Because learning changes everything.

Chapter 2
Understanding Economics
and How It Affects Business

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Learning Objectives
LO 2-1 Explain basic economics.
LO 2-2 Explain what capitalism is and how free markets
work.
LO 2-3 Compare socialism and communism.
LO 2-4 Analyze the trend toward mixed economies.
LO 2-5 Describe the significance of key economic
indicators (especially GDP), productivity, and the
business cycle.
LO 2-6 Contrast fiscal policy and monetary policy, and
explain how each affects the economy.

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 Economic Contrast

The economic contrast shown here is remarkable. Business is booming in

Seoul, South Korea (as shown in the photo on the right). But North Korea,
a communist country, is not doing well, as the picture on the left shows.
What do you think accounts for the dramatic differences in the
economies of these two neighboring countries?

© McGraw Hill (L) Hg Han/AP Images; (R) Gw. Nam/Getty Images 3

 How Economic Conditions Affect Businesses
2

What Is Economics?
• Economics — The study of how society chooses to
employ resources to produce goods and services and
distribute them for consumption among various competing
groups and individuals.
• Macroeconomics — The part of economics study that
looks at the operation of a nation’s economy as a whole.
• Microeconomics — The part of economics study that
looks at the behavior of people and organizations in
particular markets.

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 How Economic Conditions Affect Businesses
3

What Is Economics? continued

Resource development — The study of how to increase
resources and to create conditions that will make better use
of those resources.
Examples of ways to increase resources:
• New energy sources.
• New ways of growing foods.
• New ways of creating goods and services.
• Nanotechnology, 3D printing, 4D technology.

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 Production and the Economy
New ways of producing
goods and services add
resources to the economy
and create more
employment. Fish farms,
for instance, create both
food and jobs.

© McGraw Hill Violetastock/Getty Images 6

 How Economic Conditions Affect Businesses
4

The Secret to Creating a Wealthy Economy

“The dismal science.”
• Thomas Malthus believed that if the rich had most of the wealth and
the poor had most of the population, resources would run out.

Latest world statistics show population growing more slowly

than expected.

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 World Population Could Go
from Boom to Bust
The global population will grow
to nearly 10 billion people by
2050.
This increase will have a major
impact on resources and could lead
to significant lifestyle changes.
Population should stabilize by 2100.
• Due to declining birth rates.

Older people will make up a large

portion of the population for years.
• Could lead to future economic
difficulties if there is a lack of young
people in the workforce.

© McGraw Hill Goodboy Picture Company/Getty Images 8

 How Economic Conditions Affect Businesses
5

The Secret to Creating a Wealthy Economy

continued
Contrary to Malthus, some macroeconomists believe a large
population can be a resource.
• An educated population is highly valuable.
• Business owners provide jobs and economic growth for their
employees and communities as well as for themselves.

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 How Economic Conditions Affect Businesses
6

Adam Smith and the Creation of Wealth

Smith believed that:
• Freedom was vital to any economy’s survival.
• Freedom to own land or property and the right to keep the profits of a
business is essential.
• People will work hard if they believe they will be rewarded.

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 How Economic Conditions Affect Businesses
7

How Businesses Benefit the Community

Invisible hand — The process that turns self-directed gain
into social and economic benefits for all.
• As people improve their own situation in life, they help the economy
prosper through the production of goods, services, and ideas and
charitable donations.

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 Applying Adam Smith’s Theory
According to Adam Smith’s
theory, business owners are
motivated to work hard
because they know they will
earn, and keep, the rewards of
their labor. When they prosper,
as the owner of this restaurant
has, they are able to add
employees and grow, indirectly
helping the community and the
larger economy grow in the
process. What might motivate
you to start your own
business?

© McGraw Hill Alena Kravchenko/Alamy Stock Photo 12

 TESTPREP 1

• What is the difference between macroeconomics

and microeconomics?
• What is better for an economy than teaching a
man to fish?
• What does Adam Smith’s term invisible hand
mean? How does the invisible hand create wealth
for a country?

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 Understanding Free-Market Capitalism 1

Capitalism
An economic system in which all or most of the factors of
production and distribution are privately owned and operated
for profit.
• U.S., England, Australia, Canada.

State capitalism — A combination of freer markets and

some government control.
• China has experienced rapid growth using state capitalism.

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 Understanding Free-Market Capitalism 2

Four Basic Rights

1. The right to own private property.
2. The right to own a business and keep all that business’s
profits.
3. The right to freedom of competition.
4. The right to freedom of choice.

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 Understanding Free-Market Capitalism 4

How Free Markets Work

Free market — Decisions about what and how much to
produce are made by the market.
• Consumers send signals about what they like and how they like it.
• Price tells companies how much of a product they should produce.
• If something is wanted but hard to get, the price will rise until more
products are available.

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 Circular Flow Model

https://www.youtube.com/watch?v=de3iGMjA_8c

Access the text alternative for slide images.

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 Understanding Free-Market Capitalism 5

How Prices Are Determined

By buyers and sellers negotiating in the marketplace.
• A seller may want to sell shirts for $50, but only a few people may buy
at that price.
• If the seller lowers the price, quantity demanded likely to increase.

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 Figure 2.1 The Supply Curve at Various
Prices
The Economic Concepts of
Supply
Supply — The quantity of
products that manufacturers or
owners are willing to sell at
different prices at a specific time.
The supply curve rises from left to
right. Think it through. The higher
the price of T-shirts goes (the
vertical axis), the more sellers will
be willing to supply.

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 Figure 2.2 The Demand Curve at Various
Prices
The Economic Concepts of
Demand
Demand — The quantity of
products that people are willing to
buy at different prices at a specific
time.
This is a simple demand curve
showing the quantity of T-shirts
demanded at different prices. The
demand curve falls from left to
right. It is easy to understand why.
The lower the price of T-shirts, the
higher the quantity demanded.

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 Figure 2.3 The Equilibrium Point
The Economic Concepts of
Equilibrium Point
Market price (equilibrium point)
— The price determined by supply
and demand.
The place where quantity
demanded and quantity supplied
meet is called the equilibrium
point. When we put both the
supply and demand curves on the
same graph, we find that they
intersect at a price where the
quantity supplied and the quantity
demanded are equal. In the long
run, the market price will tend
toward the equilibrium point.
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FINDING THE EQUILIBRIUM POINT
 
In 2018, Epic Electronics sold 350,000 digital video recorders (DVRs). Based on the company’s analysis of the
DVR market, the company believed that $160 was the equilibrium price based on the following supply and
demand schedules.
 
2018 Price Amount Supplied Amount Demanded
$120 290,000 390,000
140 320,000 370,000
160 350,000 350,000
180 380,000 330,000
200 410,000 310,000
220 440,000 290,000
 
As the price of gas rises, consumers start driving less and going out less frequently for entertainment. With
more people staying at home, DVR usages increased. In 2019 Epic’s executives revised their estimate of the
amount of product demanded. At each of the above price points, it estimates that consumers will purchase
(demand) 50,000 more DVRs. For instance, at $140, now 420,000 DVRs will be sold. The price–amount supplied
relationship remains the same.
 
1. Describe what has happened to the supply and demand curves for Epic Electronics’ DVRs in 2018. 
2. What is the new equilibrium price?
3. How many DVRs will be produced at the new equilibrium price?
4. Epic Electronics revised its estimate of the amount of product demanded for 2019 as described above. In
2020 a new technology became available enabling DVRs to fully partner with smartphones. Users can
access any and all of their recorded programming from their wireless devices. Epic’s competitors are selling
this new DVR, called SuperDVR, for $150. What will happen to the supply and demand curves for Epic’s
DVRs now?
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a) Identify the
Supply schedule:
Demand schedule:
b) What would be the equilibrium price for BP in the foreign exchange market? Why?
c) What would happen if both the US and the British governments fixed the price of
BP at $1.45?
d) Calculate the excess supply or demand for BP if both the US and the British
governments fixed the price of BP at $1.60.
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 Bad Medicine for Consumers?
Your company, a large pharmaceutical
firm, acquired a drug called Relivoform,
a chemotherapy drug for liver cancer.
• Your finance committee recommends
increasing the price of Relivoform
from $300 to $3,000 to help alleviate
the development costs of new drugs.
• The public reacted with rage,
accusing your firm of favoring profits
over patients’ needs.
• Will you follow your committee’s
recommendation and raise the price?
What are your alternatives? What
might be the consequences of each?

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 Understanding Free-Market Capitalism 7

https://www.youtube.com/watch?v=QJnP8jzBjvk

Competition within Free Markets

Perfect competition — Many sellers but none is large
enough to dictate the price of a product.
Monopolistic competition — Large number of sellers
produce very similar products that buyers nevertheless
perceive as different.
• Product differentiation is key.

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 Understanding Free-Market Capitalism 8

Competition within Free Markets continued

Oligopoly — A few sellers dominate a market.
• Initial investment usually very large, like aircraft.
• Products from different companies priced about the same.

Monopoly — One seller controls the total supply of a

product or service, and sets the price.

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Automotive Industry: In this industry, there are a few sellers
that tend to dominate the market
Oligopoly
Beef Industry: There are many different suppliers of these
products, which prevents any one of them from setting
prices.
Perfect Competition
Soda Industry: In this industry the products are very similar,
although consumers perceive them as being very different.
Monopolistic competition
Agricultural Commodities: There are many different growers
of these products, which prevents any one of them from
setting prices.
Perfect competition
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Airline Industry: In this industry, there are a few sellers that tend
to dominate the market.
Oligopoly
Athletic Shoe Industry: In this industry the products are very
similar, although consumers perceive them as being very
different.
Monopolistic competition
ACME Light and Power: Through special legislation, this
supplier is the sole provider of electricity to its local
municipalities.
Monopoly
Cable Television Industry: In smaller markets, one company is
the sole provider of cable television service to consumers in
local municipalities.
Monopoly
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 Understanding Free-Market Capitalism 9

Benefits and Limitations of Free Markets

Benefits:
• Allows for open competition among companies.
• Provides opportunities for poor people to work their way out of poverty.

Limitations:
• Leads to inequality as business owners and managers usually make
more money and have more wealth than lower-level workers.
• People may start to let greed drive them.

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 TESTPREP 2

• What are the four basic rights that people have

under free-market capitalism?
• How do businesspeople know what to produce
and in what quantity?
• How are prices determined?
• What are the four degrees of competition, and
what are some examples of each?

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 Understanding Socialism 1

Socialism
An economic system based on the premise that some, if not
most, basic businesses should be owned by the government
so that profits can be more evenly distributed among the
people.
• Entrepreneurs run smaller businesses.
• Citizens are highly taxed.
• Government is more involved in protecting the environment and the
poor.

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 Growth in Socialist Countries
Socialism has been more
successful in some countries than
in others. This photo shows
Denmark’s clean and modern
public transportation system. In
Greece, overspending caused a
debt crisis. What factors might
lead to slower growth in
socialist countries?

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 Understanding Socialism 2

The Benefits of Socialism

• Social equality.
• Free education.
• Free health care.
• Free child care.
• Longer vacations.
• Shorter work weeks.
• Generous sick leave.

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 Understanding Socialism 3

The Negative Consequences of Socialism

• Few incentives for businesspeople to take risks.
• Brain drain — The loss of the best and brightest people to
other countries.
• Fewer inventions and less innovation because the reward
is not as great as in capitalistic countries.

• https://www.youtube.com/watch?v=8KQQtbBYvDs

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 Understanding Communism
Communism
An economic and political system in which the government
makes almost all economic decisions and owns almost all
the major factors of production.
• Prices don’t reflect demand, which may lead to shortages of items,
including food and clothing.
• Most communist countries today suffer severe economic depression.

• https://www.youtube.com/watch?v=zV0kn7fqxPg

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 POLLING QUESTION 1

In economies, the market largely determines

goods and services that get produced, who gets them,
and how the economy grows.
A. free-market
B. command
C. communist
D. socialist

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 The Trend toward Mixed Economies 1

Two Major Economic Systems

• Free-market economies — Economic systems in which
the market largely determines what goods and services get
produced, who gets them, and how the economy grows.
• Command economies — Economic systems in which the
government largely decides what goods and services will
be produced, who will get them, and how the economy will
grow.

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 The Trend toward Mixed Economies 2

Two Major Economic Systems continued

Neither free-market nor command economies have created
sound economic conditions.
The trend has been toward mixed economies.
• Economic systems in which some allocation of resources is made by
the market and some by the government.

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 TESTPREP 3

• What led to the emergence of socialism?

• What are the benefits and drawbacks of
socialism?
• What countries still practice communism?
• What are the characteristics of a mixed economy?

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 Each person listed below is looking for a particular set of
circumstances they would prefer to live under. For each
person, select the economic system that would best meet their
needs.
1. Danielle wants to live in a country where she is free to start
a business in a field of her choice and pay minimal taxes.
Capitalism
2. Marcus enjoys living in a country that tells him where he will
work and live, and that provides his food rations.
Communism
3. Tameka prefers to live in a country with a higher tax rate
that provides healthcare and education opportunities for all of
the citizens.
Socialism

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 4. Jose prefers to live in a country with more social freedoms,
such as freedom of speech, press, assembly, job choice,
movement, and elections.
Capitalism
5. Meagan would rather live in a country that focuses on
quality of life where they provide more generous sick leave,
longer vacations, and fewer work hours per week.
Socialism
6. Drew likes the control the government provides by making
everyone follow one religion and obeying authority. Everyone
in his country gets along as it is against the law to protest,
practice a different religion, move, or change jobs.
Communism

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 Economic Systems Debate
 Guidelines:

1. Read about the 5 characteristics of both your economic

system and your opponent’s system.
2. Take notes of the advantages and disadvantages for each
system.
3. Write speech explaining why your system is better than your
opponent’s system.
a. Cover your system’s strengths.
b. Their weaknesses
c. Make sure you cover ALL 5 characteristics in your speech.

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 Economic System 1

Key Economic Indicators

Gross domestic product (GDP) — The total value of final
goods and services produced in a country in a given year.
• As long as a company is within a country’s border, their numbers go
into the country’s GDP (even if they are foreign-owned).
• When the GDP changes, businesses feel the effect.
• Gross output (GO) — A measure of total sales volume at all stages of
production.

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 Countries Challenging the U.S. in GDP

Access the text alternative for slide images.

© McGraw Hill Source: World Bank, worldbank.org, accessed November 2017. 44

 Economic System 2

Key Economic Indicators continued

Unemployment rate — The number of civilians at least 16
years old who are unemployed and tried to find a job within
the prior four weeks.
• Real unemployment rate is comprised of those included in the
standard unemployment rate plus those who are underemployed,
discouraged, and marginally attached.

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 Figure 2.6 Four Types of Unemployment
Frictional unemployment

Frictional unemployment refers to those people who have quit work because they didn’t like the job, the
boss, or the working conditions and who haven’t yet found a new job. It also refers to those people who
are entering the labor force for the first time (for example, new graduates) or are returning to the labor
force after significant time away (for example, parents who reared children). There will always be some
frictional unemployment because it takes some time to find a first job or a new job.

Structural unemployment
Structural unemployment refers to unemployment caused by the restructuring of firms or by a mismatch
between the skills (or location) of job seekers and the requirements (or location) of available jobs (e.g.,
coal miners in an area where mines have been closed).

Cyclical unemployment
Cyclical unemployment occurs because of a recession or a similar downturn in the business cycle (the
ups and downs of business growth and decline over time). This type of unemployment is the most
serious.

Seasonal unemployment
Seasonal unemployment occurs where demand for labor varies over the year, as with the harvesting of
crops.

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 Economic System 3

Key Economic Indicators continued

Inflation and price indexes.
• Inflation — A general rise in the prices of goods and services over
time.
• Disinflation — A situation in which price increases are slowing (the
inflation rate is declining).
• Deflation — A situation in which prices are declining.
• Stagflation — A situation when the economy is slowing but prices are
going up anyhow.
• https://www.youtube.com/watch?v=HQ-Kg_xgdhE

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 How a Stack of Cash Can
Become Worthless
Hyperinflation is when the price
of goods and services rises by 50
percent a month.
• In Venezuela, the inflation rate went
from 63 percent in 2014 to 481
percent in 2016.
• The currency, the Bolivar, was so low
that cash to pay for goods and
services was being weighed instead
of counted.
• The Federal Reserve in the U.S.
maintains the money supply and
carefully sets interest rates so that
inflation stays under control.

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 Economic System 4

Key Economic Indicators

Inflation and price indexes
• Consumer price index (CPI) — Monthly statistics that measure the
pace of inflation or deflation.
• Core inflation — CPI minus food and energy costs.
• Producer Price Index (PPI) — An index that measures the change in
prices at the wholesale level.

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 Economic System 7

The Business Cycle

• Business cycles — The periodic rises and falls that occur
in economies over time.
• Four phases of long-term business cycles:
1. Economic boom — Business is booming.
2. Recession — Two or more consecutive quarters of decline in the
GDP.
3. Depression — A severe recession, usually accompanied by
deflation.
4. Recovery — When the economy stabilizes and starts to grow,
eventually leading to an economic boom.

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 Economic System 8

Stabilizing the Economy through Fiscal Policy

https://www.youtube.com/watch?v=DAF81UKWCOI
Fiscal policy — The federal government’s efforts to keep the
economy stable by increasing or decreasing taxes or
government spending.
Keynesian economic theory — Theory that a government
policy of increasing spending and cutting taxes could
stimulate the economy in a recession.
Tools of fiscal policy:
• Taxation.
• Government spending.

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 Economic System 9

Stabilizing the Economy through Fiscal Policy

continued
• National deficit is the amount of money the federal
government spends beyond what it collects in taxes for a
given fiscal year.
• Deficit increases the national debt — The sum of
government deficits over time.
• National surplus is when the government takes in more
revenue than it spends.

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 Economic System 10

Using Monetary Policy to Keep the Economy

Growing
https://www.youtube.com/watch?v=IMkLAP_aj3I
Monetary policy — The management of the money supply
and interest rates by the Federal Reserve Bank.
• The Fed’s most visible role is raising and lowering of interest rates.
• When the economy is booming, the Fed tends to raise interest rates.
• When the economy is in a recession, the Fed tends to decrease interest
rates.

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 TESTPREP 4

• Name the three economic indicators.

• What is the difference between a recession and a
depression?
• How does the government manage the economy
using fiscal policy?
• What does the term monetary policy mean? What
organization is responsible for monetary policy?

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