries can “free ride,” or benefit without paying.
Free riding results in a suboptimal result, because the producers of the externality will generally create less of the benefit than
the larger community needs.
Key Terms
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Regulation
The government can respond to externalities through command-and-control policies or market-based policies.
Describe the role of government regulation in addressing externalities
The government can respond to externalities in two ways. The government can use command-and-control policies to regulate
behavior directly. Alternatively, it can implement market-based policies such as taxes and subsidies to incentivize private decision
makers to change their own behavior.
Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or
outright bans. Such measures make certain behaviors either required or forbidden with the goal of addressing the externality. For
example, the government may make it illegal for a company to dump certain chemicals in a river. By doing so, the government
hopes to protect the environment or other companies or individuals that use the river that would otherwise suffer a negative impact.
No Smoking: The prohibition of smoking in certain areas is a regulation designed to reduce the negative externalities suffered by
non-smokers when they are around smokers.
In practice, implementing regulation effectively is difficult. It requires the regulator to have in-depth knowledge of a certain
industry or sphere of economic activity. If done incorrectly, regulation can introduce inefficiency. For example, if the government
makes it illegal to dump in the river, the companies and their customers may suffer because the products must be produced using
less efficient methods. On the other hand, if the government allows too much to be dumped in the river, they have failed to mitigate
the negative externality.
If the government is unsure of how to effectively regulate the market, it should seek other methods of mitigating the externality.
Advocates of market-based policies for reducing negative externalities point to the difficulty of creating and enforcing effective
regulation for reasons why the government should create systems of incentives and disincentives instead of using the force of
regulation.
Tax
Corrective taxes incentivize economic actors to reduce the production of goods or services generating negative externalities.
Describe the role of taxes in addressing externalities
Taxes are a market-based policy option available to the government to address externalities. A corrective tax (also called a Pigovian
tax) is applied to a market activity that is generating negative externalities (costs for a third party). The tax is set equal to the value
of the negative externality and provides incentives for allocation of resources closer to the social optimum.
In the case of negative externalities, the social cost of an activity is greater than the private cost of the activity. In such a case, the
market outcome is not efficient and may lead to overproduction of the good. Taxes make it more expensive for firms to produce the
good or service generating the externality, thus providing an incentive to produce less of it. As the figure demonstrates, a tax shifts
the marginal private cost curve up. In response, producers change the output to the socially-optimum level.
Corrective Tax: A tax shifts the marginal private cost curve up by the amount of the tax. This gives producers an incentive to
reduce output to the socially optimum level.
Take environmental pollution as an example. The private cost of pollution to a polluter is less than its social cost. If the government
levies a tax on pollution, it increases the polluter’s private cost. The polluter now has an incentive to generate less pollution.
The level of the corrective tax is intended to counterbalance the externality. In practice, however, it is extremely difficult for the
government to determine the appropriate level for the tax. Moreover, in determining the tax level, the government might come
under pressure from various interest groups that would benefit from a higher or lower taxation level. Nevertheless, by introducing
corrective taxes in response to negative externalities the government can not only increase efficiency, but raise revenues as well.
Quotas
Tradable permits are a market-based approach allowing the government to limit negative externalities produced by a group of
firms.
Evaluate a permit system as a method to address externalities
To address the problem of negative externalities, governments may use a quota system to try and limit them. In a quota system, the
negative externality is capped at a certain amount. In the example of pollution, the government may put a quota on the amount of
pollution a factory can produce by issuing tradable permits.
Tradable permits are one of the market-based approaches the government can use to address externalities. In the past tradable
permits have been primarily used to control pollution.
Emissions Trading: Emissions trading or “cap and trade” is a market-based approach used to control pollution by providing
economic incentives for reducing the emissions of pollutants.
When pursuing this approach the government sets a limit or cap on the amount of a pollutant that may be emitted. It then allocates
emissions permits up to the specified limit among firms. The permits represent the right to emit or discharge a specific volume of a
specified pollutant. Firms are required to hold a number of permits equivalent to their emissions. Firms that need to increase their
volume of emissions must buy permits from firms that require fewer of them. This transfer is referred to as a trade. In effect, the
buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions. The outcome achieved by
the market for permits is more efficient, regardless of the initial allocation of permits.
The market for tradable permits creates incentives for firms to produce less pollution. Firms that have a high cost of reducing
emissions are willing to pay for the permits, while those that can reduce emissions in the most cost-efficient manner will do so and
sell their permits. Tradable permits thus achieve a desired level of the externality by allowing the market to determine which
market actors can create the externality.
There are several active trading programs for air pollutants. For greenhouse gases the largest is the European Union Emission
Trading Scheme. In the United States there is a national market for sulfur dioxide emissions to reduce acid rain. Markets for other
pollutants tend to be smaller and more localized.
Key Points
Command-and-control regulation requires or forbids certain behaviors with the goal of addressing an externality.
Regulation is difficult to implement and enforce correctly.
Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or
outright bans.
The allocation of tradable permits is a market-based policy that has been primarily used to combat pollution.
A corrective tax is a market-based policy option used by the government to address negative externalities.
Taxes increase the cost of producing goods or services generating the externality, thus encouraging firms to produce less output.
The tax should be set equal to the value of the negative externality, which is very difficult to do in practice.
Corrective taxes increase efficiency and provide the government with revenues as well.
A permit is a right to produce a certain amount of a negative externality, such as pollution.
Permits are traded among firms. Firms that are able to cheaply reduce production of the externality can sell permits to firms that
are unable to make such reductions and are willing to pay for the permits.
Regardless of the initial allocation of permits, the market for permits achieves an outcome that is more efficient for society.
Key Terms
Negative Externality: A detremental effect suffered by a party due to a transaction it was not a part of.
Pigovian tax: A tax applied to a market activity that is generating negative externalities (costs for somebody else).
Permit: The right to produce a given amount of a negative externality (for example, the right to emit a specific volume of a
pollutant).
quota: A restriction on the import of something to a specific quantity.
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Types of Private Solutions
Private actors will sometimes effectively address externalities and reach efficient outcomes without government intervention.
Evaluate how effective private solutions may be in solving market failures produced by externalities
Government intervention is not always necessary to address externalities. Private actors will sometimes arrive at their own
solutions.
There are several types of private solutions to market failures:
Moral codes: Moral codes guide individuals’ behavior. Individuals know that certain actions are simply not “the right thing to
do” or would elicit disapproving reactions from others. This is illustrated in the case of littering. The likelihood of being fined
may be small, but moral codes provide an incentive to refrain from littering.
Charities: Charities channel donations from private individuals towards fighting to limit behaviors that result in negative
externalities or promoting behaviors that generate positive externalities. The former can be seen in the case of organizations that
protect the environment, while the latter is exemplified through organizations that raise money for education.
Business mergers or contracts in the self interest of relevant parties: Two businesses that offer positive externalities to each
other can merge or enter into a contract that makes both parties better off.
The Coase theorem, which was developed by Ronald Coase, posits that two parties will be able to bargain with each other to reach
an agreement that efficiently addresses externalities. However, the theorem notes several conditions in order for such a solution to
occur, including low transaction costs (the costs the parties incur by negotiating and coming to agreement) and well-defined
property rights. If the conditions are met, the bargaining parties are expected to reach an agreement where everyone is better off. In
practice, however, transaction costs do exist, and the bargaining process does not always run smoothly. As a result, private
individuals often fail to resolve problems.
The Coase Theorem

The Coase theorem states that private parties can find efficient solutions to externalities without government intervention.
Explain the usefulness and shortcomings of the Coase Theorem.
The Coase Theorem, named after Nobel laureate Ronald Coase, states that in the presence of an externality, private parties will
arrive at an efficient outcome without government intervention. According to the theorem, if trade in an externality is possible and
there are no transaction costs, bargaining among private parties will lead to an efficient outcome regardless of the initial allocation
of property rights.
Efficient Solution: According to the Coase theorem, two private parties will be able to bargain with each other and find an
efficient solution to an externality problem.
Imagine a farm and a ranch next to each other. The rancher’s cows occasionally wander over to the farm and damage the farmer’s
crops. The farmer has an incentive to bargain with the rancher to find a more efficient solution. If it is more efficient to prevent
cattle trampling a farmer’s field by fencing in the farm, rather than fencing in the cattle, the outcome of the bargaining will be the
fence around the farm.
Take another example. The Jones family plants pear trees on their property which is adjacent to the Smith family. The Smith family
gets an external benefit from the Jones family’s pear trees because they pick up the pears that fall on the ground on their side of the
property line (see ). This is an externality because the Smith family does not pay the Jones family for the utility received from
gathering fallen pears. As a result, the Jones family plants too few pear trees. In response, the Jones family can put up a net that
will prevent pears from falling on the Smith’s side of the property line, eliminating the externality. Alternatively, the Jones could
impose a cost on the Smith family if they want to continue to enjoy the pears from the pear trees. Both parties will be better off if
they can agree to the second scenario, as the Smith family will continue to enjoy pears and the Jones family can increase the
production of pears.
Effects of Externalities: This graph exemplifies how Coase’s Theorem functions in a practical manner, underlining the effects of
an externality in an economic model.
In practice, transaction costs are rarely low enough to allow for efficient bargaining and hence the theorem is almost always
inapplicable to economic reality.
Key Points
Private solutions to externalities include moral codes, charities, and business mergers or contracts in the self interest of relevant
parties.
The Coase theorem states that when transaction cost are low, two parties will be able to bargain and reach an efficient outcome
in the presence of an externality.
In practice, private parties often fail to resolve the problem of externalities on their own.
According to the theorem, the parties affected by an externality will bargain to reach an outcome that will be more efficient.
Transaction costs must be low in order for parties to arrive at a more efficient outcome.
In the real world, transaction costs are rarely low, so the Coase theorem is often inapplicable.
Key Terms
Transaction cost: The cost incurred in making an economic exchange, such as the costs required to come to an acceptable
agreement with the other party to the transaction, drawing up an appropriate contract and so on.
Coase Theorem: The theorem states that private economic actors can solve the problem of externalities among themselves.
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CHAPTER OVERVIEW
8: Market Failure: Public Goods and Common Resources

Topic hierarchy
8.1: Public Goods
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8.1: Public Goods
Defining a Good
There are four types of goods in economics, which are defined based on excludability and rivalrousness in consumption.
Define a good
There are four categories of goods in economics, which are defined based on two attributes. The first attribute is excludability, or
whether people can be prevented from using the good. The second is whether a good is rival in consumption: whether one person’s
use of the good reduces another person’s ability to use it.
National defense provides an example of a good that is non-excludable. America’s national defense establishment offers protection
to everyone in the country. Items on sale in a store, on the other hand, are excludable. The store owner can prevent a customer from
obtaining a good unless the customer pays for it. National defense also provides an example of a good that is non- rivalrous. One
person’s protection does not prevent another person from receiving protection. In contrast, shoes are rivalrous. Only one person can
wear a pair of shoes at a time.
Combinations of these two attributes create four categories of goods:
Four Types of Goods: There are four categories of goods in economics, based on whether the goods are excludable and/or
rivalrous in consumption.
Private goods: Private goods are excludable and rival. Examples of private goods include food, clothes, and flowers. There are
usually limited quantities of these goods, and owners or sellers can prevent other individuals from enjoying their benefits.
Because of their relative scarcity, many private goods are exchanged for payment.
Common goods: Common goods are non-excludable and rival. Because of these traits, common goods are easily over-
consumed, leading to a phenomenon called “tragedy of the commons. ” In this situation, people withdraw resources to secure
short-term gains without regard for the long-term consequences. A classic example of a common good are fish stocks in
international waters. No one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for
later fishermen are depleted.
Club goods: Club goods are excludable but non-rival. This type of good often requires a “membership” payment in order to
enjoy the benefits of the goods. Non-payers can be prevented from access to the goods. Cable television is a classic example. It
requires a monthly fee, but is non-rival after the payment.
Public goods: Public goods are non-excludable and non-rival. Individuals cannot be effectively excluded from using them, and
use by one individual does not reduce the good’s availability to others. Examples of public goods include the air we breathe,
public parks, and street lights. Public goods may give rise to the “free rider problem. ” A free-rider is a person who receives the
benefit of a good without paying for it. This may lead to the under-provision of certain goods or services.
Private Goods
A private good is both excludable and rivalrous.
Define a private good
In economics, a private good is defined as an asset that is both excludable and rivalrous. It is excludable in that it is possible to
exercise private property rights over it, preventing those who have not paid from using the good or consuming its benefits. For
example, person A may have the means and will to pay $20 for a t-shirt. Person B may not wish to pay $20 or may not be able to
do so. Person B would not be able to purchase the t-shirt. Additionally, the private good is rivalrous in that its consumption by one
person necessarily prevents consumption by another. When person A purchases and drinks a bottle of water, the same bottle of
water is not available for person B to purchase and consume.
A private good is a scare economic resource, which causes competition for it. Generally, people have to pay to enjoy the benefits of
a private good. Because people have to pay to obtain it, private goods are much less likely to encounter a free-rider problem than
public goods. Thus, generally, the market will efficiently allocate resources to produce private goods.
In daily life, examples of private goods abound, including food, clothing, and most other goods that can be purchased in a store.
Take an example of an ice cream cone. It is both excludable and rivalrous. It is possible to prevent someone from consuming the
ice cream by simply refusing to sell it to them. Additionally, it can be consumed only once, so its consumption by one individual
would definitely reduce others’ ability to consume it.
Ice Cream Cone: An ice cream cone is an example of a private good. It is excludable and rival.
Public Goods
Individuals cannot be excluded from using a public good, and one individual’s use of it does not limit its availability to others.
Define a public good
A public good is a good that is both non-excludable and non-rivalrous. This means that individuals cannot be effectively excluded
from its use, and use by one individual does not reduce its availability to others. Examples of public goods include fresh air,
knowledge, lighthouses, national defense, flood control systems, and street lighting.
Streetlight: A streetlight is an example of a public good. It is non-excludable and non-rival in consumption
Public goods can be pure or impure. Pure public goods are those that are perfectly non-rivalrous in consumption and non-
excludable. Impure public goods are those that satisfy the two conditions to some extent, but not fully.
The production of public goods results in positive externalities for which producers don’t receive full payment. Consumers can take
advantage of public goods without paying for them. This is called the “free-rider problem. ” If too many consumers decide to “free-
ride,” private costs to producers will exceed private benefits, and the incentive to provide the good or service through the market
will disappear. The market will thus fail to provide enough of the good or service for which there is a need.
For example, a local public radio station relies on support from listeners to operate. The station holds pledge drives several times a
year, asking listeners to make contributions or face possible reduction in programming. Yet only a small percentage of the audience
makes contributions. Some audience members may even listen to the station for years without ever making a payment. Those
listeners who do not make a contribution are “free-riders. ” If the station relies solely on funds contributed by listeners, it would
under-produce programming. It must obtain additional funding from other sources (such as the government) in order to continue to
operate.
Optimal Quantity of a Public Good

The government is providing an efficient quantity of a public good when its marginal benefit equals its marginal cost.
Explain the optimal quantity of a public good
To determine the optimal quantity of a public good, it is necessary to first determine the demand for it. Demand for public goods is
represented through price-quantity schedules, which show the price someone is willing to pay for the extra unit of each possible
quantity. Unlike the market demand curve for private goods, where individual demand curves are summed horizontally, individual
demand curves for public goods are summed vertically to get the market demand curve. As a result, the market demand curve for
public goods gives the price society is willing to pay for a given quantity. It is equal to the marginal benefit curve. Due to the law of
diminishing marginal utility, the demand curve is downward sloping.
Often, the government supplies the public good. The supply curve for a public good is equal to its marginal cost curve. Because of
the law of diminishing returns, the marginal cost increases as the quantity of the good produced increases. The supply curve
therefore has an upward slope.
As already noted, the demand curve is equal to the marginal benefit curve, while the supply curve is equal to the marginal cost
curve. The optimal quantity of the public good occurs where MB (society’s marginal benefit) equals MC (provider’s marginal cost),
or where the two curves intersect. When MB = MC, resources have been allocated efficiently.
Optimal Quantity of a Public Good: The optimal quantity of public good occurs where MB = MC.
The public good provider uses cost-benefit analysis to decide whether to provide a particular good by comparing marginal costs
and marginal benefits. Cost-benefit analysis can also help the provider decide the extent to which a project should be pursued.
Output activity should be increased as long as the marginal benefit exceeds the marginal cost. An activity should not be pursued
when the marginal benefit is less than the marginal cost. An activity should be stopped at the point where MB equals MC. This is
the MC=MB rule, by which the provider of the public good can determine which plan, will give society maximum net benefit.
Demand for Public Goods

The aggregate demand curve for a public good is the vertical summation of individual demand curves.
Analyze the demand for a public good.
The aggregate demand for a public good is derived differently from the aggregate demand for private goods.
To an individual consumer, the total benefit of a public good is the dollar value that he or she places on a given level of provision of
the good. The marginal benefit for an individual is the increase in the total benefit that results from a one-unit increase in the
quantity provided. The marginal benefit of a public good diminishes as the level of the good provided increases.
Public goods are non-rivalrous, so everyone can consume each unit of a public good. They also have a fixed market quantity:
everyone in society must agree on consuming the same amount of the good. However, each individual’s willingness to pay for the
quantity provided may be different. The individual demand curves show the price someone is willing to pay for an extra unit of
each possible quantity of the public good.
The aggregate demand for a public good is the sum of marginal benefits to each person at each quantity of the good provided. The
economy’s marginal benefit curve (demand curve) for a public good is thus the vertical sum all individual’s marginal benefit
curves. The vertical summation of individual demand curves for public goods also gives the aggregate willingness to pay for a
given quantity of the good.
Demand for a Public Good: The sum of the individual marginal benefit curves (MB) represent the aggregate willingness to pay or
aggregate demand (∑MB). The intersection of the aggregate demand and the marginal cost curve (MC) determines the amount of
the good provided.
This is in contrast to the aggregate demand curve for a private good, which is the horizontal sum of the individual demand curves at
each price. Unlike public goods, society does not have to agree on a given quantity of a private good, and any one person can
consume more of the private good than another at a given price.
The efficient quantity of a public good is the quantity that maximizes net benefit (total benefit minus total cost), which is the same
as the quantity at which marginal benefit equals marginal cost.
Cost-Benefit Analysis
The government uses cost-benefit analysis to decide whether to provide a public good.
Explain how to determine the net cost/benefit of providing a public good
The government uses cost-benefit analysis to decide whether to provide a particular public good and how much of it to provide.
Cost-benefit analysis, which is also sometimes called benefit-cost analysis, is a systematic process for calculating the benefits and
costs of a project to society as a whole.
The positive and negative effects captured by cost-benefit analysis may include effects on consumers, effects on non-consumers,
externality effects, or other social benefits or costs. The guiding principle is to list all parties affected by a project and add a
negative or positive value that they ascribe to the project’s effect on their welfare. Benefits and costs are expressed in monetary
terms, and are adjusted for the time value of money, so that all flows of benefits and costs over time are expressed on a common
basis in terms of their net present value. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to
relatively abundant market data. It is much more difficult to capture non-financial welfare impacts. For example, it is very difficult
to place a dollar value on human life, consumers’ time, or environmental impact.
Imagine that the government is considering a project to widen a highway. The benefits side of the analysis might include time
savings for passengers who can now avoid traffic, an increase in the number of passenger trips (as more people could now use the
road), and lives saved by dint of fewer car accidents. The cost side of the analysis would include the cost of land that must be
acquired prior to construction, construction, and maintenance. These costs and benefits will need to be translated into monetary
terms for the sake of analysis.
The Highway as a Public Good: The benefits of a highway expansion project might include time savings for passengers,
additional passenger trips, and saved lives. Costs might include construction and maintenance.
The procedure for conducting cost-benefit analysis is as follows:
1. Identify project(s) to be analyzed.
2. Estimate all costs and benefits to society associated with the project(s) over a relevant time horizon.
3. Assign a monetary value to all costs and benefits.
4. Calculate the net benefit of the project (total benefit minus total cost).
5. Adjust for inflation and apply the discount rate to calculate present value of the project.
6. Calculate the net present value for the project(s).
7. Make recommendation about project(s). If the benefit outweighs the cost, then the government should proceed with the project.
Key Points
Private goods are excludable and rival. Examples of private goods include food and clothes.
Common goods are non-excludable and rival. A classic example is fish stocks in international waters.
Club goods are excludable but non-rival. Cable television is an example.
Public goods are non-excludable and non-rival. They include public parks and the air we breathe.
The owners or sellers of private goods exercise private property rights over them.
A consumer generally has to pay for a private good.
Generally, the market will efficiently allocate resources for the production of private goods.
A public good is both non-excludable and non-rivalrous.
Pure public goods are perfectly non-rival in consumption and non-excludable. Impure public goods satisfy those conditions to
some extent, but not perfectly.
Public goods provide an example of market failure. Because of the free-rider problem, they may be underpoduced.
Collective demand for a public good is the vertical summation of individual demand curves. It shows the price society is willing
to pay for a given quantity of a public good.
The demand curve for a public good is downward sloping, due to the law of diminishing marginal utility. The supply curve is
upward sloping, due to the law of diminishing returns.
The optimal quantity of a public good occurs where the demand ( marginal benefit ) curve intersects the supply ( marginal cost )
curve.
The government uses cost-benefit analysis to decide whether to provide a particular good. If MB is greater than MC there is an
underallocation of a public good. If MC is greater than MB there is an overallocation of a public good. When MC = MB then
there is an optimal allocation of public goods.
For public goods, aggregate demand is the sum of marginal benefits to each person at each quantity of the good provided.
As for private goods, the individual demand curves show the price someone is willing to pay for an extra unit of each possible
quantity of a good.
The efficient quantity of a public good is the quantity at which marginal benefit equals marginal cost.
Cost -benefit analysis is a systematic way of calculating the costs and benefits of a project to society as a whole.
Benefits and costs are expressed in monetary terms and are adjusted for the time-value of money.
Financial costs are much easier to capture in the analysis than non-financial welfare impacts, such as impacts on human life or
the environment.
The government should provide a public good if the benefits to society outweigh the costs.
Key Terms
Rival: A good whose consumption by one consumer prevents simultaneous consumption by other consumers
Excludable: A good for which it is possible to prevent consumers who have not paid for it from having access to it.
Rivalrous: A good whose consumption by one consumer prevents simultaneous consumption by other consumers.
free rider: Someone who enjoys the benefits of a good without paying for it
Non-excludable: Non-paying consumers cannot be prevented from accessing a good
Non-rivalrous: A good whose consumption by one consumer does not prevent simultaneous consumption by other consumers
Cost-benefit analysis: A systematic process for calculating and comparing the marginal benefits and marginal costs of a project
or activity.
public good: A good that is non-rivalrous and non-excludable.
net present value: The present value of a project determined by summing the discounted incoming and outgoing future cash
flows resulting from the decision.
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The Tragedy of the Commons
The tragedy of the commons is the overexploitation of a common good by individual, rational actors.
 learning Objectives
Describe the tragedy of the commons
Common Goods
Common goods are goods that are rivalrous and non-excludable. This means that anyone has access to the good, but that the use of
the good by one person reduces the ability of someone else to use it. A classic example of a common good are fish stocks in
international waters; no one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for later
fishermen are potentially depleted.
Tragedy of Commons
The tragedy of the commons is the depletion of a common good by individuals who are acting independently and rationally
according to each one’s self-interest. Consider, the example of fish in international waters. Each individual fisherman, acting
independently, will rationally choose to catch some of the fish to sell. This makes sense: there is a resource that the fisherman is
able to use to generate a profit. However, when a lot of fishermen, all thinking this way, catch the fish, the total stock of fish may
be depleted. When the stock of fish is depleted, none of the fishermen are able to continue fishing, even though, in the long run,
each fisherman would have preferred that the fish not be depleted. The tragedy of the commons describes such situations in which
people withdraw resources to secure short-term gains without regard for the long-term consequences.
Not all common goods, however, suffer from the tragedy of the commons. If individuals have enlightened self-interest, they will
realize the negative long-term effects of their short-term decisions. This would be the same as the fishermen realizing that they
should limit their fishing to preserve the stock of fish in the long-term.
In the absence of enlightened self-interest, the government may step in and impose regulations or taxes to discourage the behavior
that leads to the tragedy of the commons. This would be like the government imposing limits on the amount of fish that can be
caught.
Bluefin Tuna Caught in Net: Fish populations are at risk of becoming fully extinct due to overfishing. The Food and Agriculture
Association estimated 70% of the world’s fish species are either fully exploited or depleted.
The Free-Rider Problem

The free-rider problem is when individuals benefit from a public good without paying their share of the cost.
Describe the Free-Rider Problem
It is easy to think about public goods as free. In your everyday life, you benefit from public goods such as roads and bridges even
though no transaction occurs when you use them. However, even public goods need to be paid for. In the case of roads and bridges,
everyone pays taxes to the government, who then uses the taxes to pay for public goods.
Roads: Free riders are able to use roads without paying their taxes because roads are a non-excludable public good.
Public goods, as you may recall, are both non-rivalrous and non-excludable. It is the second trait- the non-excludability- that leads
to what is called the free-rider problem. The free-rider problem is that some people may benefit from a public good without paying
their share of the cost.
Since public goods are non-excludable, free-riders not only can’t be prevented from using the good, but actually have an incentive
to continue to free-ride. If they will be able to use the public good whether they pay their share of the costs, they might as well not
pay.
Take the military, for example. National security is a public good: it is both non-rivalrous and non-excludable. In order to have such
a public good, everyone pays taxes which are then used by the government to finance the military. However, there are undoubtedly
people who have not paid their taxes. These people, without having paid their share of the cost of having a military, still benefit
from the protection the military provides. They are free-riders.
Of course, there are commonly regulations that attempt to discourage free-riding. For government-provided public goods, the
government makes sure that everyone pays their share of the costs by enforcing tax laws. The threat of fines or jail time are enough
of a threat that most people find it more appealing (in the US, at least) to pay their share of public goods via taxes than to free-ride.
Key Points
Common goods are non-excludable and rivalrous.
When individuals act independently and rationally, they may collectively trade long-term benefit for short-term gain.
Enlightened self-interest and government intervention are two ways that the tragedy of the commons may be avoided.
Public goods are non-excludable, but have a cost, so those who don’t pay their share of the cost can still easily benefit from the
good.
Free-riders have an incentive to free ride because they can benefit from a good at a reduced personal cost.
The providers of public goods often create enforcement mechanisms to mitigate the free-rider problem.
Key Terms
Common good: Goods which are rivalrous and non-excludable.
Enlightened Self-Interest: The ability for individuals to realize when their actions, collectively, will trade long-term benefit for
short-term gain.
public good: A good that is non-rivalrous and non-excludable.
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CHAPTER OVERVIEW
9: Production
Topic hierarchy
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1
Defining the Production Function
The production function relates the maximum amount of output that can be obtained from a given number of inputs.
Define the production function
In economics, a production function relates physical output of a production process to physical inputs or factors of production. It is
a mathematical function that relates the maximum amount of output that can be obtained from a given number of inputs – generally
capital and labor. The production function, therefore, describes a boundary or frontier representing the limit of output obtainable
from each feasible combination of inputs.
Firms use the production function to determine how much output they should produce given the price of a good, and what
combination of inputs they should use to produce given the price of capital and labor. When firms are deciding how much to
produce they typically find that at high levels of production, their marginal costs begin increasing. This is also known as
diminishing returns to scale – increasing the quantity of inputs creates a less-than-proportional increase in the quantity of output. If
it weren’t for diminishing returns to scale, supply could expand without limits without increasing the price of a good.
Factory Production: Manufacturing companies use their production function to determine the optimal combination of labor and
capital to produce a certain amount of output.
Increasing marginal costs can be identified using the production function. If a firm has a production function Q = F (K, L) (that
is, the quantity of output (Q) is some function of capital (K) and labor (L)), then if 2Q < F (2K, 2L), the production function has
increasing marginal costs and diminishing returns to scale. Similarly, if 2Q > F (2K, 2L), there are increasing returns to scale, and
if 2Q = F (2K, 2L), there are constant returns to scale.
Examples of Common Production Functions

One very simple example of a production function might be Q = K + L , where Q is the quantity of output, K is the amount of
capital, and L is the amount of labor used in production. This production function says that a firm can produce one unit of output
for every unit of capital or labor it employs. From this production function we can see that this industry has constant returns to
scale – that is, the amount of output will increase proportionally to any increase in the amount of inputs.
Another common production function is the Cobb-Douglas production function. One example of this type of function is
Q =K
0.5
L . This describes a firm that requires the least total number of inputs when the combination of inputs is relatively
0.5
equal. For example, the firm could produce 25 units of output by using 25 units of capital and 25 of labor, or it could produce the
same 25 units of output with 125 units of labor and only one unit of capital.
Finally, the Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those
proportions, if usage of one input is increased without another being increased, output will not change. This production function is
given by Q = M in(K, L). For example, a firm with five employees will produce five units of output as long as it has at least five
units of capital.
The Law of Diminishing Returns

The law of diminishing returns states that adding more of one factor of production will at some point yield lower per-unit returns.
Explain the Law of Diminishing Returns
In economics, diminishing returns (also called diminishing marginal returns) is the decrease in the marginal output of a production
process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay
constant. The law of diminishing returns states that in all productive processes, adding more of one factor of production, while
holding all others constant (“ceteris paribus”), will at some point yield lower per-unit returns. The law of diminishing returns does
not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this
is common.
Diminishing Returns: As a factor of production (F) increases, the resulting gain in the volume of output (V) gets smaller and
smaller.
For example, the use of fertilizer improves crop production on farms and in gardens; but at some point, adding more and more
fertilizer improves the yield less per unit of fertilizer, and excessive quantities can even reduce the yield. A common sort of
example is adding more workers to a job, such as assembling a car on a factory floor. At some point, adding more workers causes
problems such as workers getting in each other’s way or frequently finding themselves waiting for access to a part. In all of these
processes, producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less
effectively.
This increase in the marginal cost of output as production increases can be graphed as the marginal cost curve, with quantity of
output on the x axis and marginal cost on the y axis. For many firms, the marginal cost curve will initially be downward sloping,
representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve
will eventually slope upward and continue to rise, representing the higher and higher marginal costs associated with additional
output.
The Law of Diminishing Returns and Average Cost

The average total cost of production is the total cost of producing all output divided by the number of units produced. For example,
if the car factory can produce 20 cars at a total cost of $200,000, the average cost of production is $10,000. Average total cost is
interpreted as the the cost of a typical unit of production. So in our example each of the 20 cars produced had a typical cost per unit
of $10,000. Average total cost can also be graphed with quantity of output on the x axis and average cost on the y-axis.
What will this average total cost curve look like? In the short run, a firm has a set amount of capital and can only increase or
decrease production by hiring more or less labor. The fixed costs of capital are high, but the variable costs of labor are low, so costs
increase more slowly than output as production increases. As long as the marginal cost of production is lower than the average total
cost of production, the average cost is decreasing. However, as marginal costs increase due to the law of diminishing returns, the
marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase. The
short run average total cost curve (SRAC) will therefore be U-shaped for most firms.
Cost Curves in the Short Run: Both marginal cost and average cost are U-shaped due to first increasing, and then diminishing,
returns. Average cost begins to increase where it intersects the marginal cost curve.
The long-run average cost curve (LRAC) depicts the cost per unit of output in the long run—that is, when all productive inputs’
usage levels can be varied. The typical LRAC curve is also U-shaped but for different reasons: it reflects increasing returns to scale
where negatively-sloped, constant returns to scale where horizontal, and decreasing returns (due to increases in factor prices) where
positively sloped.
Inputs and Outputs of the Function

In the basic production function, inputs are typically capital and labor and output is whatever good the firm produces.
Describe the inputs and outputs in a generalized production function
A production function relates the input of factors of production to the output of goods. In the basic production function inputs are
typically capital and labor, though more expansive and complex production functions may include other variables such as land or
natural resources. Output may be any consumer good produced by a firm. Cars, clothing, sandwiches, and toys are all examples of
output.
Capital refers to the material objects necessary for production. Machinery, factory space, and tools are all types of capital. In the
short run, economists assume that the level of capital is fixed – firms can’t sell machinery the moment it’s no longer needed, nor
can they build a new factory and start producing goods there immediately. When looking at the production function in the short
run, therefore, capital will be a constant rather than a variable. Although in reality a firm may own the capital that it uses,
economists typically refer to the ongoing cost of employing capital as the rental rate because the opportunity cost of employing
capital is the income that a firm could receive by renting it out. Thus, the price of capital is the rental rate.
Capital Goods: Capital equipment, like these motor graders, can vary in the long run but are fixed in the short run.
Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of
production; it can be increased or decreased in the short run in order to produce more or less output. The price of labor is the
prevailing wage rate, since wages are the cost of hiring an additional unit of capital.
The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be found by
taking the derivative of the production function in terms of the relevant input. For example, if the production function is Q=3K+2L
(where K represents units of capital and L represents units of labor), then the marginal product of capital is simply three; every
additional unit of capital will produce an additional three units of output. Inputs are typically subject to the law of diminishing
returns: as the amount of one factor of production increases, after a certain point the marginal product of that factor declines.
Key Points
The production function describes a boundary or frontier representing the limit of output obtainable from each feasible
combination of inputs.
Firms use the production function to determine how much output they should produce given the price of a good, and what
combination of inputs they should use to produce given the price of capital and labor.
The production function also gives information about increasing or decreasing returns to scale and the marginal products of
labor and capital.
One consequence of the law of diminishing returns is that producing one more unit of output will eventually cost increasingly
more, due to inputs being used less and less effectively.
The marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of
diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise.
The SRAC is typically U-shaped with its minimum at the point where it intersect the marginal cost curve. This is caused by the
first increasing, and then decreasing, marginal returns to labor.
The typical LRAC curve is also U-shaped, reflecting increasing returns of scale where negatively-sloped, constant returns to
scale where horizontal and decreasing returns where positively sloped.
Capital refers to the material objects necessary for production. In the short run, economists assume that the level of capital is
fixed.
Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of
production.
The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be
found by taking the derivative of the production function in terms of the relevant input.
Key Terms
rental rate: The price of capital.
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Types of Costs
Variable costs change according to the quantity of goods produced; fixed costs are independent of the quantity of goods being
produced.
Differentiate fixed costs and variable costs
Total Cost
In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is
the total opportunity cost of each factor of production as part of its fixed or variable costs.
Calculating total cost: This graphs shows the relationship between fixed cost and variable cost. The sum of the two equal the total
cost.
Variable Costs
Variable cost (VC) changes according to the quantity of a good or service being produced. It includes inputs like labor and raw
materials. Variable costs are also the sum of marginal costs over all of the units produced (referred to as normal costs). For
example, in the case of a clothing manufacturer, the variable costs would be the cost of the direct material (cloth) and the direct
labor. The amount of materials and labor that is needed for each shirt increases in direct proportion to the number of shirts
produced. The cost “varies” according to production.
Fixed Costs
Fixed costs (FC) are incurred independent of the quality of goods or services produced. They include inputs (capital) that cannot be
adjusted in the short term, such as buildings and machinery. Fixed costs (also referred to as overhead costs) tend to be time related
costs, including salaries or monthly rental fees. An example of a fixed cost would be the cost of renting a warehouse for a specific
lease period. However, fixed costs are not permanent. They are only fixed in relation to the quantity of production for a certain time
period. In the long run, the cost of all inputs is variable.
Economic Cost
The economic cost of a decision that a firm makes depends on the cost of the alternative chosen and the benefit that the best
alternative would have provided if chosen. Economic cost is the sum of all the variable and fixed costs (also called accounting cost)
plus opportunity costs.
Average and Marginal Cost

Marginal cost is the change in total cost when another unit is produced; average cost is the total cost divided by the number of
goods produced.
Distinguish between marginal and average costs
Marginal Cost
In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of
producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a
company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The
amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal
cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost
is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is $30. The total cost
for making two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.
Average Cost
The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and
average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or
impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both
short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run
average cost includes the variation of quantities used for all inputs necessary for production.
Relationship Between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:
Cost curve: This graph is a cost curve that shows the average total cost, marginal cost, and marginal revenue. The curves show
how each cost changes with an increase in product price and quantity produced.
When the average cost declines, the marginal cost is less than the average cost.
When the average cost increases, the marginal cost is greater than the average cost.
When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.
Short Run and Long Run Costs

Long run costs have no fixed factors of production, while short run costs have fixed factors and variables that impact production.
Explain the differences between short and long run costs
In economics, “short run” and “long run” are not broadly defined as a rest of time. Rather, they are unique to each firm.
Long Run Costs
Long run costs are accumulated when firms change production levels over time in response to expected economic profits or losses.
In the long run there are no fixed factors of production. The land, labor, capital goods, and entrepreneurship all vary to reach the the
long run cost of producing a good or service. The long run is a planning and implementation stage for producers. They analyze the
current and projected state of the market in order to make production decisions. Efficient long run costs are sustained when the
combination of outputs that a firm produces results in the desired quantity of the goods at the lowest possible cost. Examples of
long run decisions that impact a firm’s costs include changing the quantity of production, decreasing or expanding a company, and
entering or leaving a market.
Short Run Costs

Short run costs are accumulated in real time throughout the production process. Fixed costs have no impact of short run costs, only
variable costs and revenues affect the short run production. Variable costs change with the output. Examples of variable costs
include employee wages and costs of raw materials. The short run costs increase or decrease based on variable cost as well as the
rate of production. If a firm manages its short run costs well over time, it will be more likely to succeed in reaching the desired long
run costs and goals.
Differences
The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and
variable factors in the short run. In the long run the general price level, contractual wages, and expectations adjust fully to the state
of the economy. In the short run these variables do not always adjust due to the condensed time period. In order to be successful a
firm must set realistic long run cost expectations. How the short run costs are handled determines whether the firm will meet its
future production and financial goals.
Cost curve: This graph shows the relationship between long run and short run costs.
Economies and Diseconomies of Scale

Increasing, constant, and diminishing returns to scale describe how quickly output rises as inputs increase.
Identify the three types of returns to scale and describe how they occur
In economics, returns to scale describes what happens when the scale of production increases over the long run when all input
levels are variable (chosen by the firm). Returns to scale explains how the rate of increase in production is related to the increase in
inputs in the long run. There are three stages in the returns to scale: increasing returns to scale (IRS), constant returns to scale
(CRS), and diminishing returns to scale (DRS). Returns to scale vary between industries, but typically a firm will have increasing
returns to scale at low levels of production, decreasing returns to scale at high levels of production, and constant returns to scale at
some point in the middle.
Long Run ATC Curves: This graph shows that as the output (production) increases, long run average total cost curve decreases in
economies of scale, constant in constant returns to scale, and increases in diseconomies of scale.
Increasing Returns to Scale

The first stage, increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced
causes a decrease in the average cost of each unit. In other words, a firm is experiencing IRS when the cost of producing an
additional unit of output decreases as the volume of its production increases. IRS may take place, for example, if the cost of
production of a manufactured good would decrease with the increase in quantity produced due to the production materials being
obtained at a cheaper price.
Constant Return to Scale

The second stage, constant returns to scale (CRS) refers to a production process where an increase in the number of units produced
causes no change in the average cost of each unit. If output changes proportionally with all the inputs, then there are constant
returns to scale.
Diminishing Return to Scale

The final stage, diminishing returns to scale (DRS) refers to production for which the average costs of output increase as the level
of production increases. The DRS is the opposite of the IRS. DRS might occur if, for example, a furniture company was forced to
import wood from further and further away as its operations increased.
Economic Costs
The economic cost is based on the cost of the alternative chosen and the benefit that the best alternative would have provided if
chosen.
Break down the components of a firm’s economic costs
Economic Cost
Throughout the production of a good or service, a firm must make decisions based on economic cost. The economic cost of a
decision is based on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen.
Economic cost includes opportunity cost when analyzing economic decisions.
An example of economic cost would be the cost of attending college. The accounting cost includes all charges such as tuition,
books, food, housing, and other expenditures. The opportunity cost includes the salary or wage the individual could be earning if he
was employed during his college years instead of being in school. So, the economic cost of college is the accounting cost plus the
opportunity cost.
Components of Economic Costs
Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity. Before
making economic decisions, there are a series of components of economic costs that a firm will take into consideration. These
components include:
Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and buildings.
Variable input is traditionally assumed to be labor.
Total variable cost (TVC): same as variable costs.
Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
Total fixed cost (TFC): same as fixed cost.
Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function continuously
declines as production increases.
Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is normally U-
shaped. It lies below the average cost curve, starting to the right of the y axis.
Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
Cost curves: a graph of 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 (to minimize cost). Maximizing firms use the curves to decide output
quantities to achieve production goals.
Key Points
Total cost is the sum of fixed and variable costs.
Variable costs change according to the quantity of a good or service being produced. The amount of materials and labor that is
needed for to make a good increases in direct proportion to the number of goods produced. The cost “varies” according to
production.
Fixed costs are independent of the quality of goods or services produced. Fixed costs (also referred to as overhead costs) tend to
be time related costs including salaries or monthly rental fees.
Fixed costs are only short term and do change over time. The long run is sufficient time of all short-run inputs that are fixed to
become variable.
The marginal cost is the cost of producing one more unit of a good.
Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new
factory in order to produce more goods, the cost of building the factory is a marginal cost.
Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods
being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.
When the average cost declines, the marginal cost is less than the average cost. When the average cost increases, the marginal
cost is greater than the average cost. When the average cost stays the same (is at a minimum or maximum), the marginal cost
equals the average cost.
In the short run, there are both fixed and variable costs.
In the long run, there are no fixed costs.
Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired quantity of the
goods at the lowest possible cost.
Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials.
The short run costs increase or decrease based on variable cost as well as the rate of production. If a firm manages its short run
costs well over time, it will be more likely to succeed in reaching the desired long run costs and goals.
In economics, returns to scale describes what happens when the scale of production increases over the long run when all input
levels are variable (chosen by the firm ).
Increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced causes a
decrease in the average cost of each unit.
Constant returns to scale (CRS) refers to a production process where an increase in the number of units produced causes no
change in the average cost of each unit.
Diminishing returns to scale (DRS) refers to production where the costs for production do not decrease as a result of increased
production. The DRS is the opposite of the IRS.
Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity.
Components of economic cost include total cost, variable cost, fixed cost, average cost, and marginal cost.
Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use
Average cost (AC) – total costs divided by output (AC = TFC/q + TVC/q).
Marginal cost (MC) – the change in the total cost when the quantity produced changes by one unit.
Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use
Key Terms
fixed cost: Business expenses that are not dependent on the level of goods or services produced by the business.
average cost: In economics, average cost or unit cost is equal to total cost divided by the number of goods produced.
return to scale: A term referring to changes in output resulting from a proportional change in all inputs (where all inputs
economic cost: The accounting cost plus opportunity cost.
cost: A negative consequence or loss that occurs or is required to occur.
chosen).
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Difference Between Economic and Accounting Profit
Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary) costs; accounting profit consists of
revenue minus explicit costs.
 LEARNING OBJECTIVES
Distinguish between economic profit and accounting profit
The term “profit” may bring images of money to mind, but to economists, profit encompasses more than just cash. In general,
profit is the difference between costs and revenue, but there is a difference between accounting profit and economic profit. The
biggest difference between accounting and economic profit is that economic profit reflects explicit and implicit costs, while
accounting profit considers only explicit costs.
Explicit and Implicit Costs

Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent paid to a landowner, and material costs
paid to a supplier are all examples of explicit costs.
In contrast, implicit costs are the opportunity costs of factors of production that a producer already owns. The implicit cost is what
the firm must give up in order to use its resources; in other words, an implicit cost is any cost that results from using an asset
instead of renting, selling, or lending it. For example, a paper production firm may own a grove of trees. The implicit cost of that
natural resource is the potential market price the firm could receive if it sold it as lumber instead of using it for paper production.
Accounting Profit
Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally
accepted accounting principles (GAAP). Put another way, accounting profit is the same as bookkeeping costs and consists of
credits and debits on a firm’s balance sheet. These consist of the explicit costs a firm has to maintain production (for example,
wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.
Accounting profit is also limited in its time scope; generally, accounting profit only considers the costs and revenue of a single
period of time, such as a fiscal quarter or year.
Economic Profit
Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit
costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit.
Economic profit also accounts for a longer span of time than accounting profit. Economists often consider long-term economic
profit to decide if a firm should enter or exit a market.
Economic vs. Accounting Profit: The biggest difference between economic and accounting profit is that economic profit takes
implicit, or opportunity, costs into consideration.
Sources and Determinants of Profit

Whether economic profit exists or not depends how competitive the market is, and the time horizon that is being considered.
 LEARNING OBJECTIVES
Describe sources of economic profit
Economic profit is total revenue minus explicit and implicit (opportunity) costs. In contrast, accounting profit is the difference
between total revenue and explicit costs- it does not take opportunity costs into consideration, and is generally higher than
economic profit.
Economic profits may be positive, zero, or negative. If economic profit is positive, other firms have an incentive to enter the
market. If profit is zero, other firms have no incentive to enter or exit. When economic profit is zero, a firm is earning the same as it
would if its resources were employed in the next best alternative. If the economic profit is negative, firms have the incentive to
leave the market because their resources would be more profitable elsewhere. The amount of economic profit a firm earns is largely
dependent on the degree of market competition and the time span under consideration.
Competitive Markets
In competitive markets, where there are many firms and no single firm can affect the price of a good or service, economic profit
can differ in the short-run and in the long-run.
In the short run, a firm can make an economic profit. However, if there is economic profit, other firms will want to enter the
market. If the market has no barriers to entry, new firms will enter, increase the supply of the commodity, and decrease the price.
This decrease in price leads to a decrease in the firm’s revenue, so in the long-run, economic profit is zero. An economic profit of
zero is also known as a normal profit. Despite earning an economic profit of zero, the firm may still be earning a positive
accounting profit.
Long-Run Profit for Perfect Competition: In the long run for a firm in a competitive market, there is zero economic profit.
Graphically, this is seen at the intersection of the price level with the minimum point of the average total cost (ATC) curve. If the
price level were set above ATC’s minimum point, there would be positive economic profit; if the price level were set below ATC’s
minimum, there would be negative economic profit.
Uncompetitive Markets
Unlike competitive markets, uncompetitive markets – characterized by firms with market power or barriers to entry – can make
positive economic profits. The reasons for the positive economic profit are barriers to entry, market power, and a lack of
competition.
Barriers to entry prevent new firms from easily entering the market, and sapping short-run economic profits.
Market power, or the ability to affect market prices, allows firms to set a price that is higher than the equilibrium price of a
competitive market. This allows them to make profits in the short run and in the long run. This situation can occur if the market
is dominated by a monopoly (a single firm), oligopoly (a few firms with significant market control), or monopolistic
competition (firms have market power due to having differentiated products).
Lack of competition keeps prices higher than the competitive market equilibrium price. For example, firms can collude and
work together to restrict supply to artificially keep prices high.
Long-Run Profit for Monopoly: In the long run, a monopoly, because of its market power, can set a price above the competitive
equilibrium and earn economic profit. If price were set equal to the minimum point of the average total cost (ATC) curve, the
monopoly would earn zero economic profit. If the price were set lower than the minimum of ATC, the firm would earn negative
economic profit.
Key Points
Explicit costs are monetary costs a firm has. Implicit costs are the opportunity costs of a firm’s resources.
Accounting profit is the monetary costs a firm pays out and the revenue a firm receives. It is the bookkeeping profit, and it is
higher than economic profit. Accounting profit = total monetary revenue- total costs.
Economic profit is the monetary costs and opportunity costs a firm pays and the revenue a firm receives. Economic profit =
total revenue – (explicit costs + implicit costs).
Economic profit = total revenue – ( explicit costs + implicit costs). Accounting profit = total revenue – explicit costs.
Economic profit can be positive, negative, or zero. If economic profit is positive, there is incentive for firms to enter the market.
If profit is negative, there is incentive for firms to exit the market. If profit is zero, there is no incentive to enter or exit.
For a competitive market, economic profit can be positive in the short run. In the long run, economic profit must be zero, which
is also known as normal profit. Economic profit is zero in the long run because of the entry of new firms, which drives down
the market price.
For an uncompetitive market, economic profit can be positive. Uncompetitive markets can earn positive profits due to barriers
to entry, market power of the firms, and a general lack of competition.
Key Terms
explicit cost: A direct payment made to others in the course of running a business, such as wages, rent, and materials, as
opposed to implicit costs, which are those where no actual payment is made.
implicit cost: The opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor
hires.
accounting profit: The total revenue minus costs, properly chargeable against goods sold.
normal profit: The opportunity cost of an entrepreneur to operate a firm; the next best amount the entrepreneur could earn
doing another job.
Profit - the difference between economic and accounting costs, economic profit, economic losses, and zero economic profit.
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Index
A average total cost ceiling
Ability to decide 1.4: Basic Economic Questions 17.1: Defining and Measuring Inequality, Mobility,
9.2: Production Cost and Poverty
central bank
absolute advantage
B 27.2: Introducing the Federal Reserve
absolute quota balance of payments 30.1: Questions for Debate
32.1: Capital Flows 32.1: Capital Flows
accounting profit balance of trade centrally planned economy
32.1: Capital Flows 1.4: Basic Economic Questions
acquisition balanced budget ceteris paribus
16.4: Taxation in the United States 3.1: Demand
adaptive expectations theory Circular Flow
bank run 1.1: The Study of Economics
23.1: The Relationship Between Inflation and
33.1: Fundamentals of Banking Crises 19.1: Measuring Output Using GDP
Unemployment
adverse selection of wage cuts argument bargaining power coase theorem
22.3: Understanding Unemployment 7.4: Private Solutions
advertising Barriers to entry coercive incentives
10.3: Long-Run Outcomes 1.2: Individual Decision Making
11.2: Barriers to Entry: Reasons for Monopolies to
Affordable Care Act Exist
collective bargaining
35.1: Introducing Health Care Economics 14.2: Labor Market Equilibrium and Wage
barriers to exit Determinants
aggregate 10.3: Long-Run Outcomes
collude
barter 13.1: Prerequisites of Oligopoly
24.4: Aggregate Supply collusion
24.5: The Aggregate Demand-Supply Model bartering 13.2: Oligopoly in Practice
3.2: Supply 20.1: Comparing Economies
commercial bank
aggregate demand behavioral economics 27.3: Creating Money
23.1: The Relationship Between Inflation and 15.1: Sources of Inefficiency
Unemployment commission
Beneficiary 14.2: Labor Market Equilibrium and Wage
24.5: The Aggregate Demand-Supply Model 35.1: Introducing Health Care Economics Determinants
28.3: Impacts of Federal Reserve Policies Bertrand duopoly commodity
32.3: Equilibrium 13.2: Oligopoly in Practice 14.4: Capital and Natural Resource Markets
Agricultural Economics Biosecurity 2.1: Introducing the Market System
37.1: Introduction to the Agriculture Economics 37.1: Introduction to the Agriculture Economics common good
allocative efficiency black market 8.2: Common Resources
10.3: Long-Run Outcomes 3.4: Government Intervention and Disequilibrium comparative advantage
20.3: Productivity
brand 14.4: Capital and Natural Resource Markets
antitrust 12.1: Monopolistic Competition 20.5: The Impact of Policy on Growth
11.6: Monopoly in Public Policy 31.1: Introduction to International Trade
business cycle 31.3: The United States in the Global Economy
appropriations bill 20.2: Assessing Growth
26.2: Evaluating Fiscal Policy 22.3: Understanding Unemployment
competitive advantage
arbitrage 32.3: Equilibrium 31.1: Introduction to International Trade
15.1: Sources of Inefficiency complement
arc elasticity C 5.2: Theory of Consumer Choice
6.2: Other Demand Elasticities capacity Concentration ratio
assembly line 6.3: Price Elasticity of Supply
14.5: Capital, Productivity, and Technology capital congress
asset 1.4: Basic Economic Questions
28.1: Introduction to Monetary Policy 14.2: Labor Market Equilibrium and Wage
Determinants consolidation
asset class 14.4: Capital and Natural Resource Markets 11.6: Monopoly in Public Policy
29.2: Tools of Finance 24.4: Aggregate Supply constant returns to scale
assimilate 34.1: Interest
9.1: The Production Function 10.3: Long-Run Outcomes
capital asset pricing model Consumer Price Index
assumption
29.2: Tools of Finance 19.4: Cost of Living
1.5: Economic Models 28.3: Impacts of Federal Reserve Policies
Autarky capital market
consumer surplus
31.1: Introduction to International Trade 14.4: Capital and Natural Resource Markets
automatic stabilizers cardinal 12.1: Monopolistic Competition
26.2: Evaluating Fiscal Policy 5.1: The Demand Curve and Utility 4.1: Consumer Surplus
autonomy cartel consumption function
1.4: Basic Economic Questions 13.1: Prerequisites of Oligopoly 19.1: Measuring Output Using GDP
13.2: Oligopoly in Practice Contestable market
average tax rate
16.3: Progressive, Proportional, and Regressive
CDO 4.2: Producer Surplus
Taxes 33.2: Economic Crises contraction
contractionary monetary policy depreciate economic rent
28.3: Impacts of Federal Reserve Policies 32.2: Exchange Rates 11.2: Barriers to Entry: Reasons for Monopolies to
copyright 34.1: Interest Exist
11.2: Barriers to Entry: Reasons for Monopolies to depreciation economies of scale
Exist 19.1: Measuring Output Using GDP 11.2: Barriers to Entry: Reasons for Monopolies to
corporate income tax Derivation Exist
16.5: Personal, Property, and Sales Taxes 5.2: Theory of Consumer Choice
cost determinants efficient
9.2: Production Cost 35.1: Introducing Health Care Economics
cost of living determinants of supply Elastic
21.1: Defining, Measuring, and Assessing Inflation 3.2: Supply
countervailing duty diagnostics Taxes
31.4: Barriers to Trade 1.5: Economic Models 3.4: Government Intervention and Disequilibrium
Cournot duopoly differentiation 5.2: Theory of Consumer Choice
13.2: Oligopoly in Practice 11.1: Introduction to Monopoly 6.3: Price Elasticity of Supply
credit 14.2: Labor Market Equilibrium and Wage
Determinants elasticity
32.1: Capital Flows 16.3: Progressive, Proportional, and Regressive
crowding out diminishing marginal returns
Taxes
30.1: Questions for Debate embargo
currency discount rate
28.2: Monetary Policy Tools entrepreneurship
Cyclical unemployment discretionary 18.1: Key Topics in Macroeconomics
30.1: Questions for Debate entropy
cyclically balanced budget discretionary fiscal policy 17.1: Defining and Measuring Inequality, Mobility,
26.2: Evaluating Fiscal Policy and Poverty
equilibrium
discretionary income
D 19.2: Other Measures of Output
deadweight loss discretionary policy 3.1: Demand
11.3: Monopoly Production and Pricing Decisions 26.2: Evaluating Fiscal Policy 3.2: Supply
and Profit Outcome 30.1: Questions for Debate 32.3: Equilibrium
16.1: Introduction to Taxes What Taxes Do Equilibrium pricing
discrimination
14.2: Labor Market Equilibrium and Wage 3.3: Market Equilibrium
debit Determinants equity
32.1: Capital Flows
Disequilibrium 16.3: Progressive, Proportional, and Regressive
debt forgiveness 3.3: Market Equilibrium Taxes
32.1: Capital Flows Eurozone
disinflation
decreasing returns to scale 23.1: The Relationship Between Inflation and 27.2: Introducing the Federal Reserve
10.3: Long-Run Outcomes Unemployment evolution
deductive disposable income 20.1: Comparing Economies
1.5: Economic Models 19.2: Other Measures of Output exchange rate
deflation Dumping 32.2: Exchange Rates
1.6: Differences Between Macroeconomics and 31.4: Barriers to Trade exchange rate regime
Microeconomics 31.5: Arguments for and Against Protectionist Policy
23.1: The Relationship Between Inflation and 32.2: Exchange Rates
Unemployment excludable
28.3: Impacts of Federal Reserve Policies 8.1: Public Goods
28.4: Historical Federal Reserve Policies E exogenous
deflationary spiral economic cost 24.3: Aggregate Demand
21.1: Defining, Measuring, and Assessing Inflation 9.2: Production Cost
expansion
demand Economic crisis 18.1: Key Topics in Macroeconomics
11.3: Monopoly Production and Pricing Decisions 33.1: Fundamentals of Banking Crises
and Profit Outcome 33.2: Economic Crises
expansionary monetary policy
24.5: The Aggregate Demand-Supply Model 28.3: Impacts of Federal Reserve Policies
economic growth 30.1: Questions for Debate
demand curve 20.1: Comparing Economies
expenditure
3.1: Demand 20.2: Assessing Growth 15.1: Sources of Inefficiency
4.1: Consumer Surplus 20.4: Long-Run Growth 2.1: Introducing the Market System
20.5: The Impact of Policy on Growth 24.3: Aggregate Demand
Demand shift
3.3: Market Equilibrium economic mobility expenditure approach
17.1: Defining and Measuring Inequality, Mobility, 19.1: Measuring Output Using GDP
demographics
and Poverty explicit cost
depletion economic output 9.3: Economic Profit

24.2: Introducing Aggregate Demand and Aggregate export
Supply 19.1: Measuring Output Using GDP
deposit economic profit 31.2: Gains from Trade
deposit multiplier 11.3: Monopoly Production and Pricing Decisions
27.3: Creating Money and Profit Outcome
Externality GDP deflator Incumbents
1.1: The Study of Economics 19.3: Comparing Real and Nominal GDP 13.1: Prerequisites of Oligopoly
1.3: Interaction of Individuals, Firms, and Societies Giffen good 3.3: Market Equilibrium
35.1: Introducing Health Care Economics Individual utility
3.1: Demand
5.2: Theory of Consumer Choice 4.1: Consumer Surplus
7.1: Introducing Market Failure Gini index Inefficient market
7.2: Externalities in Depth 17.1: Defining and Measuring Inequality, Mobility, 3.4: Government Intervention and Disequilibrium
extraction and Poverty inelastic
1.4: Basic Economic Questions Glass Ceiling 16.3: Progressive, Proportional, and Regressive
17.1: Defining and Measuring Inequality, Mobility, Taxes
F and Poverty 6.1: Price Elasticity of Demand
globalization inelasticity
factors of production
14.3: Income Distribution 16.3: Progressive, Proportional, and Regressive
14.1: Demand for Labor Taxes
19.1: Measuring Output Using GDP gold standard
2.1: Introducing the Market System 25.1: Major Theories in Macroeconomics inequality
24.4: Aggregate Supply government monopoly 14.3: Income Distribution
federal funds rate 11.2: Barriers to Entry: Reasons for Monopolies to inferior good
27.2: Introducing the Federal Reserve Exist 3.1: Demand
28.2: Monetary Policy Tools government spending 5.2: Theory of Consumer Choice
fiat money 19.1: Measuring Output Using GDP inflation
27.1: Introducing Money gross domestic product 1.3: Interaction of Individuals, Firms, and Societies
financial crisis 1.6: Differences Between Macroeconomics and
Microeconomics
20.2: Assessing Growth 19.3: Comparing Real and Nominal GDP
28.4: Historical Federal Reserve Policies 20.1: Comparing Economies
financial intermediary 20.2: Assessing Growth
29.1: Introducing the Financial System gross national product 21.1: Defining, Measuring, and Assessing Inflation
19.1: Measuring Output Using GDP 23.1: The Relationship Between Inflation and
firm Unemployment
1.3: Interaction of Individuals, Firms, and Societies 26.2: Evaluating Fiscal Policy
fiscal multiplier H 27.2: Introducing the Federal Reserve
26.1: Introduction to Fiscal Policy Health care 28.4: Historical Federal Reserve Policies
26.2: Evaluating Fiscal Policy 35.1: Introducing Health Care Economics 30.1: Questions for Debate
34.1: Interest
fiscal policy heuristic
infrastructure
18.1: Key Topics in Macroeconomics 26.2: Evaluating Fiscal Policy
human capital 37.1: Introduction to the Agriculture Economics
26.1: Introduction to Fiscal Policy 20.4: Long-Run Growth input
fiscal stimulus 1.4: Basic Economic Questions
hypothesis 14.5: Capital, Productivity, and Technology
1.5: Economic Models intellectual property
fixed costs
1.4: Basic Economic Questions 20.5: The Impact of Policy on Growth
9.2: Production Cost I interest rate
fixed exchange rate immigrant 26.2: Evaluating Fiscal Policy
32.2: Exchange Rates 38.1: Introduction to Immigration Economics 28.1: Introduction to Monetary Policy
Immigration 28.4: Historical Federal Reserve Policies
floating exchange rate 32.1: Capital Flows
32.2: Exchange Rates 38.1: Introduction to Immigration Economics 34.1: Interest
foreign direct investment implicit cost Internal Revenue Service
31.5: Arguments for and Against Protectionist Policy 9.3: Economic Profit 16.2: Deploying and Measuring Taxes
foreign exchange import quotas intervention
32.1: Capital Flows 31.5: Arguments for and Against Protectionist Policy 3.2: Supply
Free market equilibrium price imports 7.1: Introducing Market Failure
3.4: Government Intervention and Disequilibrium 19.1: Measuring Output Using GDP inventory
free rider 1.4: Basic Economic Questions
incentive investment
7.1: Introducing Market Failure 1.2: Individual Decision Making 18.1: Key Topics in Macroeconomics
7.2: Externalities in Depth 11.5: Price Discrimination 19.1: Measuring Output Using GDP
8.1: Public Goods 15.1: Sources of Inefficiency
3.2: Supply
free trade J
incentive structure
1.2: Individual Decision Making Jevon's Paradox
frictional unemployment
income approach 20.1: Comparing Economies
22.3: Understanding Unemployment 19.1: Measuring Output Using GDP
full employment income effect K
22.1: Introduction to Unemployment 5.2: Theory of Consumer Choice Keynesian
28.2: Monetary Policy Tools income tax 25.1: Major Theories in Macroeconomics
16.3: Progressive, Proportional, and Regressive Keynesian economics
G Taxes 24.2: Introducing Aggregate Demand and Aggregate
16.4: Taxation in the United States Supply
game theory
increasing returns to scale
GDP 10.3: Long-Run Outcomes
L market basket N
labor 19.4: Cost of Living Nascent
1.4: Basic Economic Questions 31.5: Arguments for and Against Protectionist Policy
market demand
labor force Nash Equilibrium
3.1: Demand
22.2: Measuring Unemployment 13.2: Oligopoly in Practice
market economy
leverage national income
33.1: Fundamentals of Banking Crises 1.4: Basic Economic Questions 19.2: Other Measures of Output
Liquid assets Market power natural incentives
20.3: Productivity 11.2: Barriers to Entry: Reasons for Monopolies to 1.2: Individual Decision Making
liquidity Exist natural monopoly
27.2: Introducing the Federal Reserve 12.1: Monopolistic Competition 11.2: Barriers to Entry: Reasons for Monopolies to
33.1: Fundamentals of Banking Crises 4.2: Producer Surplus Exist
liquidity trap MB natural rate of unemployment
24.3: Aggregate Demand 27.1: Introducing Money 23.1: The Relationship Between Inflation and
loanable funds Medicaid Unemployment
28.2: Monetary Policy Tools 35.1: Introducing Health Care Economics necessary good
29.1: Introducing the Financial System Medicare 6.2: Other Demand Elasticities
luxury 35.1: Introducing Health Care Economics negative externality
6.3: Price Elasticity of Supply menu costs 7.3: Government Policy Options
21.1: Defining, Measuring, and Assessing Inflation net capital outflow
M merit good 31.3: The United States in the Global Economy
M0 7.1: Introducing Market Failure net exports
27.1: Introducing Money microeconomics 31.3: The United States in the Global Economy
32.1: Capital Flows
M1 1.6: Differences Between Macroeconomics and
27.1: Introducing Money Microeconomics net present value
18.1: Key Topics in Macroeconomics 8.1: Public Goods
M2
minimum wage network effects
14.2: Labor Market Equilibrium and Wage 11.2: Barriers to Entry: Reasons for Monopolies to
macroeconomics Determinants Exist
1.6: Differences Between Macroeconomics and mixed economy
Microeconomics
network externalities
18.1: Key Topics in Macroeconomics 1.4: Basic Economic Questions 11.2: Barriers to Entry: Reasons for Monopolies to
managed float regime mobility Exist
32.2: Exchange Rates 6.3: Price Elasticity of Supply network externality
marginal Monetarism 11.3: Monopoly Production and Pricing Decisions
25.1: Major Theories in Macroeconomics and Profit Outcome
5.1: The Demand Curve and Utility monetary policy nominal
9.1: The Production Function 18.1: Key Topics in Macroeconomics 19.3: Comparing Real and Nominal GDP
24.2: Introducing Aggregate Demand and Aggregate
marginal benefit 20.4: Long-Run Growth
Supply
1.2: Individual Decision Making 20.5: The Impact of Policy on Growth
25.1: Major Theories in Macroeconomics 32.3: Equilibrium
14.2: Labor Market Equilibrium and Wage
Determinants 26.2: Evaluating Fiscal Policy nominal exchange rate
5.1: The Demand Curve and Utility 27.2: Introducing the Federal Reserve 32.2: Exchange Rates
marginal cost 34.1: Interest
nominal GDP
1.2: Individual Decision Making 19.3: Comparing Real and Nominal GDP
money multiplier
nominal interest rate
10.2: Production Decisions in Perfect Competition 21.1: Defining, Measuring, and Assessing Inflation
11.3: Monopoly Production and Pricing Decisions money supply 28.1: Introduction to Monetary Policy
and Profit Outcome 21.1: Defining, Measuring, and Assessing Inflation
9.1: The Production Function 28.1: Introduction to Monetary Policy
normal good
9.2: Production Cost 28.2: Monetary Policy Tools 14.2: Labor Market Equilibrium and Wage
marginal product Determinants
monopolistic competition 3.1: Demand
14.1: Demand for Labor 10.1: Perfect Competition
14.2: Labor Market Equilibrium and Wage 12.1: Monopolistic Competition
normal profit
Determinants 9.3: Economic Profit
monopoly
normative economics
marginal product of labor 10.1: Perfect Competition 1.5: Economic Models
22.3: Understanding Unemployment 11.1: Introduction to Monopoly
marginal productivity 11.6: Monopoly in Public Policy O
22.3: Understanding Unemployment 12.1: Monopolistic Competition
7.1: Introducing Market Failure objective
marginal revenue 15.1: Sources of Inefficiency
moral hazard
10.2: Production Decisions in Perfect Competition oligopoly
11.3: Monopoly Production and Pricing Decisions 15.1: Sources of Inefficiency
and Profit Outcome moral incentives 10.1: Perfect Competition
14.1: Demand for Labor 13.1: Prerequisites of Oligopoly
multiplier oligopsony
Determinants 22.3: Understanding Unemployment
marginal tax rates open market operations
16.3: Progressive, Proportional, and Regressive 27.2: Introducing the Federal Reserve
Taxes 28.2: Monetary Policy Tools
opportunity cost positive economics progressive tax
1.2: Individual Decision Making 1.5: Economic Models 16.1: Introduction to Taxes What Taxes Do
14.2: Labor Market Equilibrium and Wage poverty 16.3: Progressive, Proportional, and Regressive
Determinants Taxes
25.1: Major Theories in Macroeconomics property rights
3.3: Market Equilibrium poverty line
31.1: Introduction to International Trade 17.1: Defining and Measuring Inequality, Mobility,
9.2: Production Cost and Poverty property tax
ordinal present value 16.4: Taxation in the United States
5.1: The Demand Curve and Utility 29.2: Tools of Finance prospectus
output price 29.2: Tools of Finance
10.2: Production Decisions in Perfect Competition 2.1: Introducing the Market System protectionism
20.4: Long-Run Growth price ceiling 31.2: Gains from Trade
24.4: Aggregate Supply 32.3: Equilibrium
24.5: The Aggregate Demand-Supply Model 3.4: Government Intervention and Disequilibrium
4.1: Consumer Surplus public assistance
32.3: Equilibrium
9.1: The Production Function price control 17.2: Policies for Reducing Poverty
output approach 3.4: Government Intervention and Disequilibrium public choice theory
19.1: Measuring Output Using GDP price discrimination 15.1: Sources of Inefficiency
output gap 11.5: Price Discrimination public good
27.2: Introducing the Federal Reserve 11.6: Monopoly in Public Policy 1.3: Interaction of Individuals, Firms, and Societies
price elasticity of supply 7.1: Introducing Market Failure
8.1: Public Goods
P 4.2: Producer Surplus
paradox price fixing Purchasing Power
15.1: Sources of Inefficiency 17.1: Defining and Measuring Inequality, Mobility,
Pareto efficiency and Poverty
price floor 20.2: Assessing Growth
1.3: Interaction of Individuals, Firms, and Societies 21.1: Defining, Measuring, and Assessing Inflation
Pareto optimal 3.4: Government Intervention and Disequilibrium 4.1: Consumer Surplus
13.2: Oligopoly in Practice 4.1: Consumer Surplus 5.2: Theory of Consumer Choice
16.1: Introduction to Taxes What Taxes Do price index Purchasing power parity
3.4: Government Intervention and Disequilibrium 32.2: Exchange Rates
patent Price leadership
11.2: Barriers to Entry: Reasons for Monopolies to
Exist
13.1: Prerequisites of Oligopoly Q
13.2: Oligopoly in Practice Qualitative
payroll tax price stability 1.5: Economic Models
27.2: Introducing the Federal Reserve 19.1: Measuring Output Using GDP
peak Price support quality of life
37.1: Introduction to the Agriculture Economics 20.4: Long-Run Growth
pegged float exchange rate Prisoner’s Dilemma Quantitative
13.2: Oligopoly in Practice 1.5: Economic Models
per capita producer surplus 19.1: Measuring Output Using GDP
1.3: Interaction of Individuals, Firms, and Societies quarter
12.1: Monopolistic Competition 26.2: Evaluating Fiscal Policy
perfect competition 4.2: Producer Surplus Quota
11.3: Monopoly Production and Pricing Decisions product differentiation 31.4: Barriers to Trade
and Profit Outcome
12.1: Monopolistic Competition 37.1: Introduction to the Agriculture Economics
13.1: Prerequisites of Oligopoly 7.3: Government Policy Options
perfect information production
11.3: Monopoly Production and Pricing Decisions
and Profit Outcome
1.4: Basic Economic Questions R
Perfectly elastic production function rational expectations theory
14.5: Capital, Productivity, and Technology 23.1: The Relationship Between Inflation and
20.3: Productivity Unemployment
Permit 9.1: The Production Function
Rational individual
7.3: Government Policy Options production possibilities curve 5.1: The Demand Curve and Utility
personal income 31.3: The United States in the Global Economy
real exchange rate
19.2: Other Measures of Output production possibilities frontier 32.2: Exchange Rates
Phillips curve 31.1: Introduction to International Trade
real GDP
23.1: The Relationship Between Inflation and production possibilities frontier (PPF) 19.3: Comparing Real and Nominal GDP
Unemployment
20.3: Productivity
physical capital real interest rate
productive efficiency 21.1: Defining, Measuring, and Assessing Inflation
10.3: Long-Run Outcomes 29.1: Introducing the Financial System
piece work productivity
recession
20.3: Productivity 18.1: Key Topics in Macroeconomics
Determinants
20.4: Long-Run Growth 20.2: Assessing Growth
Pigovian tax profit 33.2: Economic Crises
10.2: Production Decisions in Perfect Competition Regressive
point elasticity progressive 14.3: Income Distribution
6.2: Other Demand Elasticities 3.4: Government Intervention and Disequilibrium
pooling 3.4: Government Intervention and Disequilibrium regressive tax
29.1: Introducing the Financial System 16.1: Introduction to Taxes What Taxes Do
remunerative incentives Social Security T
1.2: Individual Decision Making 16.5: Personal, Property, and Sales Taxes tariffs
Renewable stagflation 20.5: The Impact of Policy on Growth
36.1: Introduction to Natural Resource Economics 23.1: The Relationship Between Inflation and 31.2: Gains from Trade
rental rate Unemployment 31.4: Barriers to Trade
25.1: Major Theories in Macroeconomics 31.5: Arguments for and Against Protectionist Policy
28.4: Historical Federal Reserve Policies tax
research and development 32.3: Equilibrium
13.1: Prerequisites of Oligopoly Staple Taxes
3.4: Government Intervention and Disequilibrium tax incidence
reserve ratio Static 3.4: Government Intervention and Disequilibrium
25.1: Major Theories in Macroeconomics Tax multiplier
reserve requirement stimulus 26.1: Introduction to Fiscal Policy
33.2: Economic Crises Tax Structure
28.2: Monetary Policy Tools Strategic dominance 3.4: Government Intervention and Disequilibrium
reserves 13.2: Oligopoly in Practice Tax system
27.2: Introducing the Federal Reserve strike 3.4: Government Intervention and Disequilibrium
27.3: Creating Money 14.2: Labor Market Equilibrium and Wage Taylor Rule
28.2: Monetary Policy Tools Determinants
retailer structural deficit
technology
1.4: Basic Economic Questions 32.3: Equilibrium
returns to scale structural unemployment
The law of supply
13.1: Prerequisites of Oligopoly 22.1: Introduction to Unemployment
14.1: Demand for Labor 22.3: Understanding Unemployment 3.2: Supply
9.1: The Production Function subjective poverty time horizon
9.2: Production Cost 29.2: Tools of Finance
revenue subsidy Time value of money
10.2: Production Decisions in Perfect Competition 25.1: Major Theories in Macroeconomics
11.5: Price Discrimination 29.2: Tools of Finance
Reverse engineering 31.5: Arguments for and Against Protectionist Policy Total factor productivity
31.5: Arguments for and Against Protectionist Policy 37.1: Introduction to the Agriculture Economics 14.5: Capital, Productivity, and Technology
risk premium substitute total revenue
29.2: Tools of Finance 5.2: Theory of Consumer Choice 10.2: Production Decisions in Perfect Competition
rival 6.2: Other Demand Elasticities
trade
8.1: Public Goods substitute good 31.2: Gains from Trade
6.1: Price Elasticity of Demand 32.3: Equilibrium
S substitution effect trade balance
5.2: Theory of Consumer Choice 31.5: Arguments for and Against Protectionist Policy
sales tax
superior good tradeoffs
16.4: Taxation in the United States 6.2: Other Demand Elasticities 1.2: Individual Decision Making
sanctions supply 5.2: Theory of Consumer Choice
31.5: Arguments for and Against Protectionist Policy 24.4: Aggregate Supply transaction cost
24.5: The Aggregate Demand-Supply Model 7.4: Private Solutions
saving 6.3: Price Elasticity of Supply
18.1: Key Topics in Macroeconomics transitive
supply and demand 5.2: Theory of Consumer Choice
Say's Law 3: Introducing Supply and Demand
3.3: Market Equilibrium transportation
supply chain 1.4: Basic Economic Questions
scarce 1.4: Basic Economic Questions
1.2: Individual Decision Making trough
1.6: Differences Between Macroeconomics and
supply curve 18.1: Key Topics in Macroeconomics
Microeconomics 24.5: The Aggregate Demand-Supply Model
3.2: Supply
turnover
scarcity 22.3: Understanding Unemployment
supply shifts
3.2: Supply
security market line 3.3: Market Equilibrium U
supply shock unemployment
shirking 23.1: The Relationship Between Inflation and 22.1: Introduction to Unemployment
22.3: Understanding Unemployment Unemployment 22.2: Measuring Unemployment
shoeleather costs 24.5: The Aggregate Demand-Supply Model 28.3: Impacts of Federal Reserve Policies
21.1: Defining, Measuring, and Assessing Inflation surplus unemployment insurance
shortage 11.5: Price Discrimination 22.3: Understanding Unemployment
3.2: Supply 3.2: Supply union
3.3: Market Equilibrium 3.3: Market Equilibrium
shutdown sustainable Determinants
10.2: Production Decisions in Perfect Competition 36.1: Introduction to Natural Resource Economics unit elastic
simplify systematic risk 6.1: Price Elasticity of Demand
1.5: Economic Models 29.2: Tools of Finance universal healthcare
social insurance 35.1: Introducing Health Care Economics
social science
utility variable cost W
1.3: Interaction of Individuals, Firms, and Societies 1.4: Basic Economic Questions wealth effect
4.1: Consumer Surplus 10.2: Production Decisions in Perfect Competition
5.1: The Demand Curve and Utility 9.2: Production Cost 5.2: Theory of Consumer Choice
5.2: Theory of Consumer Choice Veblen good welfare
3.1: Demand 19.1: Measuring Output Using GDP
V velocity of money
Vaccinations 21.1: Defining, Measuring, and Assessing Inflation wholesaler
35.1: Introducing Health Care Economics voting system 1.4: Basic Economic Questions
Value of marginal product of capital 15.1: Sources of Inefficiency World Health Organization
14.5: Capital, Productivity, and Technology voucher 35.1: Introducing Health Care Economics
variable 17.2: Policies for Reducing Poverty
Glossary
Sample Word 1 | Sample Definition 1
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ECONOMICS

Boundless (now LumenLearning)

Boundless (now LumenLearning)

2: The Market System

3: Introducing Supply and Demand

5: Consumer Choice and Utility

6: Elasticity and its Implications

7: Market Failure: Externalities

8: Market Failure: Public Goods and Common Resources

10: Competitive Markets

12: Monopolistic Competition

14: Inputs to Production: Labor, Natural Resources, and Technology

15: Challenges to Efficient Outcomes

16: Taxes and Public Finance

17: Income Inequality and Poverty

18: Introduction to Macroeconomics

20: Economic Growth

23: Inflation and Unemployment

24: Aggregate Demand and Supply

25: Major Macroeconomic Theories

26: Fiscal Policy

27: The Monetary System

28: Monetary Policy

29: The Financial System

30: Current Topics in Macroeconomics

31: International Trade

32: Open Economy Macroeconomics

33: Economic Crises

34: Interest and Profit

35: Health Care Economics

36: Natural Resource Economics

37: Agriculture Economics

38: Immigration Economics

Individuals Face Opportunity Costs

Individuals Make Decisions at the Margins

Apply the concepts of marginal analysis and utility to decision-making

Marginal Benefits and Costs for Pollution

Individuals Respond to Incentives

Predict how pay incentives will influence a person’s work performance

Incentives and Performance

The Evolution of the Firm

The Transaction Theory of the Firm

Explain why parties trade.

Thinking about Efficiency

Define economic efficiency.

The Function and Nature of Markets

Summarize the defining characteristics of a free market economy

Markets are Typically Efficient

Government Intervention May Fix Inefficient Markets

Discuss the role of government in addressing common market failures

Full Economy Interactions

Production Inputs and Process

Explain the use of capital and labor in production

Differences Between Centrally Planned and Market Economies

Centrally Planned Economy

Market Based Economy

Explain the characteristics of a mixed economy

Common Mathematical Terms

Assess the benefits and drawbacks of using simplifying assumptions in economics

Criticisms of Economic Assumptions