Economics For Educators Revised V 18G

Economics for Educators
Revised Edition
Robert F. Hodgin, Ph.D.

Texas Council on Economic Education
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Economics for Educators, Revised
Copyright 2012 Texas Council on Economic Education All Rights Reserved
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For Whitney, again
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Reviewers
Economic for Educators, Revised benefitted from many comments and suggestions from the reviewers listed alphabetically below. Sally Adamson Retired, Duncanville High School Duncanville ISD Dr. Steve Cotton University of Houston - Clear Lake
Michael Clark Bellaire High School Houston ISD
Dr. Alberto Davila University of Texas-Pan American Texas Council on Economic Education Center Director
Dr. Steve Cobb University of North Texas Texas Council on Economic Education Center Director
David Pruitt University of North Texas Texas Council on Economic Education Consultant
Support
Laura Ewing President, Texas Council on Economic Education
Allen Reding Webmaster, Texas Council on Economic Education
Catherine Rinhart Program Director, Texas Council on Economic Education
Preface
I wrote this short primer to help K-12 educators prepare to properly teach economic ideas to their students. Economics provides a useful way of thinking about how the world works and its main themes deserve a rightful place in each students mindset. The main themesefficiency, trade-offs and opportunity costecho throughout the eighteen Microeconomic and Macroeconomic lessons. Written in plain language, each lesson orients the busy educator on the meaning and application of core economic terms, concepts and tools. Other economic concepts then can be directly integrated with the more fundamental ones presented. It is my hope that the work enhances teacher knowledge and confidence, and then gets multiplied by the number of students they enlighten on this useful subject. I thank the Texas Council on Economic Education for financial support to pen this revision. I also thank Laura Ewing, President of the Texas Council for her generous assistance, along with the academic and professional manuscript reviewers for their valuable comments. Lingering errors remain mine alone. Robert F. Hodgin, Ph.D. Hodgin@uhcl.edu University of Houston - Clear Lake Houston, Texas
Biographical Sketch
Robert F Hodgin, Ph.D., has taught economics to K-12 teachers, undergraduates and graduate students at the University of Houston-Clear Lake campus for four decades. His zeal for the subject radiates through presentations, academic articles, lay writing and consulting. Motivated by the rigid grade-level content demands imposed by state legislators, he penned Economics for Educators, Revised Edition, to give teachers a very short and readable guide to the discipline. With a keen eye on common misunderstandings, he walks the reader through the major turns of the discipline in common language. With Economics for Educators, Revised Edition, a teacher can swiftly grasp a concept, develop a lesson plan and confidently address student questions class after class. Robert and his wife, Johnette, have two grown daughters, Kristen and Whitney, and two granddaughters, Sloane and Elle. They live on a lake near the Big Thicket area of East Texas.
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Table of Contents
Lesson 1: The Economic Problem 1
Economic Foundations 1 Economic Resources 1 Understanding Economic Behavior 2 The Economic Way of Thinking 3
Lesson 2: Goals of Economic Systems 7

The Economizing Questions 7 Comparing Economic Systems 8 An Economys Production Possibilities 9
Lesson 3: Wants and SubstitutesDemand 12

Economics Fundamental Divisions 12 Demand and the Search for Substitutes 12 Buyer Response to Price Changes 14 Demand Responses to Non-price Changes 16
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Lesson 4: Production Costs and the Division of Labor 19

Resources and the Pursuit of Profit 19 Diminishing Returns and Marginal Cost in the Short Run 19 Derived Demand for Factor Inputs 21 How Firms Grow in the Long Run 22
Lesson 5: Opportunity Cost and ChoiceSupply 24

Cost as Value 24 The Sellers Dilemma 24 Producer Choices and Supply 25 Seller Responses to Price Changes 26 Supply Responses to Non-price Changes 27
Lesson 6: How Markets Coordinate Exchange 30

Exchange Creates Wealth 30 Market Price as a Signal 30 Choices and Trade-offs at the Margin 31 Equilibrium Responses to Non-price Changes 32
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Lesson 7: Competition, Market Power and Economic Efficiency 35

Market Power and the Structure of Industry 35 Competitions Efficiency Promise 35 Monopolys Efficiency Failure 37 When a Few Firms Dominate the Market 38 Monopolistic Competition 39
Lesson 8: Economic Justifications for Government 42

Market Failure and Government 42 Government Provision of Public Goods 43 Government Regulation of Monopoly 43 Government Regulation of Common Resources 43 Private Goods with External Effects 44 Constitutional Right to Tax 45 Principles of Taxation 46 Fairness in Taxation 46 Tax Incidence and Efficiency 47
Lesson 9: Value, Time and Uncertainty 50

Time Preference and Present Value 50 Smart Investing in Any Market 51 Insurance as Risk Coverage 52
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Lesson 10: Consumer Economics 54

Life is a Marathon, Not a Sprint 54 First Paycheck 54 First CarSo Many Options 55 The Economics of Attending College 56 Credit Cards High Cost 57 First CareerLooking at the Long Run 58 First Home or Last HomeRent or Buy? 59 Planning Early for Living Long 61
Lesson 11: Gross Domestic Product and Growth 63

National Income Measurement 63 The Supply View of GDP 65 The Demand (Expenditure) View of GDP 65 Sources of Economic Growth 66 Economic Productivity and Well-being 67 How Technology Enhances Economic Growth 67 The Interrelatedness of Sectors 68
Lesson 12: Employment and Unemployment 71

Employment and Unemployment 71 Natural Rate of Unemployment 72 Curing Unemployment 72 Economics of Minimum Wage Laws 73
Lesson 13: Money and Prices 75

Money 75 Measuring Inflation 75 Inflations Winners and Losers 77 Controlling Inflation 78
Lesson 14: Money and Interest Rates 80

Moneys Official Definitions 80 Money is Not Credit 80 Moneys Scarcity Preserves Its Value 80 Times Value is the Interest Rate 81
Lesson 15: Federal Reserve System 83

What Commercial Banks Do 83 What Central Banks Do 83 Money and the Federal Reserve 84 The Money Multiplier 84 Monetary Tools of the Fed 86
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Lesson 16: Macroeconomics: Long Run and Short Run 89

Macroeconomic Goals 89 The Long Run and Short Run 90 The Equation of Exchange 91 The Multiplier 92
Lesson 17: Fiscal and Monetary Policy 94

Laissez-faire versus Government Intervention 94 The Demand for Money 94 Monetary Policy Tools 94 Fiscal Policy Tools 96 National Debt and Fiscal Policy 96 Crowding Out Effect of Deficit Financing 97
Lesson 18 Gains from Trade 99

Trade and the Law of One Price 99 Comparative Advantage Theory 99 Currency Markets and Exchange Rates 101 The Balance of Payments 102
Lesson 1: The Economic Problem

Economic Foundations Economic data are read daily by millions of people, yet many citizens hold mistaken notions about how the economy works. Since economic events affect everyone in some way, that statement suggests a gap in training, not a lack of relevance or interest. To begin converting economic information into knowledge, this lesson introduces the economic problem then presents the economic way of thinking. Each subsequent lesson adds new economic concepts and useful applications, several with real data to demonstrate how economics works in free markets to enhance societys well being. Economic activity permeates much of modern life, but achieving personal and social economic goals also requires effective institutions. For example, when a nations citizens feel secure from foreign invasion, perhaps through a strong national defense, borrowers more willingly undertake long-term investments using loaned funds. Well functioning courts, clear property rights, a responsive political system, all support the operation of free markets to meet individual needs and achieve social goals. Citizens in a democracy are free to choose from among the wide array of market-based opportunities, but achieving individual wealth or business success can be another matter. People have the freedom and the right to enjoy the rewards of legitimate commerce, but they must accept that there is no guarantee of individual success or uninterrupted growth for society. Economicsthe study of how society manages its scarce resources. The Economic Problemhow to meet societys material needs given scarce resources. Gooda product or service that provides value to its acquirer. Free marketsan exchange system for the production, distribution and consumption of goods and services between buyers and sellers. Economic Resources In economics, the productive means to address the economic problem fall into one of four all-encompassing categoriesland, labor, capital (machinery) and entrepreneurship. No matter the type of economic systemcapitalist, socialist or traditionalor the era, these four categories comprise the totality of economic resources. The compelling question is how a society is to organize and effectively employ its resources.
Economic resources and the market returns they earn: Labor earns wages from its human capital Land earns rent for its productive application Capital (plant and equipment) earns interest Entrepreneurship (leading, organizing) earns profit The US Bureau of Economic Analysis (BEA) measures resource payments to the factors of production each quarterthis is the income view of Gross Domestic Product (GDP)as part of the National Income and Product Accounts (NIPA). Economists at the BEA, using official methodologies compile figures for each resource category, as shown below for 2009. Each category is a resource building blocka factor of productionfor making goods and services, and each, in return, earns payment for its use.
US National Income by Economic Resource Categories, 2009 ($ Bill.)

Economic Resource Natural (land) Human (labor) Capital (physical assets) Entrepreneurship Source: www.BEA.gov Understanding Economic Behavior Economists reduce market-based behavior to a set of logical relationships. They do so by distilling their observations on human activity down to a few measures in a cause-and-effect structure premised on assumptions. For example, most of us would agree that people commonly act in the pursuit of their own self-interest. Many of the behaviors and assumptions economists employ may seem obvious, but when used to construct explanatory models, they can provide a rich understanding of peoples choice-making behavior. The better economists understand the roots of economic behavior under select conditions, the more able they are to define policies to influence the economy and potentially improve the human condition. Selected behavioral assumptions in economics People desire a multitude of goods People are willing to make trade-offs to be better off Not all people make the same trade-offs People respond to incentives Why study theory? We cannot discover the cause and effect relationships at work in a complex society without theory. Economic theory attempts to explain human behavior by testing presumed logical relationships among economic measures. A proposed Resource Payment Type Rent Wages Interest Profit US National Income $ 1,285.9 $ 7,811.7 $ 784.3 $ 1,258.0

relationship, when verified using real world data, becomes knowledge about how people in economic society function. Through this hypothesis testing process, economists have come to feel confident about many relationships like work to leisure or earning to spending. For example, in the macro economy, it is very useful to know that, on average, $1 of additional income, when spent, will generate an additional 86 cents in new spending for the economy, during normal economic times. Uses of economics and economic theory Descriptiondefines and measures economic activity Analysisorders economic measures into logical cause-and-effect models Explanationstatistically tests economic relationships using real world data Predictionuses proven models to assess and forecast market indicators The Economic Way of Thinking Observing how people weigh and measure options then act to improve their position reveals the economic way of thinking in action. What is the practical structure of this process? When faced with a need and a dilemma, like whether to buy a new or used car, astute people usually assess the known costs and benefits of their optionsthen reduce the options down to just two: the first best and, what will become the next best alternatives. The buyer then makes the purchase in a mutually beneficial exchange with the seller, in dollars (or credit) for the car. As long as the purchase is affordable and the car functions as promised, the buyer is satisfied. We can generalize from this example and describe the workings of the economic logic. Value always lies in the eye of the beholder. It is a persons willingness and ability to make a sacrifice to acquire a good that gives it value. That action of sacrificing one thing of value to acquire another more highly valued good in a specific place and time, confirms the acquired goods relative scarcity and worth. Effort also must be expended, a sacrifice made, by someone to produce and deliver the good satisfying the conditions of the acquirer. Producers make goods only when their expectation of reward is greater than the value of their own sacrificei.e. a price above their cost of making the good. Economics provides the logic that makes the production-to-distribution-to-consumption process sensible and efficient. Once market participants have enough information about an economic good, some idea of relevant property rights (what belongs to whom and how to consummate the trade), rational exchanges benefiting both parties can occur. A prospective buyers desire and ability to pay a price greater than a potential sellers sacrifice for making a particular good provides the opportunity for mutual gain.

Scarcityeconomic goods are not naturally available in the form, time or place desired without a cost or sacrifice. Opportunity Costwhen making a choice, it is the next most highly valued option forgone that measures the cost of the chosen option. Trading-offmaking choices regarding the amount of one good sacrificed to get more of another good. Neither individuals nor nations can have all the goods they want without making trade-offssacrifices occur at all levels to achieve a desired end. If the acquirer made a sacrifice to possess a desired good, then it must be an economic good by definition. To allocate goods to their best use requires an efficient production-distribution-consumption systemideally using prices determined in free and informed markets. Efficiency means that people in the economic system make choices intended to make them better off. Economists believe that most consumers make self-interestednot selfishchoices that improve their personal position. A person will consume units of a private good up to the point where the expected additional costs equal, but do not exceed, the expected additional benefits. In doing so, the person maximizes his or her total net benefit. The steps and example presented below detail that process. Efficient economic choice making for a desired option means: Assessing the expected additional benefits and the expected additional costs Checking that the options expected benefit-to-cost ratio is greater than one Comparing the first options benefit-to-cost ratio to the next best option Then, choosing the option with the greater net value, and sacrificing the other As an application of efficient economic choice making, suppose that you have allotted $60 to purchase some nice casual T-shirts for summer. While shopping, you find a store where designer label T-shirts are on sale today only for $15 each. You think the price is a bargain. Ignoring sales taxes, how many T-shirts will you buy?
Suppose the blue bars in the chart above reflect the personal value that you place on each T-shirt you might buy, beginning with the first one. Notice that you feel willing to pay as much as $30 for that T-shirt, well over the sale price. The value-to-cost ratio is certainly positive; 2-to-1 ($30 value/$15 cost). Also notice that as you anticipate purchasing each additional T-shirt, their value to you falls (just how many nice summer T-shirts does one need?). Will you purchase the first T-shirt? Yes. At the same price, what is the benefit-to-cost logic for the second T-shirt? Well, the cost is the same$15. But the value to you has fallen to about $25. You still feel the value is greater than the costand besides, the sale ends today. So you purchase that one also. Would you purchase the 3rd T-shirt? Yes, again. Your perceived value of about $20 is still greater than the cost of $15. Now what about the 4th T-shirt? Here you are indifferent, at the limitand in two ways. First, the value just equals the cost for the T-shirt. Second, you will have spent precisely all the money you allotted from your budget for the total T-shirt purchase. The action described above is smart economic choice makingthey are decisions made at the margin. What does that mean? You optimized the use of your scarce funds by individually assessing the benefit and the cost, and purchased the most T-shirts possible given their price and your budget. That means for each additional (i.e. marginal) T-shirt you considered its cost compared to its valuemaking sure that the value exceeded the cost, up to the count of T-shirts that used all funds allotted. In the end, you maximized your total net benefit.
In Sum Economics is the study of how society allocates scarce resources among competing options. The economic problem is how to satisfy the material well-being of people in the society. Scarcity means that economic goods have a cost in the form of the value sacrificed to acquire the desired good. Economic resources fall into one of four categories: land (earns rent), labor (earns wages), capital (earns interest) and entrepreneurship (earns profit). Economists believe that theory provides understanding of citizens behavior toward solving societys economic problem. Opportunity cost is the value of the next best option foregone when a more attractive option is chosen. Making trade-offs involves sacrificing some of one good to get more of another good, so that total benefit rises. Economic efficiency means making rational benefit-cost choices in the consumption, production and distribution of goods. An action is economically efficient if a person makes choices where the net benefit (expected additional benefits less the expected additional costs) is positive or rejects choices where the net benefit is negative.
Lesson 2: Goals of Economic Systems

The Economizing Questions In America, with its high standard of living, necessities such as food, clothing, shelter, and even a few luxuries are accessible to most income earners. In 2006, US per capita gross domestic product$44,155ranked 7th highest in the world. While an estimated 14 percent of its own 310 million citizens in 2009 lived below the government-estimated poverty level, forty percent of the worlds 6.5 billion people had a per capita income below $1,000 per year. What explains such dramatic differences in living standards between countries? It is how each nation addresses the three economizing questions whether by default or with purpose. The three economizing questions What goods to produce? How to produce the goods? To whom to distribute the goods? Geography, culture, law, religion, and ideology together shape each countrys response to the three economic questions. Satisfying a peoples economic needs depends on the nations natural physical resources, societal work ethic, population growth rate and technology. Every society adopts a mechanism to address the well-being of its citizens. Precisely how a country addresses the economizing questions reveals much about their views on human nature, the sanctity of the individual versus the state, the ownership of resources and the bases for human motivation. Distinguishing from among those aspects of the social order that are the domain of government and those accorded to the individual is an early step toward defining how and how effectively an economic system will function. To help clarify the different arenas in which government or markets most efficiently address the economizing questions, economists distinguish between private goods, public goods, common resources and natural monopolies using the concepts of rivalry and excludability. Classifying economic goods and the role of markets Private GoodBuyer enjoys the consumption benefits by excluding others from consuming the good while reducing the goods availability. Market solutions work best here. Examples: candy bar, clothes, cell phones. Public GoodOne persons consumption does not diminish the quantity availableno rivalry; and others cannot be excluded from consumption. Markets do not work effectively here. Examples: national defense, roads at non-peak times, education. Common ResourceGoods that can be rival but not excludable. Markets require government oversight or regulation. Examples: clean air, ocean fishing, congested roads. Natural MonopolyGoods that can be excludable but not rival. Markets require government oversight or regulation. Examples: television, fire and police protection.
Comparing Economic Systems An economic system provides mechanisms through which to achieve individual and collective well-being. Fundamentally, leaders must choose between sustaining traditional provisioning methods, centralizing economic decision-making, decentralizing economic decisions via a market mechanism or some mix of these options. The requirements necessary to meet all societys needs, including those labeled economic, are sufficiently complex that debate on which economic system is best requires judgments. Even so, identifying some of the major benefits and trade-offs in each system is possible. Three types of systems to address the economizing questions Traditionhistorical and customary social processes are sustained through law, religion and belief Commandimposed authority guides the system via orders from an economic general Marketsocietal members pursue their own economic well-being via free markets for goods Every economic system provides collective and individual benefits and costs. Traditional economic systems place much emphasis on group hierarchy, communal beliefs and maintaining social customs. Change halts in favor of cultural routine and familiarity. Tradition-based economies solve the economic problem, but at the expense of progress. In a command system, the central authority may own or control the means of production. Central authorities make major economic decisions related to wages, output and distribution of goods. Mandates from the central authority subsume individual choices. Command-based economic systems can be useful in times of war, or for mandated economic change, where direction by a central agent guides resources toward a goal that leaders envision more clearly than individuals can. Human motivation, efficiency, and critical resource supplyfood, clothing, and sheltermight suffer in the pursuit of the central authoritys goals. A market system vests control of economic resources with individuals who pursue their own self-interests for the relatively unintended betterment of all. The cornerstones of market-based exchange include the rights to freedom of choice, private property ownership and the reward of profits as incentives. Those rights support risk taking and self-determination. Yet, the sum of individual choices may not be socially optimal as time passes. A free markets most serious social trade-off is occasional dramatic fluctuations in the level of economic activity. Government, at least in principal, plays a relatively limited role in the private sector. Governments roles in a market system Oversee the economic system so it operates in agreement with and laws and property rights Provide public goods and services such as national defense, public education and public highways Sustain common resource utilization at a socially desirable level
Governments goals in a market system Protect citizens freedom to choose between opportunities Support efficient markets through competitive prices Maintain equity and a sense of fairness in dealings Ensure security and stability to support risk taking There is no compelling evidence that market-based economies naturally evolve from tradition or command systems. Free markets require political support, legal validation, social acceptance and institutional structures. The transformation from traditional economies, like India, or from command economies, such as the former Soviet Union, to a market system can be fraught with uncertainty and social upheaval. An Economys Production Possibilities No matter the chosen economic system, every country addresses the three economizing questions when bringing scarce economic resources into their desired use. No nation, however wealthy, can make economic choices without sacrifices. As the system allocates its scarce resources it must make trade-offs when producing goods to meet societys economic needs. A Production Possibilities Curve shows both the production limits and opportunity costs of resource trade-offs when a society produces two or more goods in a given time period, with fixed current resources and unchanging technology.
Production Possibility Example

In One Day: Ann makes Ben makes Cal makes Widgets 10 6 2 OR OR OR Gadgets 5 6 4
Consider a simple economy with just three people (Ann, Ben and Cal) and two product sectorsWidgets and Gadgetsboth socially useful. To begin, one question is the order of hiring into each sector. For example, who makes gadgets at lowest cost? Since no money values appear in the table above, how can the answer be motivated?
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Should we hire Ann first to make gadgets? No. Hiring Ann first overlooks the economic basis for efficient choice makingopportunity cost. To see how, notice in the table that for every one gadget Ann produces each day, it costs her, and the society, 2 widgets not produced (10 widgets divided by 5 gadgets = 2 widgets lost per gadget made). Instead, can you see why Cal should be hired first to make the first 4 gadgets (where his gadget costs only a widget not made)? Its true. Using this same opportunity cost logic Ben will be hired second, where his opportunity cost of making 1 gadget is 1 widget. Finally, Ann should be the last hire, since her relative gadget-making cost is highest of the three (each of her gadgets costs 2 widgets not made). The same logic applied to making widgets will find the hiring order precisely reversed. How is this so? Look at Ann again, for her 10 widgets made per day, only 5 gadgets are sacrificedso a widget costs just half a gadget in production foregone. That cost is lower than either Cal or Ben in widget making. For Ben each widget made by him costs one gadget, while for Cal each widget costs two gadgets. Notice that when opportunity cost prevails as the criterion to determine the hiring order for either good, the least costly (opportunity cost, again) person is hired first and the most costly person is hired last. More, since society likely wants both widgets and gadgets at least one person will make the opposite good. Should it not be the last person hired in one sector (the most expensive and least efficient) who transfers to the alternate sector, where they can become a more efficient (less costly) maker in the other sector? Yes and their world will be better off for that.
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One more example is valuable. Suppose their economy currently makes 4 gadgets, produced by Cal, with 16 widgets produced by Ben and Annpoint A on the chart. If their society now wants more gadgets, then Ben should move to the gadget sector. For each new gadget Ben now makes, up to 6 per day, the trade-off means one less widget producedlower than Anns opportunity cost. If Ben moved to making only gadgets, the economy would be producing at point B on the chart above. While there is no way to avoid an opportunity cost sacrifice when moving resources between sectors, economic logic assures that the shift of societys resources occurs efficiently. Finally, if any of the three either quits working or chooses to work less, their economy provides fewer widgets or gadgets for all. When that happens, the economy is producing, inefficiently, below its production capability. In Sum Every society must successfully address the three economizing questions: what to produce, how to produce and to whom to distribute the production. Government has a legitimate economic role for producing public goods, and some limited justification for regulating natural monopolies, and overseeing common resources, then sustaining the operation of free markets for private goods. The 3 fundamental types of economic systems to operate an economy are tradition, command and market o Traditionworks by custom and belief to satisfy economic needs at the expense of economic progress. o Commandthe means of production are government-owned and work incentives are limited. This system can lead great economic change through central decision-making but has difficulty efficiently allocating goods. o Marketprivate resource ownership, the pursuit of self-interested objectives, the incentive to retain the net proceeds from work via market exchange provide for efficient output. Occasional, and perhaps dramatic, swings in business activity can occur. Governments goals in a free enterprise economy include maintaining freedom and security, sustaining market efficiency and promoting economic growth and stabilization. Production Possibilities Curve for an economy in the short run shows: o The possible output limits of two or more sectors using existing productive resources in an economy. o The importance of opportunity cost when determining the order of hiring productive resources into each sector. o The opportunity cost trade-off a society must make when moving productive resources from one sector to the other.
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Lesson 3: Wants and SubstitutesDemand

Economics Fundamental Divisions In Western Europe about the thirteenth century the evolution of the guild system could be said to mark the first great division in the formation of marketsthe separation of buyers from sellers. Prior to that time, custom accorded who worked on what and how the fruits of labor were distributed. Since then, economists have puzzled over the power of the market as a mechanism for allocating goods. This separation of buyers (demand) from producers (supply) represents the first and most fundamental division in modern economics. The second, often unstated, division grew from the need to understand how market forces affected the exchange of goods. About the middle of the nineteenth century, economists began formally applying time as an analytical device. Two distinct time-periods emerged, omitting the past, where no new action was possible: a) the present (short run) where all decision-making and actions occur and b) the future (long run) where the consequences of prior decisions and actions manifest. The application of time also underscores the role that price plays in coordinating market decisions. Since action can occur only in the present, knowledge of current price options provides useful information about whether to act now or to wait. Good economic analysis permits only one market force at a time is to operate, so its full logical consequences come into view in cause-and-effect sequence. Useful assessment regarding the impact of all market forces requires that each force be viewed separately, at least at first. Doing so can help clarify a market scene that at first looks hopelessly muddled. This mechanical, timeseparated, one-change-at-a-time technique is the proper means to apply economics to market analysis. So a clear-headed economic thinker inspects a situation drawn from the ordinary business of life; requires that all action stop for a moment; allows only one market force to change; then traces the results of the force on relevant economic measures. This logical stop-action assessment of dynamic market activity helps reveal the consequences of human choice making. Demand and the Search for Substitutes Much of economics can be said to begin with demand. A persons wants transformed into both a willingness and ability to sacrifice one thing to acquire another, elicits productive processes attempting to satisfy those wants. Note that wants and needs are not the same thing in economics, and that wants is the more useful term in demand analysis. The concept of demand relates the amount purchased of a good the buyer wants to the sacrifice suffered to obtain themthe price. Customers choose and make trade-offs, given their preferences and knowledge of available substitutes compared to the current offer price. They then choose the option at the moment believed to most improve their current position.
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Demandthe quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other market forces held constant. The definition of demand implies that potential buyers assess the prospective benefits from consuming a good compared to what it will cost. This statement is only half-right. Good economic decision-making always poses pairs of options. The first option is the offer immediately at hand. The second option is the next best offer known to be available, given its price and perceived benefits. By choosing one, the consumer sacrifices the other on the expectation that the benefits-to-cost assessment for the chosen option will deliver greater net satisfaction. How is it that the definition for demand presumes a range of prices for a given good? In any particular store, most American shoppers see only one price. Here, the economist makes two more mental assumptions: other vendors prices for the same or similar good are known, at little cost, and travel in the market place is free and fast. These useful assumptions let the buyer efficiently select the product from a potentially wide array of vendors and range of prices then available.
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Does the assumption of no time and search costs have the ring of reality? In very many cases, it does. How often do you shop using coupons and select one store over another as a result? For items with a larger price tag, how often do you shop several sources by phone or catalogue or compare prices to those posted on the Internet? Law of Demandthe inverse (or opposite in direction) relationship between current price and the quantity demanded of a good. That ordinary demand curves slope downward and to the right, as stated by the law of demand, economists fully accept. In steps, as the current price goes up, the quantity demanded falls. As the current price goes down, the quantity demanded rises. Why? First, let us establish that the demand schedule reflects the maximum price buyers are willing and able to pay for a given quantity of a good. Certainly, budget-conscious consumers would willingly pay less. The downward to the right shape for demand curves reflects the diminished benefit to the buyer from presently consuming additional units of the same good. As an example, ask yourself how many individual small boxes of popcorn you might eat during a long movie. Once you consume the first box of popcorn, if you still want another, is the anticipated value of the second box as high as for the first box? Likely it is not. You willingly purchase the second box of popcorn only if the perceived, though falling, value remains greater than its cost to you. So, the maximum price the buyer is willing to pay now for a good falls as consumption of it increases. In summary, smart consumers willingly pay a price for a good no higher than the limit of its perceived value, given known substitutesand hopefully less. The value of additional units consumed during a short time period usually diminishes with additional consumption by the buyer. A lower value per unit means that the consumer is willing to buy more units of the good only at a lower price. That is why demand curves slope downward. Buyer Responses to Price Changes The law of demand states that the current price of a good and the quantity demanded move in opposite directions. The reason is that each unit of the good consumed in a short period reduces the next units value to the consumer. Two rather subtle economic effects motivate this response. Income Effect-If a certain number of dollars are allotted to making a purchase, when the unit price for the good rises (or falls), the quantity of the good the consumer can willingly afford falls (or rises). Substitution EffectAs the unit price of a good rises (or falls), the consumer substitutes away from (or toward) the good. Consistent with the definition of demand, a range of prices usually prevails at any given moment in the marketplace. If the price is relatively high, a lesser quantity of the good is purchased. If the price is relatively low, a greater quantity of the good is purchased. So a change in current price is a movement along the given goods demand curve. To emphasize, the demand curve for a named
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good, in the short run, will not move or shift due to a change in its current price. Knowledge of current price merely helps the consumer efficiently allot scarce income among currently desired goods by adjusting the amounts purchased in response to known substitutes. So consumers respond to changes in the current price of a good. When the unit price changes, sometimes the change in the quantity purchased is small, sometimes it is large. What accounts for this variation in the size of buyer response to a price change? Price Elasticity of Demanda measure of the relative change in quantity demanded in response from a change in current price. A goods demand is said to be elastic (relatively responsive to changes in current price) when a small change in price brings about a relatively large change in the quantity of the good demanded. A goods demand is said to be inelastic (relatively unresponsive to changes in current price) when a large change in price brings about a relatively small change in the quantity of the good demanded. What is it that makes the quantity change to price change response occur? It is the buyers knowledge of substitutes for the desired good. The consumer best knows what she wants. The consumer knows what she is willing to substitute in place of precisely what she wants. The closer perceived substitute products are to the current good, the more responsive (more elastic) will be the quantity demanded change to a change in its current priceand the opposite is also true. When there are few close substitutes; demand will be less responsive (less elastic) to price. Determinants of buyer responsiveness to current price changes Closeness of perceived and known substitutes: more substitutes means more elastic demand; fewer substitutes means less elastic demand Goods price as a portion of buyers income: larger price means more elastic demand; smaller price means less elastic demand Timea longer time period allows more substitutes to be discovered for a more elastic demand The more expensive the goods purchase as a proportion of income, the greater will be the buyers response to current price changes. For example, a large increase in the price of salt will bring about a much smaller reduction in the quantity of salt demanded than will a large increase in new automobile prices in reduced car sales. Finally, as time passes, the more elastic the demand for a good tends to becomebecause more substitutes can be identified.
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Demand Responses to Non-price Changes Demand analysis for an individual buyer and demand analysis for an entire market of buyers are quite similar. This is true because a markets demand is the sum of the amounts demanded at every price by all buyers in the market. While the behavior of a single individual in the market may vary in magnitude from other buyers, the market demand curve still slopes downward and to the right. The definition of demand contains a phrase that reads all other market forces held constant. We have seen above that when time is artificially constrained, price changes bring about a change in the quantity demanded, noted by reading along a fixed-in-place demand curve. As you likely have suspected, other forces are at work in the market.
Inspect the chart above. Choose a price on the vertical axis, say $10, then read horizontally across to the right edge of the bright blue demand graph and read the quantity demanded; 30 units. If demand INcreased from that point and shifted rightward (like the green arrow) to the outer edge of the lighter blue graph, the number of units demanded at the original price would be larger, nearly 40 units. That is an increase in demand, current price held constant. Again, select a price on the axis, say $40, then move horizontally across to locate the outer edge of the light blue demand graph and read the quantity demanded; about 20 units. If demand DEcreased from that point by shifting leftward (like the red arrow) to the edge of the bright blue graph, the number of units at the original price would be smaller, about 15 units. That is a decrease in demand.
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As time passes, market forces other than price affect the entire level of demand. These non-price forces cause the demand curve to shiftwith NO change in current price. So a change in demand means that, at any price, a different quantity of the goodgreater or lesser than beforeis desired. This important distinctionbetween changes in quantity demanded due to changes in the current price of the good, a movement ALONG the demand curve versus SHIFTS in demandcaused by market forces other than current price, lets the careful economic thinker correctly understand market dynamics. Economists organize the forces that move or shift market demand, prices constant, into categories called determinants or shift factors. Demand determinants: factors that shift the demand curve (with no change in price) Number of buyersif buyer count rises, demand rises and the opposite is true Buyer tastesif buyers desire more, demand rises and the opposite is true Buyer incomesif buyer incomes rise, demand rises and the opposite is true (for normal goods) Future price expectationsif future price is expected to fall, current demand falls, and the opposite is true Related goods price: o Complementsif a complements price rises, demand for original good falls and the opposite is true (example: if the price of printer ink rises, the total demand for printers may fall) o Substitutesif a substitutes price rises, demand for original good rises, and the opposite is true (example: if the price of movie house tickets rises, the total demand for NetFlicks kiosk movies may rise) How to Analyze the Effect of Determinants on Demand From the facts, determine which demand determinant is operating Determine the direction of the determinants force: increasing or decreasing From the determinants direction and knowledge of economic incentives, deduce the direction of change for the demand curve: increase (rightward shift) or decrease (leftward shift) In Sum The two fundamental divisions in economics are: o The separation of buyers (demand) from sellers (supply). o TimeShort run, where quantity demanded responds to current price. Long run, where other market forces shift demand. Buyers seek substitutes and make trade-offs to acquire goods they want because their income is limited. Economic choice making selects between pairs of options: the chosen option and the next best one sacrificed. Demandthe quantity of a good that buyers are willing and able to purchase at a range of current prices, other forces constant.
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Law of DemandThe inverse (or opposite in direction) relationship between current price and the quantity demanded. Demand curves slope down and to the right due to the: o Income effect where price changes affect buyers purchasing power, and o Substitution effect where buyers move toward less expensive substitutes and away from more expensive substitutes Current price changes for a good bring about changes in the current quantity demanded, as read along a given demand curve. Price Elasticity of Demandmeasures of consumers relative quantity response to a relative change in current price. Three main determinants of demand elasticity are: o Closeness and availability of perceived and known substitutes o Passage of time allowing for more substitutes o Goods price as a percent of buyers income Non-price market determinants shift the demand curve, over time, reflecting changes in quantity demanded at all prices o Increase in demand is a rightward shift of the demand curve in price quantity space o Decrease in demand is a leftward shift of the demand curve in price quantity space Non-price market forces that shift the demand schedule, current price held constant, include: o Number of buyers: more buyers in the market increase the demand (shift to the right) and the opposite is true o Buyer tastes: customers liking more of the good increase the demand (shift to the right) and the opposite is true o Buyer incomes: higher income increases demand for normal goods (shift to the right) and the opposite is true o Future price expectations If consumers expect future prices to rise, they buy more of the good now, increasing demand (shift to the right). If consumers expect future prices to fall, they will buy less of the good now, decreasing demand (shift to the left). o Price of related goods: Complementsif the price rises for a good that complements the original good, the demand for the original good falls (and the opposite is true). Substitutesif the price rises for a good that is a substitute for the original good, the demand for the original good rises (and the opposite is true).
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Lesson 4: Production Costs and the Division of Labor

Resources and the Pursuit of Profit In business, a branch of applied microeconomics, the motivation for risk taking is the chance to earn profit. That is why entrepreneurs seek their fortune by using others resources to achieve a chosen business goal, like making a profit. For the economist, profit plays a particular role and has a specific meaning. Profit is a residualwhat is left after paying opportunity costs of production from revenue received by selling the good. In simple equation form: Profit equals total revenues less total costs. To the economist, normal profit is part of total cost because it is sufficient to keep the entrepreneur working for the particular enterprise. Successful entrepreneurs are able to spot gaps in the current market place and move to take advantage of them before they are exploited by others. When net revenue to the enterprise exceeds the necessary minimum profit, it represents a payoff earned by bearing risk in an uncertain environment and flows to the entrepreneurits rightful claimant. Diminishing Returns and Marginal Cost in the Short Run The moment the entrepreneur moves from mental commitment to action on a business proposition, formerly estimated paper costs become real. The entrepreneur is the only economic actor with an incentive to take into account all relevant costs. So controlling costs is very important. The more competitive the market the less control management has over setting price, so cost containment assumes a key role in most business operations. Short runthe time-period during a production cycle, where variable (avoidable) costs are incurred (e.g. wages, materials) and some costs not directly related to the rate of production are fixed (e.g. rent, utilities, insurance). Even though companies wish to earn a profit in every reporting period, it is not always possible. At times, management must deal with short-term losses. During a production cycle, only avoidable production coststhose that will change with higher or lower rates of output, are relevant. Costs already paid that cannot be alteredsunk costsare not relevant for operating decisions. Why? Because they provide no opportunity for choiceand should not enter into calculations to determine if making more of the product would be profitable on the margin. When pricing a given production run, only two questions are relevant: 1) are operations at the capacity limit (if so, a full cost price is warranted) or not and 2) if not, the price must at least cover the costs that actually change when producing an additional amount of outputthe marginal cost. The costs that vary in the short run comprise the minimum cost necessary to produce. Economists label those marginal coststhe costs that change as the level of output changes.
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Production cost categories Avoidable or variable (opportunity) costschange directly with production levels Fixed operating costscosts invariant to production levels Sunk costscosts not recoverable during the production period Total coststhe sum of fixed and avoidable production costs Marginal costthe cost of producing one more unit of the product Every fixed-in-size production operation has an output capacity limit. As the production level nears that capacity limit, per unit costs of the output will begin to rise. This natural phenomenon, the increase in per unit avoidable costs occurs because of a non-economic law, the law of diminishing returns. Law of diminishing marginal returnswhen at least one factor input, plant capacity, is fixed, the additional output produced from additions to labor will eventually decrease as more labor is added. The consequence of diminishing returns to labor in the short run is that variable costs per unit rise. Why? It takes increasingly more labor effort per time to compensate for the diminishing output per labor hour. So in the short run, labor cost per unit of output increasesan important marginal cost. Notice that during a production run it is variable costs, such as labor and materials, which must be covered. Fixed costs, which are sunk, at least during the production period, leave no opportunity for choice and need not be considered at the moment, though they eventually must be paid to preserve the ability to operate. What happens to product produced that does not sell as expected? The business runs a sale. The interesting economic dilemma is what price to set for the leftover inventory. Given that production, distribution and set-up costs have already been incurred for the unsold product, what costs are relevant and what price should be charged? Only current (new) opportunity costs are relevant and any price above zero just might do. How can this be? All prior costs not recoverable during the production period are sunk. Any cash flow generated from the inventory liquidation is of some benefit. There is even a case to be made for giving the inventory away, if it is preventing new merchandise from taking up valuable floor space and spoiling new sales. Each situation must be assessed in its own factual context. Do not be misled into thinking some earlier lost profit margin must still be considered. That, too, is a cost sunk by foiled market expectations. Economic goods can never sell for more than the buyers perceived value. Relevant costs are those incurred in a chosen action. Once the action has occurred, spent costs become sunk and unrecoverable. The only remaining decision is what price to set for the now excess goods.
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Derived Demand for Factor Inputs The business owner seeks and allocates productive resourcesfactors of production: land, labor and capitalbecause she needs them to meet the demand for the good or service offered by the business. Efficiency dictates that a match of capabilities be achieved using the productive resource inputsphysical with human capitalat the least possible cost. The owner must determine both the skill mix and number of people to hire. The prevailing market wage for the type of labor skills sought provides a good measure for labor costs. The market wage rate multiplied by the number of positions required per production cycle (time) determines the total wage cost for the firm. Crucially it is product demandthe number of units demanded per time multiplied by the market pricethat provides the ability to pay for the labor services. That is why economists call the demand for factor resources a derived demand. Derived demandthe relationship between the resource factor's price and quantity wanted by firms directly depends on market demand for the final product(s) the factor helps produce. So how many input units of each type will be hired? The economists rule is to hire input factors until the cost of the last unit acquired or last hour workedthe wage rate times the last factor input hired or last hour workedjust equals the value of its production product price times the additional output units produced. Yet another marginal efficiency rule that helps generate profits by keeping variable costs low.
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How Firms Grow in the Long Run As demand for the companys product increases and sales revenue grows, so does the need to hire additional resources. As the market for the product expands, requiring more jobs and equipment to produce the enhanced volume, jobs and tasks become more specialized. The profit motive and economic efficiency accommodate the specialization process as the expanding sales volume enables it. The entrepreneur must decide to expand or contract the level of factor inputs employed as demand for the product rises or falls, given current capacity. If sales volume continues to expand, the owner eventually faces the decision of whether or not to increase the size of the production facility. In the long run there can be no sunk costs. All costs, in a planning process are variable because projections are always fluid. Through time, the larger and more sustained the demand for the good, the larger the enterprise may be willing to grow. Long runa time-period long enough to make changes in the scale of production and where all costs are variable. All costs must be paid or the business enterprise has insufficient resources to continue and leaves the industry. Most successful large enterprises look 1 to 10 years ahead, predict the markets character then plan how to meet the anticipated demand. They spawn new product development and define new strategies to guide organizational shifts. The two basic dimensions always within a strategy are working to: 1) expand demand and 2) reduce operating costs within the evolving scale of the operating plant. An increasing industry product demand forces firm management to grow or it will lose relative market share to other sellers as competitors expand their own plants to meet the rising industry sales. Firms can grow internally, driven by product market expansion, or externally, driven by merger and acquisition. Three notable long run cost reducing effects work to lower long run costs as capacity expands. Economic reasons why long run production costs fall Economies of Scalea reduction in the average cost of per unit output as the firm increases its size (scale) achieved through enhanced market purchasing power, lower per unit overhead and engineering efficiencies Economies of Scopelower per unit costs from producing two goods in-house than producing them separately through outsourcing Learning Curve Effectsthe reduction in total production costs from improvements learned across many production cycles
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Once the entrepreneur establishes the worthiness of a product or idea, the challenge is to sustain the advantage. In the absence of market barriers, success attracts many copycats and intensifies competition. Profit maximizing firms can pursue legal protections such as patents, trademarks, copyrights and trade secrets to protect their product from rivals. Where legal protections are not possible, savvy entrepreneurs pursue strategies like branding, specialized product design and selective integration to sustain their competitive advantage. Advertising, technology investment and even appeals for outright government protection can be creatively adapted to sustain or grow a firms market share. In Sum Entrepreneurs seek and earn profit by taking advantage of gaps in the market before others exploit them. Profit is the return for successful risk-taking in an uncertain business environment. o Profit = total revenue less total cost o Profit is the residual after paying all resources their opportunity cost, including a normal profit to the entrepreneur. Before entering a business, all costs are variable costs. Once a business has begun, costs must be divided into: o Variable or avoidable costs as opportunity costthose that vary with production levels. o Fixed operating costsexpenses not related to production levels o Sunk costsnon-recoverable costs that leave no opportunity for choice, and exist only in the short run. o Marginal costthe opportunity cost of producing an additional unit of output. During a production cycle, any unit of output that yields revenue above opportunity cost will add to net profit and should be produced. Sunk costs in the short run should never enter the calculation to determine if a unit of output should be made. Law of diminishing returnswhen at least one factor input, plant capacity, is fixed, the additional output produced from additions to labor will eventually decrease as more labor is added. This law represents one reason why production costs rise in the short run. The demand for factor inputs is a derived demand. The demand for the good to be sold generates the indirect demand to hire the resources to make the good. Successful firms grow as demand for the good expands. In the long run the firm is able to take advantage of size through: o Economies of Scale a fall in the average cost per unit of output as the firm increases its size (scale) due to enhanced market purchasing power, lower per unit overhead and engineering efficiencies. o Economies of Scope where it is less expensive per unit to produce two goods in-house than to produce them separately by outsourcing one of them. o Learning Curve Effects a reduction in total costs due to production improvements learned across several cycles.
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Lesson 5: Opportunity Cost and ChoiceSupply

Cost as Value There can be no choice made without a sacrificea cost. By selecting one purchase option over another or one job opportunity over another, the person making the choice implicitly reveals their preference and their values. This view reflects the fundamental idea that all costs in economics are opportunity costs. Opportunity cost-the value of the next best option foregone when making a choice. The Sellers Dilemma Decisions made and actions taken today always are based on expectations about the future. Sellers assume some risk when producing what they believe buyers will purchase ahead of the actual sales transaction. The sales price, at least by expectation, must be sufficient to cover all the costs of production and sellingopportunity costs. So what is it that makes a business proposition sufficiently attractive for a potential seller to undertake? The quick response in a market system is the reward of profit. But that response leaves out too much economic detail. To price a good or service, the producer first assesses the competition (the buyers options) then figures the sales volume per time to derive the total (opportunity) cost of the required resources. If that cost is equal to or below the price a particular buyer is willing to pay, then production can be fruitful for the seller. If the negotiated price less the estimated opportunity costs for the required economic resources is both positive and greater than the next best use of the sellers time, the proposition should be profitable. Prior to taking action or making a decision, all costs are anticipatory or avoidable, because they have not been incurred. That is the sellers decision point. Once the decision is made to proceed with the one option (and forsaking the next best option)perhaps by taking out a loan, acquiring assets or contracting for labor, the prior estimated costs become real. This fundamental economic logic reduces to the relationship below. Economic Decision Making-Choose the option where the expected additional benefit to additional cost ratio is greater than that same ratio for the next best choice.
Additional Revenue Option A Additional Cost Option A
< ? > Additional Revenue Option B Additional Cost Option B
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Profit is the reward for successfully operating a business in an uncertain market environment. The economists logic to maximize profits suggests that competitive sellers produce up to the point where market price covers all opportunity costs of production, which includes sufficient profit to retain the seller-entrepreneur in that line of work. If market price rises, a supplier operating at less than full capacity would willingly increase production, as long as the increased per unit cost is less than the new market price. Doing so adds to net profit. That is why market supply curves generally rise up and to the right, as the next section reveals.
Producer Choices and Supply Demand from buyers elicits supply from producers. And supplying a product is feasible when the buyers maximum willing purchase price exceeds the sellers minimum willing offer price. Each firms production cost is a competitive factor so much effort is spent keeping opportunity costs of production low. A seller who offers output below its opportunity cost is not being rational, because the revenue would be insufficient to pay the total opportunity costs of production. Production cost differences exist between sellers, even for a similar product. So goods produced for market get offered at a range of prices, each price covering the respective firms anticipated opportunity cost.
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Supplythe quantity of a good sellers are willing and able to offer at a range of prices, all other market forces held constant. Law of SupplySellers will produce more of a product at a higher expected price than at a lower expected price. Price and quantity supplied move in the same direction along a given supply schedule. An individual supply curve usually slopes upward and to the right in the short run because the opportunity cost of production rises as the output level nears the firms output capacity. The sum of quantities offered for sale by all sellers at each potential market price comprises the market supply curve. Short run supply curves for the entire market usually slope upward and to the right, reflecting increases in short run opportunity costs of production for all sellers. How is this so? Economists presume that with freely flowing market information, sellers enter the production stream only when market price is expected to at least cover additional production costs. Since not every seller has the same opportunity cost of production they tend to enter the market with their production in the order of their (rising) costs. The chemical industry is a good example of this tendency to produce at market price thresholds. When market prices are low, chemical production is slowed or plants are temporarily idled. As market prices rise, plant managers re-start select facilities to generate new product within desired cost ranges. Seller Responses to Price Changes In a short time period there is no chance to alter the firms productive capacity. Such decisions require more time and certainty about sustainable future market prices and the expected volume of output to justify undertaking the capital expansion. Yet suppliers in some markets can respond more swiftly to market price changesoffer a greater outputthan can suppliers in other markets. Why? Price elasticity of supplyA measure of the relative change in producer output compared to the change in selling price. The prime determinant of supply elasticity is the ability of the firm to re-direct human and physical resources so they produce more or less product during a production run. As an example, it is relatively simple for a local retail pizza producer to add or subtract workers from a work schedule so that the pizza supply can be responsive to changes in price, like a sale price on a Saturday evening. Many other industries, such as petroleum refining and automobile manufacturing have narrow production windows. These highly specialized processes often are capital intensive and their output cannot be cost-effectively altered. A products supply is said to be elastic when a small change in price brings about a large change in quantity of the good supplied. A products supply is said to be inelastic when a large change in price brings about a small change in quantity of the product supplied. The most important determinant of supply elasticity is time. As time passes, firms can more easily commit to transforming their workers and machinery to different production rates.
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Supply Responses to Non-price Changes Supply analysis for an individual producer and supply analysis for an entire market of producers are similar. This is true because a markets supply is the sum of units supplied, at each and every price, by the sellers in the market. While the behavior or response of a particular seller in a market may occasionally vary from that of all sellers as a group, the total market supply curve commonly slopes upward and to the right. Recall that the last phrase in the definition of supply is all other market forces held constant. What is the meaning and importance of this phrase? You have seen when time is artificially held still, that price changes bring about a change in the quantity supplied, noted by reading along a fixed-in-place supply curve for the short run. Just as you suspected in the lesson on demand, forces other than price also are at work in the supplier market.
Inspect the chart above. Choose a price on the vertical axis, say $40. Then read the quantity supplied at the left edge of the yellow supply line. It is about 50 units. If supply increased, by shifting to the right, to become the blue supply line, the number of units supplied at the same price of $40 would be about 55 units. Thats an increase in supply, at the same price. Had we begun with the blue supply line at the price of $40, a movement back to the yellow supply line would have represented a decrease in supply. Forces that increase supply shift the curve to the right. Forces that decrease supply shift the curve to the left. Economists categorize the forces that move or shift market supply. As non-price market forces influence sellers, the actual supply curve position changes through time. Non-price forces on supply are factors that cause a change in supplya shift of the supply curvewithout a change in
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the current price for the product. A change in supply means that, at any and all prices, a different quantitygreater or lesser than beforeof the good will be supplied. The reason for the emphasis on the difference between changes in quantity supplied brought about by changes in the current price of the good versus shifts in supply caused by other market forces is the same as for the demand discussion and bears repeating. This distinction, the time-based separation of price from other market forces, lets the careful thinker correctly understand how the supply side of the market works. The supply determinants and the logic for how to determine the direction of their influence on the supply schedule appear below. Supply determinants: factors that shift the supply curve (with no change in price) Number of sellersas the count of sellers rises, the supply increases (and the opposite is true) Technologyas technology is adopted, the supply increases (and does not decrease) Future price expectationsif future market price is expected to rise, current supply falls (and the opposite is true) Input costsif the costs of material and labor rise, the supply decreases (and the opposite is true) How to Analyze the Effect of Determinants on Supply Step 1: From the facts provided, determine which supply force is affected Step 2: Determine the direction of the force itself: increase or decrease Step 3: From the direction of the force and knowledge of economic incentives, determine the direction of change for the supply curve: increase (rightward shift) or decrease (leftward shift)
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In Sum Cost means the opportunity costs of resources in use, reflected by the owner-made choices of each economic resource. Opportunity cost is the value of the next best option foregone. A seller-entrepreneur decides if an opportunity is a good business proposition by: o Assessing expected net profits from a venture o Comparing the first options net benefits to the next best alternative Business ownerssellersmust pay a resource opportunity cost to attract them into a particular use. Revenue left after paying resources their opportunity costs becomes profit for the entrepreneur-seller. Supplythe quantity of a good that sellers are willing and able to offer at a range of current pricesother market forces constant Law of Supplysellers will produce more of a product for sale at a higher current price than at a lower current price. Price elasticity of supplyA measure of proportionate producer output response to a relative change in current price. o The main determinant of supply elasticity is time and the ability to direct resources to different uses Non-price market forces shift the supply curve, as time passes, to reflect changes in the quantity supplied at all prices. o Increase in supply is a rightward shift of the curve; o Decrease in supply is a leftward shift of the curve; Number of sellersas the count of sellers rises/falls, the supply increases/decreases Technologyas technology is integrated, the supply increases Future price expectationsif future market price is expected to rise/fall, current supply falls/rises Input costsif the costs of material and labor rise/fall, the supply decreases/increases
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Lesson 6: How Markets Coordinate Exchange

Exchange Creates Wealth People trade because when they do, the wealth of both buyer and seller increases. Some regard that statement skeptically because trade carries a poor connotation. Should trade between two people not be an exchange of equals? Some people are wedded to the idea that only material things like property, cars, or gold constitute wealth. Neither sentiment is correct to an economist. Wealth gets confused with material well-beingas opposed to perceived value, the preferred and far more useful economic idea. Consider that no object is wealth unless someone values it. An objects value is entirely subjective, and it depends solely on the willingness of admirers to sacrifice something to acquire it. Once that idea about value is accepted, it becomes clear that exchange occurs when there is a tradable difference in a goods valueproviding an increase in wealth to each party in the transaction. Information also is a good that has value. Because economic actions are undertaken based on expectations about the future and the future is never certain. A used car purchase, for example, may look superficially worthy. Once acquired, latent defects could surface to reduce or destroy the value anticipated by the buyer prior to the exchange. Buyer and seller possess unequal amounts of information, and the seller often holds the favored position. Acquiring additional information has an economic value as well as a cost. This difference in information between buyer and seller may affect negotiating power and the outcome of the exchange. Market Price as a Signal Much like the two cutting blades on a pair of scissors, price in the market place is determined by the interplay between supply and demand. Market actorsbuyers and sellerscan efficiently exchange private goods because market price serves as a signal, telling those wanting the good the size of the sacrificeopportunity costothers have paid to acquire it. A market exists anywhere a transaction between buyer and seller occurs. Free and competitive markets efficiently allocate goods and services through an anonymously determined market price reflecting substitutes available to buyers and the expectations of sellers, at a particular moment. Market equilibrium price works as a beacon, coordinating the choices of buyer and seller by providing at least one measure of a goods current worththe markets value. That value turns away those buyers seeking less expensive options and those sellers whose production costs are too high, while attracting others who may be more able to find a favorable price for the exchange. The more open, competitive and informed the markets bargaining processes, the more efficient is the allocation of relatively scarce private goods. In economics, efficiency implies several things. Most fundamentally, it means that goods are sold at a price equal to opportunity cost. Efficiency also means that goods flow to their most highly valued use.
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The lower the transaction costscosts of arranging transactions between buyer and sellerthe more efficient is the market. The clearer and more accepted the property rightswhat belongs to whom under what circumstancesthe more efficient is the market. You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics. Choices and Trade-offs at the Margin To the untrained eye, market processes can appear chaotic and directionless. Using economics fundamental division, buyers versus sellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, market demand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5 units.
To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve and the solid red lower range of the supply curve up to their intersection. Why is this so? The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that price or more.
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The intersection of the demand and supply schedules reveals the market equilibrium price, where the quantity demanded just equals the quantity supplied. While competitive market exchanges tend toward an equilibrating price that will clear the market of goods, not all prices negotiated between buyers and sellers will be at the equilibrium amount. Any transaction completed in the reddish-silver triangular area will be for a price no higher than some buyers maximum value and no lower than some suppliers minimum cost. Higher equilibrium prices indicate that sellers held the stronger bargaining position and lower equilibrium prices indicate that buyers held the stronger position in the market. Now look once more at the point of equilibrium in the graphwhere the demand and supply curves meet. At that point it can be said that the price of the good reflects the opportunity value of the last purchaser and, at the same instant, the opportunity cost of the last seller in that market. Someone did purchase the 5th unit of the good at the equilibrium price. For that buyer the sacrifice was just worth the exchange. Also as clearly, some producer sold the good at the market equilibrium price. For that producer the sale just covered all production opportunity costsincluding a minimum profit. For all units of the good sold at that particular equilibrium, and at that time, market value just equaled the opportunity cost value to the last buyer and to the last seller. Other buyers in the market place held different and higher values for the good. Other sellers in the market place held different and lower opportunity costs of production for the good. Some buyers could have paid less than market equilibrium price and reaped the extra value. Some sellers could have sold for more than market equilibrium price and reaped the extra profits. Equilibrium Responses to Non-price Changes So far this discussion has focused on the short run time period where current market price reflects the quantity demanded and the quantity supplied. What happens to equilibrium price when non-price market forces cause demand or supply to shift? Three steps to assess equilibrium effects of market change Determine if the force affects the demand or the supply curve Decide the direction the curve shiftsincrease (rightward) or decrease (leftward) Note the change in equilibrium price and quantity from the original demand and supply curve intersection to the resulting demand and supply equilibrium. From the facts given in a situation, the first step means to determine if the market force pertains to buyersthe demand side, or to producersthe supply side. Next, reason through which particular force is at work for that side of the market, then note its direction. Shift the demand or supply curve in the appropriate directionincreases to the right or decreases to the left. Finally, compared to the original equilibrium price and quantity, note the position of the new equilibrium price and quantity.
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Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green) together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market equilibrium priceand why? Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices. That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B. Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A. Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units are demanded at each price) labeled B. The green supply has decreased to the now lower supply (fewer units are supplied at each price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine the effect on the resulting equilibrium price and quantity in the market.
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In Sum Trade creates wealth because both parties perceive a gain in a voluntary exchange. An economic good provides wealth only to someone who values it. A market exists anywhere an exchange transaction occurs. The forces of supply and demand working together efficiently determine market equilibrium price when: o Competitive markets tend toward an equilibrium priceone that clears the market, and o Many buyers and sellers exist to bargain freely when market information and mobility costs are low o Property rightswhat belongs to whom under what conditions are known and respected o Transactions coststhe costs of completing a transaction are low Efficient markets in economics means: o Goods are produced at their opportunity cost and exchanged for their perceived value o Goods flow to their highest valued use o Market exchanges occur when the buyers maximum willing price exceeds the sellers minimum offer price. o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal. Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from a given demand and supply intersection with a given equilibrium price and quantity, the following are true: o Increased demand (supply constant)a rightward shift, increases both equilibrium price and quantity. o Decreased demand (supply constant)a leftward shift, decreases both equilibrium price and quantity. o Increased supply (demand constant)a rightward shift, decreases equilibrium price and increases equilibrium quantity. o Decreased supply (demand constant)a leftward shift, increases equilibrium price and decreases equilibrium quantity. o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium price and quantity can rise, fall or stay the same.
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Lesson 7: Competition, Market Power and Economic Efficiency

Market Power and the Structure of Industry The economics of industry is about market powerthe power to set product price, gain market share and improve profits. The study of economic welfare, where the social goal is to efficiently solve the economic problem for all citizensprefers competitive markets above all others. For it is only purely competitive producers, due to their individual powerlessness to affect price, that offer society the most output at no more than the opportunity cost to produce it as firms pursue profit maximization. In stark contrast, monopolistic markets permit the ruling firm to restrict output and raise the price for their production as they search for the price, above opportunity cost, that maximizes their profit. Between the polar market structures of competition and monopoly lie two others: monopolistic competitiona blend of competitive extremes; and oligopolya peculiarly postured industry where a few large firms strategically spar for market share in game-like fashion. Competitions Efficiency Promise Perfect competition is a fiction, though a highly useful one. It serves as an ideal against which to compare diversions from the economically desirable position of maximum efficiency and output. Much of competitions value rests in its ability to show just how far from the ideal other market solutions may lie. Many public policies also can be judged against their progress toward reaching selected competitive criteria. Since perfect competition resides only in the economists mind, what does it look like and what is its logic? The industry characteristics that create this idealized market structure include the following: very many buyers and sellers; identical products; costless entry into and exit from the market; perfect market information and costless market mobility. These characteristics combine to form a market where no one actorbuyer or selleror small group of actors can influence market equilibrium results. Competitors have no price-setting power. The market for selling and buying corn comes close to these requirements. Fast, faceless and efficient exchanges work through market demand and supply to achieve an equilibrium price that clears the market. So powerless is each competitive seller to affect market price that they can only accept the established equilibrium price as the per unit revenue they will receive for selling their product. Effectively, their demand curve is horizontal (completely elastic). The result is that the only decision a producer needs to make for a current cycle is to choose the level of production.
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Inspect the chart above, and notice that equilibrium market price equals $20any sellers revenue per unit. Further note that opportunity cost rises as production increases. In this situation, a rational seller will gladly produce up to 4 units per period for sale. Why? Each unit of output up to the 4th unit sells at a price above its opportunity cost and adds to profit. To produce beyond that point, say the 5th unit is not rational because its cost ($25) is greater than the market equilibrium price received ($20) and lowers profit. So the optimum output rate, the one that will generate the most profit, if profits are being made, is 4 units. How could it be that the seller might not be making a profit if each unit sells for more than its opportunity cost? In the chart above, the amount of overhead cost was not provided. Once known, short run profit determination can be made. Profit maximizing ruleoperating at the level of output where market price equals marginal cost will either maximize profits or minimize losses, if they are incurred. The competitors rule is to produce at the level of output where price equals marginal cost, the opportunity cost of production. By doing so, any profits will be maximized or any losses will be minimized. This extreme competitive pressure guarantees private goods brought to market will sell for a price equal to marginal costthe opportunity cost. Further, there will be more product available at that price than would be available through any other market structure. These results reflect competitions efficiency promise for private goods in the short run. In the long run the efficient firms best able to sustain profits by controlling cost can survive and grow.
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Monopolys Efficiency Failure At the opposite end of the competitive spectrum lies monopoly, a market possessing only one seller but many buyers. Monopoly represents one of four cases of efficiency failure in economic analysis, where failure means an inefficient allocation of goods in comparison to competition. A monopoly may achieve its market power position by taking advantage of large economies of scale, growing so large that no other firms can effectively compete on cost. A monopoly also may be granted by regulatory authority, as with a patent, legally prohibiting other rivals. Finally, a monopolist can be the sole owner of a natural resource, like a water company. No matter the genesis of a monopoly, economists detest its effects on economic welfare. Because the monopolist faces the downward sloping demand for the entire market, two important observations can be made. One, there are no close substitutes available to the monopolists product, so the firm has significant price setting power. Two, market entry barriers are prohibitively high. The only way for another firm to enter the market is to slay the existing monopolist. A monopolist incurs opportunity costs to produce its output, just like a competitive firm does, though it is under less pressure to control those costs. It also has the same business objective as a competitive firm: maximize profits. To achieve that objective, the monopolist does something the competitor cannotchange price. The monopolist also knows that additional sales can only occur through a price drop. So what makes monopoly behavior loathsome in the economists mind? Compared to competition, a monopolists price-setting power enables it to search out the price that maximizes profits. That price is higher than marginal cost and achieved due to a restriction in output. How does this happen? Like a competitor, a monopolist will produce additional units of output only as long as the additional revenue exceeds the additional cost of each unit. The culprit is the monopolists down-sloping demand curve, allowing it price searching power to maximize profits as buyers have no or very few close substitutes. In the lower (and inelastic) half of a monopolists demand curve, price increases generate rising additional revenue so total revenue also rises. Inevitably, the monopolists profit maximizing price search stops short of the output level a competitor firm would attain. Finally, the quantity demanded at that output allows the firm to charge a price above the opportunity cost of production. In response, and in fairness, the monopolists management would claim that they are pursuing the same rational economic goal as competitor firms, acting on behalf of their stockholders. Their statement would be true but at the cost of reduced economic welfare fewer units available for purchase sold at a price above opportunity cost. This reality is one of the key justifications for government regulation of some monopolized markets.
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When a Few Firms Dominate the Market Moving away from the monopoly end of the competitive continuum, we find a structure where several firms compete for many buyers. US industries where competition is highly concentrated in the hands of relatively few firms include airlines, steel, petroleum refining, and automobiles. These rivalry-intense industries, dominated by a few large firms, employ competitive strategies directly related to the similarity of their products. Entering and exiting the industry is sufficiently expensive that a firms threat to enter or leave the industry must be credible. Rival firm competition may manifest in the form of price, output or product features. Advertising may be aggressively used as a common strategic tool to gain market share, especially where similar competing products or services show observable differences. Rival firms can also compete on the basis of price or output in a context not unlike a game.
Airline Oligopoly Game Matrix

Northwest Airlines Southwest Airlines Price high Price low Profit / Profit Loss / High Profit High Profit / Loss Loss / Loss
Price high Price low
In the strategic pricing table above, two airlines each face two route-pricing options that determine possible profit payoffs from independent choices made by each firm. The payoffs for each set of choices are shown in the respective cells as [Northwest/Southwest]. Suppose each firm must decide if and when to change their own pricing structure with the end of the travel season near. What choice should each airline make and why? Notice how both airlines could benefit by maintaining their current high prices. But the reward for low pricing to gain market share, if the rival does not also price low, is very appealing to airlines operating on thin profit margins. Should both airlines choose to price low, they each suffer a loss by splitting the market with lower fares. This is an example of a famous economic game know as the prisoners dilemma where actions that might benefit each separately injure both if undertaken jointly. Southwest must consider its best response to either action by Northwest. If Northwest prices high, Southwest earns more by pricing low. If Northwest prices low, Southwest still earns more by pricing low. Likewise, no matter what Southwest does, Northwest also is better off choosing to price low. The result of this game is that both airlines, playing strategically, will price lowunless they can successfully collude to keep prices high with neither cheating to earn more profit in the short run. This type of collusion is a violation of federal law, with serious penalties for the colluding if firms.
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Games like this are common among the rivals in oligopoly industries. Often, there can be tacit collusion where the largest rival will act the part of a price leader and move first to change price, with the expectation that others will quickly follow. Airline route games of this sort have revealed a more sinister side in recent years as rivals have sometimes refused, between holiday peak pricing periods, to follow their price leader, to the detriment of the leaders profit. Monopolistic Competition Moving farther away from the monopolistic and closer to the pure competition end of the competitive continuum, we find industries blending elements of both competition and monopoly. Example industries include dry cereal, mens and womens clothing, hotels and many other retail products. Entering or leaving this industry is relatively less expensive than for oligopoly industries. The relatively large number of firms in monopolistically competitive industries still allows some degree of price setting powertheir individual demand curve slopes down to the right. Rival firms engage in stiff competition based on product feature similarity, location, advertising affects and other strategic economic dimensions. For these firms, significant resources are applied to the marketing function. Marketing includes all activities between product production and customer purchase as a legitimate cost of product positioning. Components of marketing as strategic tools Advertising Distribution activities Transportation and storage Product planning Market research Customer service Financing Product design
Characteristic
Price setting power Product similarity Price to opportunity cost Excess capacity Advertising Market entry cost Information access
Pure Competition
None Identical Equal & Ideal None None Zero Total
Monopolistic Competition
Little Similar/Identical Price above Some Much Modest Modest
Oligopoly
Some Similar/ Identical Price above Some Much High Limited
Monopoly
Much N/A Price far above Much Little Great Limited
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Monopolistically competitive firms product demand curves are interdependent due to the closeness of rival product features to their own. A price decrease for one firms product can lower the demand for a close rival as the rival products customers opt out in favor of the now less expensive and not-that-different substitute, for example frozen turkey dinners instead of frozen chicken dinners. A similar demand response is possible from successful advertising campaigns. If one firm aggressively advertises customerimportant features, buyers may leave the rival products market to join that of the newly perceived better product. Television commercials often mention the name of the closest rival and compare selected features. The economic objective of all advertising is to increase demand for the one producta rightward shiftand to make the demand inelasticless responsive to a rival producers campaign in the market place.
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In Sum Economics strongly favors competitive markets because forces work to bring equilibrium price down to opportunity cost and to provide more output than any other market structure. Competitive market characteristics include: o Very many buyers and sellers o Identical goods o No market entry or exit costs o Costless market information and mobility Competitive markets efficiently achieve an equilibrium price and quantity that clears the market. o They are powerless price takers and must accept the markets price as their own as they seek to maximize profits. o They produce output up to the point where the market price just equals the opportunity cost of the last unit produced. Monopoliessingle sellersface a downward sloping demand curve for the entire market comprised of many buyers. o To sell more the monopolist must lower price. o Monopolies are economically inefficient since: Their market pricing power lets them search for the price that maximizes profits, and At the monopolys profit maximizing price: Output is lower than for a competitive market Price lies above the opportunity cost for the output Because output is inefficiently allocated monopolies represent a form of market failure. Oligopoly industries contain many buyers and several rival firms with interdependent product demand where strategic pricing and production games are common. o Large market entry and exit costs o Competition can be on the basis of price or output depending on the nature of the good. o Advertising is common when rivals produce similar goods with differing features. Monopolistic competition represents an industry with many sellers and very many buyers. o Market entry and exit costs are low o Product differentiation is used to gain market share o Advertising is a strategic tool designed to: Increase product demandshift rightward Decrease product demand elasticity All less-than-competitive industry structures are relatively inefficient compared to pure competition and prevent society from receiving the full value of additional production and lower product price.
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Lesson 8: Economic Justifications for Government

Market Failure and Government In theory, with perfect information and clearly defined property rights, a competitive free-market will efficiently allocate private goods. But what about cases where there is imperfect information (for example, a food buyer has less information about the quality of food safety than the meatpacker) or property rights are not clearly defined (for example, who owns the right to odor-free air around your home, you or the local paper mill?). In these cases, there is market failure in terms of not attaining the desired efficient outcome for all concerned. The US government has a constitutional right to coerce certain actions, such as the payment of taxes and enforcement of anti-trust laws, to help correct market inefficiencies. An economically efficient outcome does not necessarily mean that it is socially equitable or preferred. More, while government can correct for market failure in specific cases, proper and useful policies must be in place. Even then, no policy is perfect and policy applications often spawn unintended consequences. So if government is to pursue a nonmarket solution, it should weigh the expected benefits of the policy against the expected costs to individuals and society. Cases where markets fail to efficiently allocate goods Public goodsgoods where use by one person does not reduce the goods availability to society, and some people to ride free at the expense of others, causing such goods to be under-produced by private markets Natural monopolya single firm provides services at a lower cost than two or more competing organizations Common resourcesnatural resources where overuse by one or more individuals reduces the availability to society, and high transactions costs with ill-defined property rights, hinder efficient allocation for society Externalitieswhere benefits or costs from the consumption or production of a private good unintentionally affect others not a party to the private goods consumption or production Defining the types of goods produced and consumed in society is a first step. The characteristics used to distinguish them are rivalry and excludability. Rival goodone persons consumption reduces the amount of the good available to others. Nonrival goodconsumption by any person(s) does not reduce the amount of the good available to others. Excludable goodothers can be excluded from consuming the good, usually because it has been consumed already. Nonexcludable goodpreventing others from consuming the good is too expensive.
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Economic Good Types

Good is Nonexcludable Good is Excludable Good is Nonrival Public goods (national defense, fireworks shows) Natural Monopoly (cable television, water and sewer) Good is Rival Common resources (ocean fisheries, irrigation systems) Private goods (apples, cars, airline flights, haircuts)
Government Provision of Public Goods Consider the voluntary provision of national defense. National defense is a public good because individuals cannot be excluded from consuming it and consumption of national defense by one individual does not reduce the amount available to others. Caring people may contribute funds to national defense, but persons self-interested in maximizing their wealth have an incentive to ride free, letting others pay for the service while they also receive the benefits. Because of the incentive to ride-free and the inability to exclude non-payers, national defense would be under-provided if left to the private sector. So government uses tax revenue to fund national defense for the benefit of society. Government Regulation of Monopoly Lets consider a water company, which has characteristics of natural monopoly whereby the larger it gets the lower the cost of its output. Also, potential competitors are not eager to build a second network of pipes for a chance to compete, a barrier to market entry. Sufficient water means that its consumption is nonrival. An unregulated profit-maximizing monopolist would restrict quantity to charge higher prices, resulting in an inefficient level of water provision and economic losses. But if government owned the water supply, it can behave in a social-enhancing way rather than a profit-maximizing way and sell the water at cost. Or, if the water supply were privately owned, the government could regulate the price charged. Government Regulation of Common Resources The Tragedy of the Commons occurs when individuals, acting in their own self-interest, exhaust a common resource even though it was in no ones long-term interest to do so. Consider a public fishery, where the fish population doubles each year until it reaches a level that the ecology can support. Because users cannot be excluded from fishing, and the fish are a rival good (the fish one person catches is a fish another person cannot catch), the incentive is to catch as many fish as possible before others do so. One solution is to privatize the resource. In the case of fisheries, government might restrict the size of the catch or length of time catching is allowed (through fishing season definitions) to avoid depleting the resource, or it can tax the catch or act of fishing to reduce the benefits of fishing and the quantity caught.
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Private Goods with External Effects Private markets trading private goods often do achieve a socially optimal solution, without government intervention. So under what circumstances should government intervene in markets for private goods?
Externality Types and Market Consequences

Externality Type Production: Positive Supply of Good from Societys View Society wants more of the good than is produced by sellers (e.g. R&D) Society wants less of the good than is produced by sellers (e.g. coal power) Externality Type Consumption: Positive Demand for Good from Societys View Society wants more of the good than is consumed by buyers (e.g. vaccinations) Society wants less of the good than is consumed by buyers (e.g. heroin)
Production: Negative
Consumption: Negative
Private goods, when produced or when consumed, may unintentionally impose benefits or costs on a party that is neither the purchaser nor the producer. In short, externalities affect someone external to the transaction. For example, if Mary buys a pack of cigarettes from a machine in a restaurant and smokes it, the smoke is a negative externality imposed on other diners. Or, if Robert pays landscapers to plant a beautiful garden in his front lawn, the garden is a positive externality enjoyed by his neighbors. A now famous proposition put forth by Ronald Coase at the University of Chicago, says that if property rights are clearly defined, the transactions costs of bargaining are zero, and the affected parties are willing to bargain, efficient market-based resolutions can be achieved when the parties negotiate compensation or agreed upon restrictions. The Coase Theoremstates that if private parties can bargain without cost about how to allocate resources, then they can resolve the externality problem on their own. Property rightslimits on the use of private property, goods and services that help define the limits of social behavior. Transactions coststhe costs of negotiating a transaction with all relevant parties.
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Real limitations hinder Coases theorem in practice. An externalitys impact does not always lend itself to negotiation with the affected parties if the parties are difficult to locate, there are too many to easily bargain with or the property rights are too vague. Imagine fifty thousand residents of a city bargaining with a local coal plant over acid rain caused by sulfur emissions. If the private market solution cannot be made to work, government may play a role. Air pollution, a negative production externality, is such a case. Air pollution has several known detrimental effects on public health. Identifying and negotiating with companies individually or even in groups can be costly. Government has alternatives such as 1) limiting the pollutant volume, 2) taxing polluter or 3) providing tradable pollution rights. Although the idea of selling pollution permits strikes non-economists as strange, it is an efficient allocation mechanism. Once the air pollution goal, say parts per million per geographic area, has been set, each company is allowed to trade its allotted rights to pollute with other companies for a negotiated price. If one company can achieve better than its mandated target, it can sell its remaining pollution limit to another company that cannot meet its requirement. Through this process, the overall pollution goal is attained and individual firms get to make economically efficient benefit-cost decisions on how to comply with the pollution regulation. Notice that no approach above would reduce pollution to zero. Achieving that goal would likely mean closing down the companies generating the pollution. Society then is denied all benefits from the companys private production. Economic solutions most often try to balance benefits against costs at the margin, maximizing total (net) benefits or minimizing total (net) costs. Constitutional Right to Tax An economist would argue that any government with such a constitutional privilege can, and in many ways should, act in an economic mannerfirst weighing social costs and benefits at the margin. While some taxes are economically justifiable, no tax is popular. On the other hand, should informed citizens not recognize the personal and collective value of supporting a public good or using a common resource and willingly submit some value to authorities? It is easy for people to rationalize that the fruit of their labor stems solely from their own acts and that any related benefits should flow exclusively to them. As individuals we tend to forget that we drive our cars to work on the freeway, or that our national defense system protects our investments as well as our freedom. If citizens could be somehow induced to reveal the value implicit in the public goods or common resources they useparks, libraries, public transportation, education, trash collection, and all the rest honestly bargain for the price, then pay it, much less direct government taxing or policy coercion would be necessary. Unfortunately, research has shown that surveys are unreliable in eliciting peoples values for public goods and services. There are few simple means to get citizens to accurately reveal their true valuations for public goods and common resources. That reality, along with a strong tendency for many people to ride free on the efforts and opinions of fellow citizens, invites more rather than fewer government strictures. Among the more vexing issues that economists have undertaken is how to impose tax policies.
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Economists apply the criteria of fairness and efficiency to assess how taxes affect work incentives and the distribution of resources in the market place. At the onset, two things are clear, taxes alter economic behavior and, ultimately, only individuals pay taxes. Principles of Taxation An efficiently designed tax system would let the government determine the necessary level of public goods and services. Then use the tax system to raise the revenue in the most efficient and equitable manner possible. The two principles for designing a tax system are the benefits received principle and the ability to pay principle. The benefits received principle of taxation says that people should contribute taxes in some proportion to the benefits they receive from using public goods. This justification applies fairly well to user-fees like gasoline taxes to fund highways or to public education via local property taxation. But some public good benefits are so broad and diffuse that the benefits received principle is neither an adequate nor an appropriate rationale. An alternative, the ability to pay principle, says that taxes should be levied based on how well the person can shoulder the financial burden. Simply, those who earn more pay more taxes. The federal income tax system is based on this concept. Public goods like national defense and education require tax expenditures but often it is difficult to match their use, or the option to use them, to specific benefiting individuals or groups. For these public goods, many citizens would simply ride free if not for the ability-to-pay justification to collect the tax. A person rides free when they experience benefits from a public good or common resource due others actions, but avoids paying for those benefits. As one small example of riding free, have you ever enjoyed visiting an historical site but ignored the voluntary contributions box when exiting? We all ride free on some public value some of the time, but how many fewer tax dollars would have to be coerced from us if we honestly volunteered contributions in proportion to the value received? Fairness in Taxation The ability to pay principle raises the issue of fairness in levying taxes. Economists apply two relative assessment criteria when speaking of fairness, horizontal equity and vertical equity. Horizontal equity suggests that taxpayers with a similar ability to pay should pay a similar amount in taxes. Vertical equity suggests that tax payers with greater ability to pay should pay larger relative amounts of taxes.
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Tax Incidence Based on Annual Income

Annual Income $ 25,000 $ 50,000 $ 75,000 $100,000 Regressive Tax $1,000 = 4% $1,000 = 2% $1,000 = 1.3% $1,000 = 1% Proportional Tax $1,000 = 4% $2,000 = 4% $3,000 = 4% $4,000 = 4% Progressive Tax $1,000 = 4% $3,000 = 6% $6,000 = 8% $10,000 = 10%
The table above highlights the dilemma of equitably trading-off tax dollars by count of dollars versus tax dollars as a percent of income. Horizontal equity, while a seemingly good idea, is difficult to apply in practice. What criteria should determine the similarity between individuals or households? Does the act of imposing the criteria not bear upon the personal choice of lifestyle and expenditure pattern? For example, one simple approach is to apply the same tax rate to families with the same income level. But that single criterion presupposes that other dimensions such as family size, family member age, and the cost of supporting a chosen lifestyle are somehow similar. Vertical equity, too, suffers critical vagaries in the attempt to equitably apply it. While the objective is to tax less those with smaller incomes and to tax more those with larger incomes, what should the rate be for each income level and how fast should the tax rate rise as income rises? During Ronald Reagans presidency in the 1980s the marginal income tax ratethe rate applied to the last dollar of taxable earningswas reduced from a maximum of 70 percent on the highest income levels to 28 percent. Was vertical equity served? The answer is not immediately obvious. Tax Incidence and Efficiency Economists also are concerned about who ultimately pays a given taxthe incidence of the taxand how much a tax distorts the allocation of goods in the market placethe efficiency of the tax. Most people, to the extent legally possible, try to avoid paying more taxes than necessary. Business owners, to the extent allowed by the market, try to pass taxes on to their customers. This avoidance tendency illustrates the power of taxes to altereven distortthe allocation of resources in the market place. Two things are almost certain to occur in the market when a new tax is applied. First, the quantity sold of the taxed good or service will fall. A second, and not at all obvious, effect is that both the buyer and the seller share in paying the tax. The proportion of the tax paid by each party in the transaction depends on the markets competitiveness. The more competitive the market, the more the seller bears the burden of the tax. The less competitive the market, the more the buyer bears the tax burden. While it may sound strange to speak about an efficient tax, economists would favor the tax that least distorted the allocation of goodsthat is, was more efficient. To a person of limited means, a proposal to heavily tax luxury goods like yachts and fur coats might seem appropriate. Yet wealthy individuals can simply avoid such taxes by purchasing different luxury items, and they do. The
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burden of such a tax would then inefficiently fall more on the makers and sellers of yachts and furs, via diminished sales, than on the targeted wealthy buyers. The type of tax that least distorts goods allocation in the marketa lump sum taxis one where each person pays the same single sum, regardless of income. It causes the least market distortionis most efficientbecause the amount of tax owed does not alter peoples private market decisions. The problem with the lump sum tax is that it is regressive with respect to income. For example, a $1,000 lump sum tax paid by someone earning $25,000 a year is a larger percentage (4%) than for someone earning $100,000 (1%) per year. Another aspect of tax inefficiency, apart from market allocation distortions, is the cost of tax policy administration. A prime example is US personal income tax collection, enforcement and preparation where such costs are high and sustain one of the largest bureaucracies in the federal government, the Internal Revenue Service. What messages should be drawn from this discussion on taxation? Only people pay taxes. Many taxes are justifiably necessary to fund expenditures on public goods, preserve common resources and redress externalities for the benefit of society. People often will ride free, benefiting from a public good or common resource without paying, if they can. Taxes tend to distort both market incentives and goods allocation because citizens and business owners work to avoid taxes where possible. No tax is both efficient and fair in the eyes of all people or from all logical vantage points. In Sum Markets fail, operate inefficiently to some degree, when competitive forces cannot prevail. o Government should enter the market only after carefully weighing the private and social costs and benefits o Public goodsgoods where use by one person does not reduce the goods availability to society and no one can be excluded from their use. o Natural monopolya single firm provides a service at a lower cost than two or more firms. o Externalitiescosts or benefits accruing to other than the transacting parties are not measured when conducting market transactions. Types and results: Production positivebenefits others, goods are under-produced in societys view Production negativeimposes costs on others, goods are over-produced in societys view Consumption positivebenefits others, goods are under consumed in societys view Consumption negativeimposes costs on others, goods are over consumed in societys view Common resourcesnatural resources where use by one individual reduces the availability to society Property rights bounds placed on the use of private property that help define the limits of social behavior. Transactions costs the costs of negotiating a transaction with all relevant parties.
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Coases Theoremstates that if private parties can bargain without cost about how to allocate resources, then they can resolve the externality problem on their own. Tragedy of the commonsfree common resource overuse, where all citizens have access but no single user directly pays, diminishes the use value for all as the tragedy of the commons. Two categories of economic goods o Public Goodconsumption by one person does not diminish the amount available to another person, and others cannot be excluded from its consumption. o Private Goodonly the consumer enjoys the benefits of consuming the good and the act of consumption reduces the goods availability to others. Taxation principles o Benefits received principle of taxation says that people should contribute taxes in some proportion to the benefits they receive. o Ability to pay principle, says that taxes should be levied so that those who earn more pay proportionately more. Tax policy fairness o Horizontal equity means that taxpayers with a similar ability to pay should pay a similar amount in taxes. o Vertical equity means that tax payers with greater ability to pay should pay larger amounts of taxes. Free rider a person who receives benefits from a public good or from others decisions regarding a public good, but who avoids paying for the benefit. Tax incidence the party who ultimately pays the tax, always a person or group. Tax efficiency the nature and size of the market distortion from a given tax. Tax burden on income, types: o Regressive; taxation where there is a greater percentage burden on lower income levels o Proportional; taxation where there is an equal percentage burden on all income levels o Progressive; taxation where there is a greater percentage burden as income level rises
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Lesson 9: Value, Time and Uncertainty

Time Preference and Present Value Human behavior validates that people prefer consumption today over consumption tomorrow. This positive rate of time preference is fundamental and reflected in the interest rate. How much a person is willing to pay to have the privilege of more money now is weighed against their willingness and ability to pay the interest charge over time. Those who value today highly (a high rate of time preference) are willing to pay higher interest rates in order to consume more now rather than wait for later. Since time (waiting until later) now has a value, we cannot correctly compare the value of an object today to the same object later without some adjustment. Suppose you can earn 10 percent per year on money placed into your riskless savings account. For those who contribute to the savings account, their personal time preference must be less than 10 percent. Those who do not to contribute to their savings account at that interest rate possess a personal time preference greater than 10 percent. As money is paid into the savings account the power of compound interest, versus simple interest, can perform an amazing growth feat over time. The table below shows annual simple a compounded interest earnings at 10% across selected time-periods for an initial $100 saved. Simple interest means that the interest accruing on the principle is withdrawn each period, and not added to the principle base for future year interest accrual. That approach is decidedly not the way to accumulate a fortune. Compound interest means that at the end of each interest earning time-period, the earned interest is added to the prior principle balance so that the next periods interest amount is based on the new and growing base amount. Savers earn interest on all previous interest accruals. Pick any cell value after year 1 and compare the respective balances for the simple versus the compound rows. Notice that the compounded amounts are always larger. As time goes on the difference between the column cell values over time becomes significant if not dramatic.
Compound Versus Simple Interest

Years Saved Compound 10% Simple 10% 1 $ 110 $ 110 5 $ 161 $ 150 10 $ 259 $ 200 20 $ 672 $ 300 40 $4,526 $ 500
A handy formula permits reasonably good estimates on the number of years it takes a single amount to double at a given compound interest rate. The Rule of 70 says to divide the compound interest rate an amount will earn each year into the number 70, for a good estimate for the number of years it will take to double the initial amount. The rule provides pretty accurate estimates for whole interest rates between 2 and 20. Notice that if the earnings on the initial $100 were 10% compounded annually, the $100 doubles almost 6 times over the 40-year periodto equal $4,526!
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Smart Investing in Any Market Most people would like to be financially independent. A sizeable percentage of Americans have achieved that goal. The fundamental ideas to be dealt with are the value of time and risk, due to an uncertain future. So the basic question becomes what proportion of current income needs to be saved, given an accumulation goal to meet future needs, lifestyle and contingencies? And how should those proportions be invested? Risk is the term economists use to describe the consequences of an uncertain outcome. Placing a portion of income into just a regular savings account likely is not sufficient. An investor also must recognize that higher expected rates of return mean greater levels of riskvariations in the portfolios value. A good investment plan has four key aspects: 1) the financial wealth goal, 2) the accumulation amount, 3) the year to achieve the financial goal, and 4) the level of risk, which is the level of uncertainty regarding the final value. The task is to determine the mix for various investments that on average honor the risk tolerance while heading toward the established goal.
Sample Investment Allocations

Category Savings High-yield savings Municipal BondsLong Term Corporate BondsShort and Long Term Corporate Stocks Total Proportion 20 20 30 20 10 100 Expected Return 1% 2% 4% 6% 10% 4% Risk Level Very low Low Moderate Moderately high High
Sample information in the table above reflects an overall moderate risk level, where the greater proportion of investments is in lower risk opportunities. The expected return represents the best guess, often the historical average, of what those types of assets will return in the future. By shifting the proportions among the components, for example, by moving savings into corporate stocks, higher overall risk levels are possible. Typically, higher expected returns come with greater risk, because as discussed before, borrowers must compensate lenders for that increased risk. Working with a qualified investment counselor can help determine the optimal allocation for any persons life situation. Placing the funds into chosen investment vehicles also requires a decision about who will manage the fund(s). The two choices are to directly place the funds yourself or hire an investment service for a fee. The fees vary widely and are a significant cost annually levied against your fund(s). High quality, low fee investment portfolios do exist. Realigning portfolio allocations at retirement can be complicated due to tax laws and usually requires professional advice.
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Insurance as Risk Coverage Insurance is the rare product people purchase hoping not to use it. Yet fear due to uncertainty coerces most people to purchase some form(s) of insurance. What consumers are buying when they purchase insurance is a reduction of risk. More specifically, the insurance company is being paid to take on risk on the consumers behalf. This is economically efficient, because insurance companies, using the law of large numbers, diversify policy holders across a wide range of locations and policy types and are unlikely to be financially crippled. The insurance concept works by pooling risks among a group of policyholders so the expected losses are estimable. If these loss estimates are correct, then a policy premium plus overhead expenses can be determined and charged to each policyholder to cover them. In the case of life insurance, the cynical view is that the policy holder is betting they die before the policy expires and the insurance company is betting the insured lives is not accurate. Insurance is a means to protect an individual or single business against catastrophic economic loss of unknown size and date, for a known price. The vexing question for customers is how much and what type insurance to purchase? The three main categories of insurance are life, health and property. All insurance carries inherent aspects and risks Independent risk-the value of one risk gives no information about the value of any other risk For example, a fire downtown does not influence a fire in the suburbs Premium-cost of the policy per year, the expected dollar amount of the groups losses plus a margin for expenses and profit spread over all policy holders Face value-the amount of insurance paid in the event of a specific named loss Adverse Selection-situation where those more in need of insurance seek insurance coverage Moral Hazard-a reduction in an insureds level of care to avoid or minimize losses Life insurance should be considered when others depend on the insured for economic well-being. Loss of income from the bread winner would place most families in financial peril. Two related questions are the type of life insurance to acquire and the payoff amounts. Whole life insurance charges relatively high premiums to cover the cost of insurance but provides an accumulation value in the policy. Premiums continue as long as the policy is in force or until the accumulated balance is large enough to generate the premiums. Term life insurance is purchased for a named time-period, usually no longer than 20 years. The premiums are smaller than for whole life because they cover only the expected payoff and do not accumulate value. At the end of the specified term, insurance coverage ceases, with no residual policy value. The insured gets more insurance coverage for the premium dollar than with a whole life policy. Which insurance type to purchase depends on personal needs and goals. The question of how much insurance face value to carry must balance after-death economic needs with the ability to meet premium payments. The range can run from sufficient funds to cover burial costs to supporting a spouse and children until the youngest child reaches the age of majority.
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Health insurance covers health and disability expenses according to a detailed listing of medical maladies. As an employment benefit, employers commonly provide health and disability insurance coverage using third party providers. Rising premiums in recent years have forced many employers to either reduce their health insurance coverage or share the premium cost with their employees. One way to reduce premium costs for health and property insurance is to maintain high deductibles. A deductible represents the first dollars of coverage in the event of a loss. Essentially, the policyholder self-insures the first several hundred dollars or more of each claim. Property insurancehome, auto, business propertycovers tangible asset damage to the insureds property by others or certain named events such as fire. For consumers whose homes are mortgaged or cars financed, it is common for the third party beneficiarythe lenderto insist on some minimum property insurance coverage. That way, the financier as well as the home or car owner is protected in the event of a loss. In Sum Time has a value and your personal time preference is reflected in your personal behavior. o If you spend all your income and save nothing, you do not value the future very highly o If you save and earn 5 percent a year, then you value the future and can accumulate wealth The power of compound interest versus simple interest is very large and should be used to full advantage Investing in uncertain times can be made less risky by diversifying the types of investment held Work to achieve a positive balance between net earnings and current expenses throughout life. Pay yourself first in the form of regular monthly savings. Purchase insurance to minimize the risks of loss to the extent affordable, based on your financial needs. o Life insurance protects against lost income for your survivors. Term life covers insurance costs only and is less expensive than whole life Whole life insurance accumulates value at a certain rate and is more expensive Health insurance pays for illness or accident via detailed specified coverage, but not loss of income. Property insurance covers damage to physical assets caused by you or others.
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Lesson 10: Consumer Economics

Life is a marathon, Not a Sprint Fulfillment in life has many dimensions. This lesson focuses on those economic aspects of life over which most people can exercise some degree of choice. An adage in business states that its not what you earn but what you keep that matters. The same holds true for individuals. Though some may challenge the extent of that influence, American citizens possess far more choice-making opportunities than do people in other countries. We might say our personal economic problem is how to freely and legally achieve the most from the economic dimension of life. During normal times, average US households spend 95 percent of their annual after-tax income. Because our material wants outstrip our financial means much of the time, that reality forces most citizens to economize. But even work is a choice in America. We are motivated to work by the income benefits it provides. And for nearly every occupation there is a life-cycle profile of earnings. Early career income is relatively low, rises then peaks in the middle 50s and slowly declines until retirement, yet another life choice. So if we take the very long view and ask how we want our golden years to be, the importance of how much personal income and wealth we earn and keep becomes clear. First Paycheck Somewhere between the ages of 16 and 19 many teenagers enter the job market for the first time. That is where the world of work and the lure of consumption merge and conflict. Current federal minimum wage in 2011 is $7.25 per hour. Full-time students working no more than 8 hours a day and not more than 20 hours a week can legally be paid as little as 85 percent of the minimum wage $6.16 per hour. Using the full federal minimum wage rate and a 20-hour work week for a student, the table below estimates weekly take-home pay, after basic payroll deductions.
Part Time Job Weekly Paycheck Example

Gross pay per week: $7.25 X 20 hours Federal income tax withholding: 10% Social Security/Medicare: 7.65% X $ Basic insurance plan premium Weekly take home pay Amount $145.00 14.50 11.09 10.00 $109.41
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Notice that our part-time employed student receives only about 75 percent of his or her gross wages in take-home pay. The example assumes the student has few material tax deductions, uses tax rates based on the 2010 tax year and that the company requires contributions to a basic group insurance policy. A few hours after our teenager picks up their first paycheck often is a good time for parents to explain why net income (75%) is so much smaller than gross income (100%). Few employed persons are exempt from contributing toward their estimated tax liability, basic social programs or medical insurance. The ability-to-pay justification for taxesthose who earn more can pay moreis built into the US federal income tax structure, as the 2011 tax table below on single filers ordinary taxable income reveals. Insurance, while a seemingly unnecessary cost to a healthy teen, provides medical coverage in the event of an accident or illness. Yet, $109.41-per-week take-home pay seems to disappear quickly, even though there are relatively few hours left after school and work obligations.
Prospective US Earnings Tax Rates 2011

Tax Rate Single Filer 10% Under $8,525 15% $8,525 $34,650 25% $34,650 $83,900 28% $83,900 $194,150 36% $194,150 $380,500 39.6% Over $380,500
Source: www.IRS.gov First CarSo Many Options Nothing represents freedom to an American teenager so much as their first car. As a virtual right-of-passage, and whether its a shiny new one or a dented used one, it places nearly unlimited mobility and opportunity into the hands of its youthful driver. As with all material fascinations, this one too has an anchor in hard reality. The thing just costs a lot of money. To give our teen a taste of adult responsibility, most parents want their driving child to help support the 4-wheeled chariot. Some insist their child bear the total financial cost of car ownership. The table on the next page divides representative monthly automobile expenses into two categories; fixed and variable. The example assumes the car, a used 2006 Honda Civic, is financed for 4 years.
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Sample CAR Ownership Costs/Month

Fixed Expenses Car note Insurance Annual Registration by month Annual Inspection by month Sub-total Fixed Variable Expenses Gasoline Maintenance Parking Accessories Sub-total Variable Total Car Costs/Month $280 $125 (= $84/12) $7 (= $48/12) $4 $416
$120 $25 $10 $35 $190 $676
Even if we suppose that our driving teens parents are financially able and willing to cover the fixed expenses of owning the vehicle, variable expenses still total $190 monthly. If our teen is the same one from the example above who nets $437.64 per month ($109.41 per week X 4) from their 20-hour per week minimum wage job, they have just under half ($247.64) left for dating and personal purchases. If the parents insisted their teen pay for the car insurance, spendable monthly earnings would be $122.64. Not many expensive dates possible there. The Economics of Attending College The strong and positive relationship between education and earnings is hard to over-state. The national data in the table on the next page are compelling. Completing four years of college opens doors to opportunities not available through any other social institution. National studies using sound methodologies confirm that investing in ones own human capital may offer the greatest long-term benefits of any personal investment. Education also returns dividends to society in the form of economic growth. That is one economic reason why the federal government offers direct loans and grants to willing and qualified candidates to complete their college education. Even with tuition costs rising, the rate of return on training and educational investment is high.
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US Median Earnings Over Past 12 Mos. 2005-2009

Population 25 years and over with earnings Less than high school graduate High school graduate (includes equivalency) Some college or associate's degree Bachelor's degree Graduate or professional degree $34,159 $19,420 $27,272 $33,457 $47,747 $62,708
Source: www.Census.gov. *2009 inflation-adjusted values Credit Cards High Cost There is an almost irresistible allure to reach into our expected future income and use some of it for current purchases. Hard reality also attends the act. First, the borrower will have to pay for the privilege in the form of interest, often at an unconscionably high rate. Second, the borrower is contractually committed to pay back the principal and the interest from expected future income, whether or not expectations about the future incomes size come true. Credit CardA short-term loan agreement that enables holders to enjoy goods and services today by borrowing against tomorrows income for a fee called interest. When should a consumer borrow money? The best response is when current income is insufficient to cover an unexpected expense and there is room in expected future income to repay the loan with interest. If living expenses exceed income every month, credit card coverage for the difference is a very poor choice, serving only to postpone an inevitable and bad end. Monthly expenses must somehow be reduced or monthly income enhanced. Ultimately, using credit cards, or any borrowing instrument, in this fashion only adds misery to an already serious personal financial situation. The credit-seeking customer should shop for credit lending rates, just as they would shop the price of any economic good. Cardissuing companies set rates according to each customers credit profile: lower rates for good paying customers and higher rates for customers with a poor history. Commercial credit counseling firms offer services to those needing advice.
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Costs of Credit Card Use and Misuse Categories Option 1 Option 2 Option 3 Beginning Balance $1,000 $1,000 $1,000
Monthly Payment Balance $100 Minimum
Total Interest Paid Months to Pay-off
$0 1
$74.10 11
$700 260
The table above illustrates three options to manage credit card debt. Option 1 pays off the entire balance due monthly. It is possible to accomplish this by first limiting credit purchases, then using part of the following months income to pay the entire balance. Most card issuing companies now assesses the monthly annual percentage rate (APR) on the average daily balance (ADB) from the date of purchase. So some interest charge is unavoidable. Options 2 and 3 assume an initial $1,000 purchase, a 15% APR (15%/12 = 1.25% per month) and a minimum monthly payment equal to 3% of the average daily balance (ADB). Option 2 for managing credit purchases assumes the cardholder pays $100 monthly toward the entire balance, and makes no additional purchases on credit ever. Option 3 assumes the cardholder pays only the minimum balance printed on the monthly statement, and makes no additional credit purchases-ever. All options show results as of the year the card balance is zero or very close to zero. Option 2 illustrates the benefit from limiting credit card use and for making payments larger than the issuer-prescribed monthly minimum. Total interest paid equals $74.10 on the $1,000 purchase and the balance is paid off in 11 months. Option 3 vividly demonstrates how the credit balance is almost never extinguished if the cardholder pays only the companyprescribed minimum amount each month. How can this be? Customer payments on the credit card balance apply first to the monthly interest due, only the remainder goes toward the principal balance. The monthly interest charge is about one-third of the small minimum monthly payment of $30.00. So, the principal balance shrinks but by only $17.50 per month at first then falls very slowly over time as the balance is reduced. Imagine how quickly our minimum balance-paying customer would sink financially if they continued to add new purchases each month while pursuing this minimum payment habit. Is this legal? Yes. Is it fair? Economics alone cannot answer that, but most certainly it can be ruinous to those unaware of the facts and the consequences. First CareerLooking at the Long Run The annual expenditure profile in the table on the next page is based on an average household income before taxes of $62,857 per year. Notice that housing consumes just over a third of all expenditures. Transportation costsprimarily a personal automobile and related expensesaccount for 15 percent of total expenditures. Then food absorbs almost 13 percent. Taken together, basic needs; living space, mobility and food account for just under two-thirds of average total expenditures. In a modern society, these expense categories are difficult to reduce beyond some livable level.
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Average Yearly Expenditures for US Consumer Units 2007-2009

Category Food Housing Transportation Apparel and services Healthcare Entertainment Insurance and Pensions Other expenditures Totals Source: www.BLS.gov Amount $6,372 $16,895 $7,658 $1,725 $3,126 $2,693 $5,471 $5,127 $49,067 Percent 12.9 34.4 15.6 3.5 6.3 5.5 11.1 10.4 100.0
A typical US workers career income path shows income rising as a trend through their late 40s to mid-50s. Thereafter income tends to level off or even fall slightly through age 65. In the early career years there is much pressure to spend on family needs. Setting ones sights on a distant retirement date is hard to do during the child-rearing years. Yet, the benefits of following a consistent personal savings program are economically profound. Contemporary job market studies indicate that the average worker will change jobs at least five times in a career and the rate of job turnover is rising. Coping with change of that magnitude requires sticking to a personal wealth accumulation plan. The secret law of financial success is to pay ones self first. No matter what, set aside a certain amount of current monthly income in an interestbearing account and do not touch it until retirement. Take advantage of special programs such as 401(k)s, where employers match contributions you make up to a certain amount, essentially giving you free money for saving. Other options such as IRA (Individual Retirement Accounts) allow you to invest income without paying taxes on it, reducing the cost of saving (e.g. if your tax bracket was 25%, you could take $300 in net pay now, or invest $400 in your retirement account). First Home or Last HomeRent or Buy? A home remains the largest single investment most people make. The Internal Revenue Service permits homeowners to deduct from taxable income the interest payments annually made to their mortgage company. This deduction provides a large financial inducement for homeownership. It also helps support one of the largest sub-industry construction sectorsnew home buildingin the US economy.
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The question of whether to rent or buy a home is determined as much by lifestyle choice as by financial criteria. Renters still pay taxes and maintenance, though implicitly through the assessed rent. Often the decision of whether to rent or buy is based on a cost per square foot basis at certain life stages. Early career singles most often rent for the flexibility and minimum responsibility. Retirees often rent for convenience and ease of upkeep of their living quarters.
Sample Home Mortgage Costs $140,000 30-year Loan @ 5%

Category Down payment = 10% 1 point = 1% of $124,000 Closing costs Monthly payment Cost $14,000 $1,240 $1,200 $663.30
Those who choose to buy a home, most often are young married couplesstarter homes, couples with childrenmore established homes, empty nesters and early retireesboth to smaller residences. Each purchase typically is financed through a mortgage company at the agreed upon sales price less down payment, at the current mortgage lending rate for either 15 or 30 years. A consumers past actions follow them in the financial world. Creditworthy customers get the lowest mortgage interest rates. Customers, whose credit history reflects payment problems or prior defaults, pay a higher rate to compensate for additional lender risk. The lender profiles all loan applicants based on certain criteria to determine their financial risk. Traditionally the three Cs of credit: characterpersonal financial history, capacityfinancial ability to repay the obligation and capitalcollateral value, are used to determine the worthiness of a prospective loan customer. Refer to the table above and suppose a young married couple has just agreed to purchase a $140,000 home for 30 years at 5 percent. Further suppose the couple paid 1 point plus closing costs to process the loan package. A point equals 1 percent of the loan amount and reduces the interest rate to be paid on the loan, thereby lowering the monthly interest cost on the loan. Buying points for cash may or may not make good economic sense. Analysis is required to see if the value of the monthly payment reduction is worth the upfront cash cost of a point. Closing costs are bundled fees for processing, a title search and for closing on the mortgage loan. Minimum down payment for a home purchase is commonly 10 percent of the agreed upon price. If the buyers make a down payment of 20 percent or more, then mortgage insurancea policy to protect the lender, not the purchaser, is not required. For the home in the table, the monthly payment is $663.30 for principal plus interest, only. The Annual Percentage Rate (APR) is slightly greater than 5 percent because the point costs and closing costs affect the effective rate. To the monthly payment can be added hazard (homeowners) insurance and, often, local taxes on a pro rata monthly basis, paid through the mortgage company as a service. For
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a small fee the mortgage company manages the buyers escrow accountan accumulation account where allotments for the local taxes and hazard insurance is maintained and paid through the mortgage company. Plan Early for Living Long Americas graying population makes planning for retirement more difficult than it was a generation ago. The demand on services for the elderly will rise due to the increasing numbers of geriatric citizens. The average life span of US men and women of all colors is rising mainly due to the eradication of disease and improved healthcare. Official projections indicate that the sheer number of people over age 65 will double from 40 to 80 million by 2050. Those over 85 years of age are projected to more than triple, from 6 million in 2000 to 20 million in 2050. So the relevant but difficult-to-answer question is how long will one likely be retired? The current-tax-funded US Social Security program, providing retirees a standard retirement allotment since the 1930s, will face its greatest funding test in the next 40 years. This is so because the proportion of aging eligible recipients may exceed the proportion of income-earning citizens in the workforce. It is the contributions of those working who finance the pay-as-we-go US social insurance system. Healthcare costs also rise dramatically after age 65. National estimates reveal that as much as half of lifetime personal healthcare expenditures occur in the last 10 years of life. Lowering the cost of healthcare options may be necessary; but how? Economic thinking provides some guidance. Increasing revenues and decreasing costs during retirement is nothing new, but the reality is more pressing. Personal bias and market reality require an objective appraisal to guide decisions in lifes final stretch. Determine the available and expected economic resources: expected retirement income, social security income, Medicare coverage, supplemental insurance coverage, then the value of major assets such as the home, property and financial wealth. Decide on the following: a) an affordable lifestyle, minimum desired estate size, limits to health insurance coverage and final burial arrangements. In addition, make out a final will and testament using legal oversight. To the extent still possible, increase savings during income-earning years. In the last lesson, we discussed the power of compound interest. Money saved early in the 20s and 30s has much more opportunity to grow than money saved in ones 40s and 50s. Once retired, simplify life to the important essentials and reduce fixed costs to a minimum. Doing so leaves more liquid funds available to enjoy daily life and special events. Consider bartering instead of buying. In some ways it is simpler and less costly to swap mutuallydesired services with someone or to establish a line of credit for services rendered instead of receiving or making monetary payments. Yes, it is legal. Find an enjoyable hobby. One that earns a modest cash flow and that does not conflict with Social Security earnings can provide spending flexibility. Once a comfortable financial margin for daily living is established, stay as active as health permits. Stay close to loved ones and friends. Do what you wish, for as long as possible. Both relaxation and laughter are good medicine. Lastly, prepare to leave the economic realm of life.
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In Sum Think about your future before you act rashly today. Your income is based on your ability and education. Your financial ability to have a full life begins with a plan for the future. Control monthly expenses; keep the fixed costs of home and auto as low as possible. If possible, attend college and earn a degree, at least a certification. Loans and scholarships are available. The labor market likely will reward you. Prudently use credit cards, if at all. If you must, then strictly limit their use. Pay as much as possible toward the balance each month. Never be content paying only the company prescribed minimum balance. Investigate large and non-routine purchases to make sure your income expectations likely will be met, before buying. Have a regular savings plan that earns compound interest. Let it grow without interruption. Follow an investment plan. Diversify your investments. Spread your investment dollars across independent assets to achieve a return that will meet your objective within your risk tolerance. Buying versus renting a home has lifestyle and economic motivations. Total price per square foot can be a useful guide. o The tax deduction for mortgage interest is the largest single financial incentive for buying a home. o A good credit history qualifies one for the lowest current market interest rate. Retirement needs to be prepared for. o Estimate expected income, medical coverage costs and keep fixed living expenses as low as possible. o Consider bartering for services instead of making outright purchases Make legal and economic preparations for lifes final turn.
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Lesson 11: Gross Domestic Product and Growth

National Income Measurement Prior to 1940 there was no consensus gauge by which to measure macroeconomic activity. That changed when Simon Kuznets of the US National Bureau of Economic Research devised the national income account structure and published his work in 1941, earning him the 1971 Nobel Prize in Economics. With only minor modifications, his schema survives to this day and most countries on the planet use it. The summary measure of this national income structure was named Gross Domestic Product (GDP). Gross Domestic Product Equivalent Views The market value of all final goods produced within a country in 1 year, OR The total income received by all producers (Supply View), OR Total purchases of newly produced final goods (Demand View), OR The sum of all transactions regarding final goods (Q = real output) sold at market value (P = average price level) = PQ This national product measurement system with its interrelated income accounts rests on several key assumptions and, as with all macro measures, suffers some limitations. The objective is to accurately and consistently account for all current economic activity and its major components over a stated period. By distinction, Gross National Product (GNP) is the total income earned by a nations permanent residents, wherever they currently reside. For example, Toyota cars built in Texas are part of US GDP. Ford autos built in France are part of US GNP, but not US GDP. Key assumptions behind the National Income and Product Accounts Price changes during the period ignored Population growth ignored Technology advances ignored Investment beyond asset replacement ignored Limitations to Gross Domestic Product as a measure Ignores product quality changes Omits household production Omits sales of used goods Omits in-kind and invisible transactions Excludes illegal transactions Omits financial transfers A poor measure of psychological well-being
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The important theoretical and practical questions are how and if the income paid to earners from the production process will be used to collectively buy all the goods produced? This question is not trivial. For example, workers usually will not offer their labor services for free. When all factors of production are paid for their effortfrom revenues the seller generates from sales to customersthe value of all income equals the value of all production. But will the act of supplying goods generate an equal demand to purchase them in a reasonably short time period? If not, some current resources will be unemployed. The table below shows the major components for US GDP, $14.1 trillion for 2009, from both the supply view and the demand view. Notice that GDP sums to the same figure for either view, except for a less than 1% error labeled statistical adjustment which accounts for the difficulty of reconciling the nations income and consumption reporting.
US Gross Domestic Product 2009 In Circular Flow Format*

Income Categories or Supply Households supply Factor Inputs to Businesses $ 11,114.4 Factor Income (F) $ 1,861.1 Depreciation (D) $ 1,024.7 Indirect Business Taxes (T) (-)118.8 Statistical Adjustment Expenditure Categories or Demand Business Hires and Pays $ for Factor Inputs Household Consumption(C) Business Investment (I) Government Purchases (G) Net Exports (NE) $ 10,001.3 $ 1,589.2 $ 2,914.9 $ - 386.4
$14,119.0
Income Earned by Factor Resources = GDP GDP = Expenditures on Goods & Services
$14,119.0
Businesses produce and sell goods and services to households Households Purchase Goods and Service from Businesses $ Source: www.bea.gov; *Billions of US Dollars
To interpret the economic circular flows in the table above, the upper brown clockwise arrow represents the physical flow of labor and other inputs from households to businesses. The lower brown clockwise arrow represents the goods and services produced by business using the factor inputs. The upper green counter clockwise arrow is the dollar income earned by households for supplying factor inputs (wages, interest and rent). The lower green counter clockwise arrow represents dollar expenditures for goods and services purchased from businesses by households.
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The Supply View of GDP From Factor Income to Household Consumption Factor Income (F = $11,114.4 billion) is the total National Income paid by business for using all economic resources (land, labor, capital, entrepreneurship) as a cost of production. Factor costs to businesses are income payments to households. Households use their income, after paying income (direct) taxes, to consume or to save. From Depreciation to Business Investment Depreciation (D = $1,861.1 billion) accounts for the depletion of productive assets during the year. These are real costs in the sense that productive assets have limited useful lives and must be replaced when worn out. From Direct and Indirect Taxes to Government Purchases Indirect business taxes (T = $1,024.7 billion) are taxes levied on productive business enterprises and are a cost of doing business. Indirect business taxes transfer income from businesses to the government so it can make purchases. Direct taxes are levied directly against an individuals income. Income taxes are a good example. Direct taxes are not a cost of doing business. These taxes, a percentage of each individuals personal income, generate flows moving directly from the income earner to the government so it can make purchases. The Demand (Expenditure) View of GDP Total economic activity (GDP = $14,119.0 billion) from the supply view must equal the sum of goods purchased by the four demandside sectors. The largest demand-side sector, household consumption (C = $10,001.3 billion), measures purchases by the households from the factor income paid to them, and accounts for nearly seventy percent of total demand for GDP. Next, government purchases of goods and services (G = $2,914.9 billion) provide public goods, market regulation, common resource oversight and other public functions to account for 18 percent of GDP.
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Business investment (I = $1,589.2 billion) is used to add new capital, replace currently depreciated plant and equipment plus inventory replacement to add another 15 percent to GDP. Though it is a relatively small percentage of GDP, investment plays a large role in accommodating economic activity. The fourth demand sector, net exports (NE = $ - 386.4 billion) measures the activity of the US with the rest of the world. The negative sign indicates that for 2009, the US purchased more foreign goods (imports, where dollars leave the US as payments for foreign goods) than it sold to foreign countries (exports, where dollars enter the US as foreign payments for US goods) by the net export figure, -$386.4 billion. Using letter notations for each demand side component, GDP = C + I + G + NE, becomes the aggregate supply equals aggregate demand relationship in macroeconomics. In words, as an accounting identity, the total dollar value of goods supplied in the economy in one year equals the total amount of those goods demanded by household consumption, business investment, government purchases and net exports. It is also true that C + I + C + NE = PQ, the sum of all GDP transaction values, where P is the average price level and Q equals current real output. Sources of Economic Growth Classical economic writers of two centuries ago had it nearly right. Economic growth came from the application of human capital and physical capital given a countrys abundance of natural resources. With these three economic resource groupsthe factors of productionoutput could be increased simply by applying more of each of them. Productionthe quantity of goods produced per hour of labor timewould rise as more factor inputs were added to existing and new enterprises. In 1776, Adam Smith famously wrote in An Inquiry Into the Nature and Causes of the Wealth of Nations, using a pin factory analogy, that the greater the extent of the market, the greater could be the specialization of labors tasks. But economy-wide there was a natural limit to growth and specialization, because one base factor, land, is completely fixed in supply. Since the economy was predominantly agriculturally based the limits to growth were almost pre-determined. So claimed Classical thinkers of the day. Expressed as the law of diminishing returns, what Classical economists believed determined the limit to growth was the fact that additions of factor inputs would inevitably exhaust the land and define societys maximum production. The extant classical writing to carry that idea to its conclusion was Thomas Malthus1798 Essay on Population. He grimly argued that linear output growth would eventually be outstripped by geometric population expansion and inexorably return society to a subsistence level of existence. This law, more than any other single idea, pinned the moniker of the dismal science on economics. Law of diminishing marginal returnsgiven fixed amounts of land, as the quantity of labor incrementally increases, total output will increase but at an eventually diminishing rate.
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The missing dimension in the Classical worlds view, the one that had only begun to reveal its salient characteristics two centuries ago, was technology combined with entrepreneurship. Economists of the day missed it because its power had been barely recognized. When combined with the other three factors of production in a market economy where freedom of choice encourages risk-taking and rewards success with profits, the industrial revolution entered a technologically spawned and generally sustained 275year expansion into the 21st century. Economic Productivity and Well-being A societys economic standard of living is measured by dividing total annual production by total population. US 2009 GDP per capita equaled $44,155, the 7th highest in the world. This total output-per-person indicator directly implies that to improve the standard of living, the economy must increase production faster than population increases. Though widely used, the measure ignores the distribution of production in an economy. Alternate measures of well-being and economic growth also can be useful. Wages adjusted for inflation, output per worker or output per hour also reflect useful aspects of economic well-being. Productivity determinants Quantity and quality of the labor force Quantity and quality of capital equipment Level of work force education Rate of technological development How Technology Enhances Economic Growth Technology, the application of improved methods to produce goods and services, was the missing ingredient in Classical economic growth models. That technology is a significant determinant of economic growth is no longer debated. That debate centers on how to sustain and guide technological advances. Technologys influence shows up in two fundamental economic ways, as capital saving or as labor saving. Either savings effect lets producers generate more output with fewer resources and lower cost. As a direct result, profits rise. Profit spurs other firms to adapt, as far as the law and competition allow, new technological innovations so they too can reap the markets benefits. Some, like unions, resist technological change arguing that technology displaces workers and adds to unemployment. The reality is that technology, over the long term, generates many more jobs than it temporarily displaces and offers a higher average wage for those trained to accommodate its applications. The vexing business and policy question is just how much money to allocate to technology development, both corporately and socially. Invention and innovation do not come cheaply. As much as 80 percent of every dollar in corporate research and development fund fails to generate saleable product. With returns as uncertain as they are, corporations only willingly undertake a
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limited amount of Research & Development (R&D). Another constraint is that an economy as a whole can only invest up to its total amount of savings during any period. The truly difficult question becomes, what portion of scarce national economic savings should go toward enhancing technology? Since the benefits from successful technology contain a broad public distribution aspect, government allocates public revenues to enhance it. The first national-scale programmatic allocation of US government research funds in the 1920s and 1930s guided pathbreaking agricultural research. Today, with the virtual institutionalization of R&D, many original scientific discoveries first occur in doctoral-granting universities, a great many of them federally funded. Over the past 140 years, four major technology waves lifted the US economy and the world to unprecedented economic heights. The monumental economic largess created by large-scale electricity generation, the internal combustion engine, followed by a revolution in chemicals and, finally, the electronics and digital revolution, have raised the trajectory of our economic standard of living through timetotal production per populationto the benefit of all. To place the impact of these innovation waves into a context, consider that 150 years ago on average one farmer fed two people. Today, using advanced techniques one farmer feeds fifty people. Along the way, displaced farm employees moved from field to factory using education and training to acquire the requisite skills for new industrial production methods. The Interrelatedness of Sectors The mystery of economic growth is not yet fully understood. Economists, though they have identified the components of growth, are unable to predict turning points in the business cycle with accuracy. Free markets themselves are prone to economic fluctuations because economic agents pursue their own interests. So when a significant economic sector, like household consumption or business investment, changes course without announcement, the effects echo throughout the entire economy. Business cyclefluctuations in economic activity caused by changes in expectations and business conditions affect income, production, employment, prices and interest rates. Economists once believed that business cycles could be logically modeled. Today, that earlier consensus view has waned. Economists do recognize that when output falls, unemployment increases. They also observe that macroeconomic indicators employment, output, spending, saving, investmenttend, on average, to move together, though sometimes with a time lag. What troubles cycle theorists is how to accurately and consistently predict the timing of irregular short run economic fluctuations. Even though economists have models that fit current and historical data, correctly anticipating the next economic turn remains more art than science.
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Business cycle phases Expansionrising GDP and employment Recessionfalling GDP and rising unemployment Depressionsignificantly falling GDP and rising unemployment Recoveryrising GDP and employment after a recession Separating time into two distinct periods helps. In the long run, a period of several years, an economy will tend to settle into what economists define as its natural rate of unemploymentthe rate around which unemployment fluctuates in a healthy economy. In this long period, changes in total economic demand affect only prices, not output, because the economy is producing along its natural growth path, about 3.5% annually for GDP in the US. In the short run, a period of one to three years, much can change, and suddenly, from either the demand side or the supply side of the economy. When one sector of the economy shifts, the resulting chain of events can be described but not easily predicted in time sequence, since the underlying economic responses at work stem from all too human group behavior. Even for the 2008-2010 recessionary cycle the pace and character of economic recovery were difficult to predict and to manage.
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In Sum Gross Domestic Product (GDP) is the current dollar value of all final goods and services produced within a country in one year; and serves as the official measure of a nations economic activity. o GDP measurement ignores: population growth, technology changes, investment above replacement and variances in industry market structure. o GDP is a rather narrow measure that ignores: product quality changes, household production, used good sales, inkind transactions and illegal transactions. The two views of GDP allow economists to measure and assess activity by the income earned by factors of production (supply) and the product purchased by economic sectors (demand). o Supply view measures factor income in the form of rent, wages, interest and profit plus capital depreciation and indirect business taxes, the sum of which equals GDP. o Demand view measures household consumption, government purchases, business investments and net exports, the sum of which equals GDP. Demand = C + I + G + NE = F + T + D = Supply, is the basic macroeconomic relationship. In words, the total dollar value of goods supplied in the economy in one year equals the total amount of those goods demanded by the sum of household consumption, business investment, government purchases and net exports. Law of diminishing marginal returnsgiven fixed amounts of land and capital, as the quantity of labor input increases, total output increases but at an eventually diminishing rate. Standard of livingA societys economic standard of living is measured by dividing total production for a year by total population Productivity measures and determinants of economic growth o Quantity and quality of the labor force o Quantity and quality of capital equipment o Level of work force education o Technology Business cyclefluctuations in economic activity caused by changes in business conditions affect income, production, employment, prices and interest rate o Expansion rising GDP and employment o Recession falling GDP and rising Unemployment o Depression significantly falling GDP and rising Unemployment o Recovery rising GDP and employment after a recession
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Lesson 12: Employment and Unemployment

Employment and Unemployment Work is essential to solving the economic problem for the individual and for society. Though the very young, the old, the infirm, the incarcerated and those in military service are excused from private market work, those in the workforce toil to produce the goods consumed by those groups, as well as for their own consumption. Human effort marks the beginning of the circular flow of economic activity. In a market-based society, sales of product fashioned through human application generate the earnings to sustain their collective makers. Those persons working are employed. Persons temporarily not working but seeking work are unemployed. Economists focus on the unemployed because their status reflects a loss of value to society and the affected individuals. Economists use carefully-crafted definitions to measure and assess employment and unemployment. Labor force components Total populationall persons in the society Less: persons under 16 years or institutionalized Equals: the non-institutional population o Less: those serving in the armed forces Equals: the civilian non-institutional population o Less: persons not in the labor force (neither working nor seeking work) Equals: Civilian Labor Force (CLF) total number of workers over 16 years of age who are either employed or unemployed. o Employedpersons in the labor force who have a fulltime or part time job. o Unemployedpersons without a job who are actively seeking work and are available for work. o Unemployment Ratethe number of unemployed persons divided by the labor force count. o Labor force participation ratethe civilian labor force divided by the adult population 16 to 64 years old
US Labor Force Data

Year Labor Force Employed 2009 153,172,000 137,960,000 2010 153,690,000 139,206,000 Source: www.BLS.gov Unemployed 15,212,000 14,484,000 Rate 9.9% 9.4%
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Employment figures are dynamic. Unemployed workers seeking work continue to be classified as unemployed. If a person quits seeking work they drop out of the labor force altogether. Perhaps they should be labeled as not employed to distinguish them from the unemployed. The official unemployment definition is narrow in terms of time and job-seeking actions. Many more persons are actually without market work than unemployment figures suggest. Another missing element in labor statistics is a definition for under-employment; those persons working at jobs that underutilize their skills or training. More puzzling is the situation where some people earnestly claim they want a job but make no real effort to find one. That last thought suggests that expectations influence the search for market work. If you had recently lost your job and were receiving unemployment benefits, what is the minimum wage you would accept in a new job? When your unemployment benefits ran out would you change the minimum wage you would accept in a new job? What other requirements would you impose on a new position? These and other relevant questions combine aspects of relatively impersonal labor market dislocations with personal job search criteria. Natural Rate of Unemployment In their quest to understand the nature of unemployment in the macro economy, most economists agree on this operational definition. Natural rate of unemploymentthe rate around which the unemployment fluctuates, in a healthy economy. For the US economy, the natural rate lies between 4% and 6% of the labor force. That idea is useful in advanced economies, where unemployment can never be zero, some workers will always be between jobs. Reasons for job change may be personal, such as a voluntary return to school for retraining; seasonal, like new home construction, or cyclical, driven by the ups and downs of whole industries. As long as the deviations from the natural unemployment rate are not too large or prolonged, government in a market-based economy chooses not to actively interfere with the labor market. Government does offer some buffers for those temporarily out of work such as unemployment insurance, paid for by employers through statebased insurance mechanisms. Curing Unemployment When the unemployment rate reaches an unacceptably high and sustained level, the government considers some form of policy intervention. As economists learned during the Great Depression of the 1930s, public spending as a demand side stimulus, even if financed by public borrowing, can increase total output and reduce unemployment, though not without economic trade-offs. Another policy-based means to reduce unemployment from the supply side of the economy is to offer job training subsidies for displaced workers and incentives to employers promising to hire and train newly displaced workers. Job search, seeking the position that is right for the individual, is another aspect of unemployments duration. Job searching takes time and can be frustrating. That
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frustration comes largely from lack of good information about the types, pay scale, location and availability of open positions. Economists recognize that while job search is costly, it is rarely due to a mismatch between supply and demand in the labor market. Rather, unemployed workers are busily searching for those jobs best suited to them. Economics of Minimum Wage Laws US minimum wage laws become a topic for political debate each time the federal minimum wage is increased. The economic reality of minimum wage legislation is firmly established through many well-crafted studies. When the mandated minimum wage is set above the market clearing wage ratethe unemployment rate for workers in minimum pay jobs rises.
In the chart above, you can see the two components of the increased unemployment from a higher minimum wage rate. Those jobs where the value of work lies below the new minimum wage will be laid offthe demand-side market response. The markets supplyside reveals formerly discouraged job seekers, enticed by the new higher minimum wage, trying to re-join the labor force but unable to find work. Workers in minimum wage positions who manage to keep their jobs do get higher pay. Though the higher minimum wage may or may not sustain a life style above the government defined poverty level. Persons unemployed due to the new minimum wage have
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two choices as they seek gainful employment. They can find other firms who see how their limited skills might offer value exceeding the new minimum wage, or re-train to gain marketable skills and earn a wage above the federal minimum. In Sum Civilian Labor Force (CLF) total number of workers over 16 years of age who are either employed or unemployed o Employed persons in the labor force who have a job. o Unemployed persons who do not have a job, are actively seeking a job and are available for work. o Unemployment Rate the number of unemployed persons divided by the labor force. o Labor force participation rate civilian labor force divided by the adult population over 16 years of age. The natural rate of unemployment is that rate around which the unemployment rate fluctuates. Minimum wage economicsincreases in the minimum wage also increases unemployment among those holding minimum pay jobs. Two sides of the unemployment effect: o Demand sidejobs where the value of the work is less than the new minimum wage the business owner must pay will be eliminated. o Supply sideformerly discouraged job seekers will attempt to join the labor force seeking work at the new minimum wage but will be unable to find it.
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Lesson 13: Money and Prices

Money Imagine a long-ago time where money as we know it did not exist. Consider a desert scene where two haggling nomads try to barter one ox for an equivalent value in food and clothing. Then multiply that vision times every transaction in the land. Moneys invention as a medium of exchange was destined to occur as a solution to inefficient bartering. Yet, that solution is not perfect. True coinage in the form of imprinted metal, commonly silver or gold pieces of predetermined weight, is first attributed to the kings of Lydia around the 8th century B.C. From that era forward, the means of exchange became more efficient as moneys use lowered the barriers of barter. Coinage, with all the benefits of dramatically reduced transaction costs in economic exchanges, also carries with it the scourge of fraud and debasement. As a practical matter, moneys use as a medium of exchange is validated when parties accept as payment coins and currency they believe others will honor. Roles of Money Medium of exchangepermits commodity values to be easily divided Measure of valuea standard way to meter value Store of valueeasily kept for later use Means of deferred paymentrecognized as valid for future payment Characteristics of Money Stable in value Portable Divisible into units Measuring Inflation In a barter economy, where the mutual exchange of goods occurs in the absence of an accepted money form, it is logically impossible for general prices to rise. There can be no inflation in a barter economy because each transaction involves commodity exchange equivalents uniquely defined by the parties in each transaction. Absent a common money form as a measure of value, a goods worth in one exchange has no effect on other barter transactions. In advanced economies like the US, the dollar as designated currency meets all requirements to qualify as money. Checkable accounts in banks also have emerged as a large component of the US money supply over the past 100 years. The wide acceptance of checks as payment makes them money. Currency and coins comprise about 50 percent of what is defined and accepted as money. Checking deposits in commercial banks made up the 50 percent remainder of the US money supply of $1,832.42 billion in Durable Uniform in unit size Recognizable
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2010. In 1913, the US centralized control of the US money supply control through the Federal Reserve Act. Since that time, it has been the prime responsibility of the Federal Reserve System (the Fed) leadership to manage the volume of money in circulation. Inflation often can be traced to a common sourceexcess money compared to the quantity of money households hold to purchase goods and services in an economy. To the extent that is true, if the central monetary authority successfully controls the money supply, it can strongly influence the overall level of prices and interest rates in an economy. Inflationa rise in the average level of prices; equivalently, a fall in the value of the money supply. As long as the purchasing power of the money held by the public changes so slowly that it does not alter perceptions of the future, the economy functions effectively. But when prices begin to increase at a rate that is unanticipated and too rapidly erodes the currencys purchasing power, citizens begin to panic as institutional processes falter. The difficulty with unanticipated inflation is that it assaults our usual protections against it. For example, if you open a savings account making annual deposits that earn 5 percent toward the expected cost of sending your child to college and average consumer prices begin rising unexpectedly at 10 percent annually, your prior expectations of affording those future college-related expenses evaporate.
US Consumer Price Index [CPI]

Year US CPI-U 1982-1984 100.0 2009 217.2 2010 220.3 Percentage Price Change 2009 to 2010 (220.3 217.2) X 100 = 0.47% 217.2
Source: www.BLS.gov
The US Bureau of Labor Statistics is charged with the task of measuring inflation. Among several related measures is the popular consumer price index (CPI). The BLS also tracks other price indexes like the producer price index, the wholesale price index and the GDP deflator, the broadest of the inflation measures. Consumer Price Index (CPI)a measure of the average change in prices over time, paid by urban consumers for a market basket of goods and services. The idea behind the CPI is to measure consistently the price of representative consumer purchases in a particular year compared to prices for the same items prevailing in a base year. The CPI market basket contains 200 goods and services in 8 major groups. From the table above, in 2009, average consumer prices were 117.2% higher than in 1982-1984. As a consequence, to have the same purchasing power in 2009 as in 1982-1984, your income would need to more than double over that same period. Between 2009 and 2010, average consumer prices rose less than one-half of one percent (see table above). The base year choice for a given price index series is arbitrary and does not alter the results.
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US Gross Domestic Product Deflator

Year 2009Q4 2010Q4 Current GDP (Billions) $14,277.3 $14,870.4 GDP Deflator (2005 = 100%) 1.09665 1.11118 Real GDP (Billions) $14,277.3 / 1.09665 = $13,019.0 $14,870.4 / 1.11118 = $13,382.6
Source: www.BEA.gov The CPI adjusts for prices in a consumers market basket of goods. A different index (see the table above), the GDP Deflator is used to adjust prices for all goods and services produced. A base year, currently 2005, is selected and subsequent years GDP output is valued using the 2005 base year prices. Using that technique allows the government to measure real GDPactual goods and services produced, without the effect of price changes. Inspect the GDP Deflator column in the table to see that 2010 4th quarter prices are 11.1% greater than in the 2005 base period. To adjust the 2010Q4 current dollar value GDP figure (where both output and prices have changed from 2005) divide the 2010Q4 deflator value into the current GDP of $14,870.4 to get $13,382.6 billion in real GDP. Hence, between 2009 and 2010 fourth quarters, US real GDP grew by $363.6 billion ($13,382.6 minus $13,019.0). Inflations Winners and Losers While it is easy to typecast inflation as evil, in moderationabout 2 or 3 percent per yearit has beneficial economic effects. Entrepreneurs like modest inflation when they decide to invest, because they expect higher prices for their companys product in the future. Some leading economists credibly claim that moderate expected inflation helps stimulate economic growth. The difficulty with inflation is its drain on purchasing power and wealth among citizens and institutions in the economy. There are recognizable groups who lose and other groups who gain from inflation. Persons on fixed incomes, or whose incomes increase much less rapidly than the inflation rate, lose relative purchasing power through time. Creditors also can fall into the category of inaccurate inflation forecasters. If a bank or mortgage company lends funds at 5 percent per year and the inflation rate over time turns out to be 5 percent annually, the lender will be paid back a fixed quantity of money with the same purchasing power as was loaned. But if future inflation is greater than 5 percent, the lender is paid back in dollars of lesser purchasing power. Taxpayers can also lose during inflationary times in a more subtle way. An inflated personal income level can fall into higher tax bracket, making the tax filer pay more federal tax dollars. Inflations winners appear as debtors who can pay off loans in less valuable dollars, especially if their own incomes are among those keeping pace with the inflation rate. Owners of inflation-sensitive assets often win during inflationary times when they sell the priceinflated asset. Landowners and homeowners may see the value of their homes rise, though their property taxes also may increase.
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Taxing authorities may gain from inflation, for example, through property taxes based on current appraised valuations, if the taxation method does not adjust for inflations effect. Controlling Inflation Moderate and relatively steady inflation of a few percentage points per year does not appear to be detrimental and can help stimulate economic growth. But at what point does a relatively benign inflation rate become worrisome or destructive? The US record during the 1970s shows that inflation rates above 10 percent per year cause significant resource dislocations, arbitrary redistributions of wealth and general unrest. Labor unions during that time discovered that attempts to neutralize inflations effects by holding out for wage increases equal to expected inflation will ultimately fail if future prices rise faster than the newly bargained wages. Two serious risks for government policy makers are that the inflation will become institutionalized, so strongly built-in to contracts, interest rates and expectations that reducing inflation becomes extremely difficult, or reach uncontrollable levels that literally exhaust the economy as citizens rush about making hasty transactions and seeking shelter from exploding prices. World events for other countries have shown that hyperinflation episodes, where annual inflation rates crest 100 percent or more, destroy confidence in the government as businesses, citizens and institutions fail to cope. An excessively high inflation rate must be addressed via an equally heavy cure. The economic and political costs of getting prices under control can be large, yet not taking action can be ruinous. The government faces the dilemma of launching a credible antiinflationary program when they are perceived as most responsible for the inflationary spiral. Fundamentally, the central monetary authority must consistently reduce the volume of money in the economy. Unfortunately, the economic price of a restrictive money policy usually is a recession, perhaps a deep one. Harsh and sustained reductions in the money supply make nominal GDP fall as companies lay off workers due to uncertainty about future economic adjustments and the central banks will to sustain its antiinflationary stance. More, the policy-induced poor business outlook makes investment fall even as inflation-padded interest rates remain stubbornly high. The recessions length and depth will directly reflect how long it takes people and institutions to dismantle the inflationary protections they erected during the period of rising prices and to, once again, regain their pre-inflation level of social trust.
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In Sum Money is denoted by the government as legal tender and the public validates it by honoring it in transactions. Money fulfills its role as a useful medium of exchange as long as its value does not change rapidly. Inflation cannot manifest in a barter economy because each transaction involves different commodities and different people. Inflation is a rise in the general level of prices over time. Consumer goods inflation is measured by the Consumer Price Index (CPI) as the change in value from a given base year for a market basket of typical goods. The GDP Deflator is used to adjust all of a given years GDP to the prices prevailing in another year. Inflations winners and losers o Winners include debtors, tax collectors, holders of inflating real assets o Losers include creditors, fixed income earners, income tax payers Inflation nearly always owes its origin to prior increases in the money supply. Curing inflation requires systematic and consistent reduction in the money supply, which can cause a recession. Hyper-inflation is particularly damaging because it is very difficult to break and overwhelms economic institutions.
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Lesson 14: Money and Interest Rates

Moneys Official Definitions The US government officially denotes the dollar as currency to be legal tender and society validates that designation by accepting it in exchange for goods and services. With the rise of banking as an institution, checkslegal instruments accepted for payment called demand depositshave found their way into the operational definition of money. Printing physical currency and stamping coins is the responsibility of the US Treasury. Accommodating the volume of money the economy needs is the duty of the Federal Reserve System, the US central bank. The difficulty in defining and controlling money in the economic system is due to the many creative ways people can use cash or near cash. Demand deposits (checking accounts) pass as a medium of exchange. It is less clear how to interpret checkable savings deposits that earn some nominal interest rate. The discerning question becomes at what point is money closer to an illiquid asset versus easily accessible cash? These and related questions compel economists to adopt more than one money definition. M1 = (coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010. M2 = M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010. Money is Not Credit Many Americans seem to think that credit cards are money. The truth is they are not. Credit cards are short-term promissory notes permitting the holder a line of credit for a fee called interest. The monthly balance on the credit card is paid using money, commonly a personal check drawn against the cardholders bank account, a demand deposit. The credit card balance, a short-term loan, can for a while, run ahead of the cardholders ability to pay the total balance in moneycheck or cash. Over time, either the cardholders credit balance is paid in full or the consequences range from card cancellation to personal bankruptcy. Indiscriminate credit card users also pay higher interest rates. Moneys Scarcity Preserves Its Value Goods and services satisfy basic human needs. Money is merely a means to economic ends. If the central monetary authority were to increase the money supply so that each citizen could fill their pockets and purses with it, then prices for goods would rise dramatically as shop owners witnessed a mad rush of cash-laden customers scrambling to outbid their neighbors for available goods. Ruinous inflation would inevitably result.
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The practical objective of the central monetary authority is to supply the economy with a quantity of money that satisfies the needs of commerce, and no more. As average prices rise, the value of the dollar falls, and the opposite is true. Preserving a currencys value and moderating average prices, requires the monetary authority to maintain a relatively constant ratio between the volume of goods and services produced and the quantity of money in circulation. So why is this objective so difficult to achieve? Market economies are dynamic, leaky and fickle. First, business momentum can bring unanticipated swings in overall activity. Second, money leaks outside of the economy through international transactions, especially when the US buys more from other countries than it sells to them. Perhaps most vexing of all, the amount of money businesses and households holdthe demand for liquidityto meet transactions needs and uncertainty is entirely up to them. Changes in the quantity of money held can be unexpected, swift and large. These three forces: economic shifts, currency leakages and changes in money demand, make knowing how much money the economy needs difficult to predict and to accommodate. Times Value is the Interest Rate The interest rate is the measure that links the value of an economic good tomorrow to its value today. In normal economic times the rate is positive, indicating that if we choose to wait for a future good, we insist on some reward for doing so. At the personal level, it makes sense to keep a certain amount of our income in a checking account where the money is immediately accessible but earns little or no interest. It is also prudent to keep some money in a savings account, where funds are somehow restricted but earn a higher interest return. Savings accounts offer a positive interest rate to entice savers to deposit funds into financial institutions. We each carry a personal interest rate with us and it shows up in our current consumption-to-saving behavior. If we consistently spent all of our income today, we would be showing little preference for the future. Then by implication, our personal interest rate must be higher than the market savings rate. If, instead, we engage in a steady savings plan with some of our after-tax income that earns 4% in a certificate of deposit, then our personal interest rate for short-term savings must be less than 4 percent. The interest rate similarly serves to allocate business investment spending. Before making an investment, business decision-makers analyze the proposition by estimating the expected future dollar profit returns as a percentage of the total investment cost in todays dollars. They then compare that rate of return to the interest rate cost of borrowing. If the anticipated investment rate of return exceeds the cost of borrowing, the investment may be a good one. To the extent that an investment pays a return above all costs including the cost of borrowing, todays income gets converted into tomorrows wealth. Funds for investment come from household savings, business savings (as undistributed corporate profits). Without savings somewhere in the economy, investment is not possible. The prevailing interest rate represents the macro trade-off between consumption today and consumption tomorrow. From the savers view, it is the reward for postponing consumption today. From the borrowers view, it is the cost of gaining command over resources today rather than waiting until tomorrow. In the financial marketplace, as net savers supply funds and net borrowers demand fundsthe market rate of interest is determined.
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Banks and financial markets exist to permit the orderly transfer of funds from holders of excess income to borrowers with a deficit of available funds. Interest rates, as a cost of credit and as a reward for not consuming, are determined in financial markets by the interplay between demanders of loanable funds and the suppliers of loanable funds. In Sum M1, the official money supply definition equals coin + currency in circulation, bank vault cash plus demand deposits in commercial banks. Credit cards are not money. Credit cards are short-term financial contracts mandating repayment with interest. The central banks main objective is to preserve the value of the currency by providing only that amount necessary to meet the needs of commerce as it helps the economy achieve full employment. As average prices rise, the value of the currency falls and as average prices fall, the value of the currency rises. The interest rate simultaneously is a reward for saving and a cost of borrowing to invest. The orderly interaction of savers and borrowers through the financial system determines the interest rate. Leakages of money out of the economic system, swings in economic activity and changing demands to hold money make controlling the money supply difficult for the central monetary authority.
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Lesson 15: Federal Reserve System

What Commercial Banks Do Commercial banks are private stock-issuing companies licensed in their state of incorporation to conduct business as a financial institution. Many commercial banks also hold a national banking charter, making them mandatory members of the Federal Reserve System. All banks must be chartered in the state where they conduct business. State banks that choose and meet the federal requirements can become bank members of the Federal Reserve System. Banks transfer funds from net savers to net borrowers in the economy. Using the funds voluntarily deposited by their customers, uses prudent lending practices and not all customers wish to withdraw their money at the same moment (a bank run), the process of allocating funds from net savers and net borrowers, at interest, works effectively. Through this institutional system of money management, moderated by the average rate of interest, money demanded by net borrowers is matched using money supplied by net savers in the economy. What Central Banks Do In the US, the Federal Reserve System is the central bank federally authorized to a) regulate the US banking system and b) to regulate the money supply toward the broad goals of low inflation, full employment and stable interest rates. . Federal Reserve System Structure Board of Governors 7 members appointed by the President and confirmed by the US Senate, serve 14-year terms, each staggered by two years. The board chairman, appointed by the President, serves a 4-year term as chair and may be re-appointed. 12 Regional Federal Reserve Banks and 24 branches are located in US financial centers. Federal Open Market Committee determines major policy positions for the US money supply, comprised of o 7 members of the Board of Governors o 5 of the 12 Fed bank presidents serve 1-year rotations o New York Fed bank president has a permanent voting position Member commercial banks (about 7,000) includes all national banks and about 1 in 7 state banks representing nearly 85 percent of the US money supply. Member commercial banks actually own stock in their regional Fed bank that earns 6% interest annually. Source: Federal Reserve System.gov
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Money and the Federal Reserve The Fed sits outside the US economy and interacts with the financial system using its monetary tools. To understand how the Fed influences the money supply, we must define what money is. The domestic money supply (officially called M1) is the sum of coins and currency in circulation (including vault cash on hand in commercial banks) in the US plus demand deposits (checking accounts) in US commercial banks. US money supply control rests on the idea of fractional reserves. A small fraction, currently 10 percent of each member commercial banks deposits are held on reserve at the regional Fed bank, outside the economy. The remaining 90% of demand deposits are available for loans to qualified borrowers or for investment. These reserves are not imposed to protect customer accounts. That is the job of the Federal Deposit Insurance Corporation (FDIC). The reserve requirement is an instrument of monetary control that limits the maximum volume of money growth in the economy. Federal Reserve district banks monitor the commercial banks in their district, which must balance their accounts daily. On Wednesday morning every other week, commercial member banks must comply with the reserve requirement based on deposits resident in their own bank. So how does this process limit the money supply? The Money Multiplier The composition of the nations money supply divides evenly between cash in circulation and checkable accounts that serve as money (M1). The reason that demand deposits are part of the money supply is that they perform much the same functions as cash. It may seem strange, but the volume of money stock supports several times its volume in US gross domestic product flow over a years time. The money supply is spent several times over to accomplish the feat. Commercial banks, Fed policy and the non-bank public impersonally collaborate to grow or shrink the money supply. Money is created in the act of borrowing from a commercial bank and destroyed in the act of repaying the loan. If a customer enters a bank and comes out with a loan, the bank honors the agreement by creating a line of credit in the borrowers name. As the newly loaned funds are spent they become deposited into other banks as cashnew money by definition. Perhaps equally surprising, the money supply is reduced when loans are repaid. The check that clears through the system to extinguish the loan debt also reduces the borrowers checking account (money by definition, or cash holdings) by the same amount. The interesting economic aspect of these actions is that the money supply available at any one time depends on both Fed monetary policies and the borrowing behavior of citizens and businesses. To more fully appreciate this process, consider that the Fed literally sits outside the US financial system and works to accommodate the economys money stock needs, in line with established goals like keeping inflation and unemployment low. The Fed is not
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concerned, and neither should we be, with where it gets moneyit has an open account outside the monetary system. The Fed primarily focuses on how much money circulates inside the economy, not about making money itself. The reserve requirementa Fed-determined percentage of demand deposits in member banksfixes the amount of reserves banks must hold. The Fed, by setting this required rate defines the upper limit of money available in the economic system. Importantly, commercial bank required reserves are not part of the money supply but form the base upon which the money supply rests. If the Fed requires all banks to keep 10 percent of demand deposits on reserve, then $90 of every $100 in demand deposits can be loaned to customers. As soon as borrowers acquire the $90 in loans, and spend it, most of it will find its way into other banks as new demand deposits. These other banks also are required to keep 10 percent (now, $9) on reserve but are free to loan the remaining $81. You can see what is happening: $100 in new demand deposits has generated new loans (money by definition) of $171 ($90 + $81) among the borrowing public. If this process continued to its theoretical limit, the increase in the money supply would equal $900 for a total money supply volume increase of $1,000. This money multiplier process works in both directions. As a customer pays off a loan, a demand deposit balance is reduced and the money supply shrinks accordingly. How? The lending bank accepts the borrowers check as the final loan payment, the customers debt is extinguished and, once the check clears, a checking account balance is reduced, thereby shrinking the money supply. Some observations are in order. First, the money multiplier process does not reach its theoretical maximum because leakages persist in the system. Not all available funds are loaned out by all banks and not all the borrowed funds are spent. Second, loans are being extinguished, paid-off, at the same time new loans are being approved. Hence, money is being destroyed as new money is created and the net of these two sets of acts determines, in part, whether the money supply is growing or shrinking. If the money multiplier description above reads like financial sleight-of-hand, it is not. The money expansion and contraction process is no more mysterious than the physics of using a lever, instead of ones hands, to move a heavy object or using a pulley system to lift a heavy weight.
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Monetary Tools of the Fed Reserve Requirements-The percentage of demand deposits commercial banks must hold as reserves.
FED Deposit Reserve Requirement (10%)

Increase % of Demand Deposits Held on Reserve Bank excess reserves decrease Fewer loans made Money supply decreases Interest rate tends to fall Decrease % of Demand Deposits Held on Reserve Bank excess reserves increase More loans possible Money supply increases Interest rate tends to rise
The Federal Reserve Systems charter provided for three major monetary tools, and several lesser tools. We have already mentioned its most powerful, and least often utilized, toolreserve requirements. It is powerful because it affects all banks in the system and because even small changes in the reserve requirement percentage can bring about large changes in the money supplys upper limit. Open Market Operations-Buying and selling existing US government financial instruments from or to willing customers (individuals, businesses and banks) in the economy.
FED Open Market Operations

Fed Re-sells US Govt. Bonds to the Non-bank Public Public gets bonds from Fed Reduced demand deposits Money supply reduced Interest rate trends to rise Fed Buys US Govt. Bonds from the Non-bank Public Public gets money from Fed Increased demand deposits Money supply increased Interest rate tends to fall
The Feds most often used tool is open market operations. The Fed has the financial authority to buy and sell prior-issued US government bonds. These bonds originated from the Treasury as debt instruments to finance congressionally-approved increases in the federal debt. Investors willingly purchase or sell the instruments, as part of their financial portfolios, even though their interest yields are low, because they are very safe.
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Federal Reserve Discount Rate-The interest rate that the Federal Reserve charges member banks for borrowing as they work to meet the Required Reserve ratio on the one hand and satisfy the needs of business loan demand on the other.
FED Discount Rates

Discount rate increased Higher member bank costs Fewer funds borrowed Reduced money supply Interest rate tends to fall Discount rate decreased Lower member bank costs More funds borrowed Increased money supply Interest rate tends to rise
The Fed does not control the general level of interest rates in the economy. At most, it influences the money supply to nudge interest rates in the desired direction. The Fed sets only one interest ratethe discount rate charged member banks for borrowing from the Fed, when a bank comes up short on the bi-weekly reserve requirement. That rate is called the discount rate because, unlike common loans where the interest due is included in regular payments with the principal, the Fed collects the interest immediately from the amount borrowed. The member bank borrower repays the full amount of the loan typically within 12 to 72 hours. Member banks actually have two sources from which they can borrow to cover a required reserve deficit. First, they can borrow the excess reserves (named Fed Funds) from other member banks in the system and pay the interest rate determined in that sub-market. That interest rate is established by the amount of excess reserves available versus the amount of deficit reserves demanded in the banking system. Second, the deficit bank can borrow directly from the Fed. The choice is simple, the banks with the reserve shortfall borrow from whichever sourcesystem banks or the Fedoffers the lower interest rate. The Feds responsibility is to accommodate financial needs and maintain market stability. In normal times, Fed changes in the discount rate are interpreted as signals of the Feds view of the economy and its future. A decrease in the discount rate might signal a looser money supply, lower interest rates or possible future inflation. An increase in the discount rate could signal a tightening of the money supply and higher interest rates and reduce private market investment.
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In Sum Commercial banks are financial intermediaries in business to make a profit loaning and investing depositors funds. The Fed regulates commercial banks and controls the money supply toward the goals of low inflation, full employment and stable interest rates. Money supply (M1) equals the sum of coins and currency in circulation plus commercial bank demand deposits. The money multiplier is based on the fractional reserve requirement for commercial banks. o Reserve requirements are now 10% of demand deposits, leaving as much as 90% available for loans and investments o The money multiplier is limited by the Feds reserve requirement percentage and the publics demand to borrow Money is created in the act of borrowing and destroyed by loan repayment. The Feds primary obligation is to regulate the economys monetary sector to achieve the goals of low inflation, stable interest rates and full employment. o The Fed operates from outside the monetary sector and works to maintain an adequate supply of money in the economy o The Feds objective is not to profit from any of its policy moves or operational transactions. The Feds main tools for controlling the money supply are: o Reserve requirements10% of demand deposits on reserve o Open market operationsthe Feds buying (to increase the money supply) and selling (to decrease the money supply) prior issued US government bonds in financial markets o Discount ratethe interest rate the Fed charges member banks for borrowing to maintain the reserve requirement
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Lesson 16: Macroeconomics: Long Run and Short Run

Macroeconomic Goals Attempts to resolve the nations economic problem underscore the need to make real trade-offs in the macro economy. What goals should an economy pursue to best address the economic problem? The Employment Act of 1946, passed in response to the Great Depression, set forth the governments commitment to maintain full employment. That act also established the Council of Economic Advisors, an appointed body of economists, who to this day provide policy counsel to US presidents. Macroeconomic Goals Full employment Stable prices Steady growth Stable interest rates Pursuing these goals also reveals policy conflicts that cannot be resolved without sacrifice. The federal government itself must recognize the trade-offs for the economy as it passes legislation to either stimulate or restrain market forces. The essential question is just how does the macroeconomy work? Economists have sought for over two centuries to understand the nature and functions of a market economy through its two basic forcesdemand and supply. The theoretical question is whether and how a) supply creates the income to equal demand or b) demand generates enough expenditure volume to purchase the supply? The debate has two major sub-parts: 1) what forces motivate change in economic actions and 2) do macro-markets adjust for the short run or the long run? Despite disagreements on each of these questions, the majority of mainstream economists accept as true the following statements about macroeconomics. Accepted Truths About Macroeconomics Money volume is a stock, and income is a flow The money stock is a fraction of total national income generated in any year People have a demand for liquidityto hold part of their wealth as money One person can alter the money they hold by altering their own current expenditures, but all persons in a society cannot alter the money they hold without macro consequences As their wealth increases, people tend to spend more current income, and the opposite is true A nation can make new economic investments only up to the level of its current savings
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The Long Run and Short Run
Mainstream macro economists accept that the Classical economists view of two centuries on how the economy works is correct in the long run. Inspect the graph below to see what that means, in terms of aggregate demand (the down sloping green curve) and aggregate supply (the curved upward red curve). In the long runperhaps several yearsthe economy tends to adjust into equilibrium at or near full employmentthe vertical dark line in the graph. That happens because the production of real GDP ultimately depends on the supply of labor, capital and natural resources. Once at full employment and equilibrium, the price level then depends only on the volume of money in the systemand the central bank can influence the growth of the money supply to maintain price stability. Aggregate demand [AD]a down sloping line that shows the quantity of GDP demanded [the sum of household consumption (C), business investment (I), government spending (G) and foreign customers (NE = Net Exports)] purchased at each price level. Aggregate Supply [AS]an up sloping line that shows the quantity of goods and services businesses choose to produce and sell at each price level. In symbols: Aggregate Supply is a function of Labor, Capital, Land and Technology. The economys real economic variablesproduction and employment (human activity and goods production)are most important. The nominal economic variablesthose measured in money or percentage terms: prices, wages and interest rates,
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serve as facilitating signals to help determine the quantities of the real variables utilized in the economy. During normal times adjustments in prices, wages and interest ratesthe nominal variableswork to bring the production and employmentthe real variablesto full employment, the natural state for an economy in the long run. It is in the short run where reality is messiest and debate is hottest. See the down sloping green AD1 line in the graph above and note that where it crosses the ASShort Run real GDP is well below the full employment level of GDP. That means there is a large percentage of unemployed workers. Misperceptions and uncertainty about the future by both consumers and business leaders abound. When the economy goes awry, a mismatch between desired investment and actual savings sends the economy reeling. During this phase both the price level and average wages adjust rather slowly, adding to future uncertainty about the economy. The natural human instinct during times of strife is to pull back. At worst, a downward cycle of falling consumption and investment reduces aggregate demand at any price level, shifting it to the left. If the economy slips too far, the societal pain calls for aggregate demand stimulus from government. Economists and policy makers seek to bolster aggregate demand through policies like: increased government spending (financed through public borrowing), reduced federal income tax rates, and investment tax credits for business. The Federal Reserve System also may increase the money supply to lower interest rates and stimulate borrowing by households and businesses. The Equation of Exchange Classical economic thought bears a relationship to what is called the equation of exchange. The formula has held an important position in macroeconomic analysis for 200 years. We treat it here to motivate discussion on the role of money in determining nominal (current dollar) GDP. Given the definitions below, the two sides of the relationship are identities. In other words, the money stock (M1) times the number of times the stock is spent (V for velocity) must equal the real GDP (Q) times the average price level (P). In short, the money stock times its expenditure turnover must equal goods produced times their average price. Equation of exchange: M V = P Q, the relationship between money, prices and goods production where: M = quantity (stock) of money in circulation (here, M1), V = velocity of money, the average number of times the money stock is spent in a year to buy new goods and services, P = average price level for goods and services, Q = physical quantity of goods and services produced in one year = real GDP, and P Q = nominal GDP. It is V that holds the greatest interest for economists. It measures, indirectly, the publics demand to hold money. V is very stable over time, though it is not constant. The reason is that the publics desire to hold some of their wealth in the form of liquid money varies with swings in the economy and their mood concerning future economic expectations. Consumers and businesses play a crucial role determining the actual amount of the money stock and that makes monetary policy an art form. For example, if the
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Federal Reserve moves to increase the money supply to stimulate the economy but citizens absorb the increase by holding more money than usual instead of spending it, they unwittingly undermine the Feds policy objective. The household sectors response to money supply variations becomes difficult to forecast when economic times are uncertain. This is so because holding money has two costs: a) the lost opportunity of interest return on an investment and b) the prospect that in times of inflation, the asset named money is losing value. Add to this the tendency for effects from changes in the money supply to take effect from 12 to 18 months after a policy change, and the usefulness of monetary policy in periods of recession is limited. The Multiplier Though it may appear to non-economists as sleight-of-hand, $100 of new spending actually generates more than $100 in GDP. This phenomenon occurs in a manner not visible to individuals. In short, expenditures that initiate new economic activity are re-spent more than once, though by different people, as businesses along the production chain work to replenish inventories and workers receive additional income to spend. Multiplier-The effect of additional spending from an initial spending stimulus from either the private sector (consumption or investment) or the public sector (government spending or government taxes). Suppose that the auto makers in Detroit determine that the next year is going to be less robust than originally forecast, so they reduce their orders for new cars by $5 billion. Call this the initial shock. Recall that GDP measures production or income and it will not fall simply due to a reduction in automobile orders. What will happen is that the automakers collective $5 billion reduction in investment will cause manufacturers to add $5 billion of unsold cars to their inventories, an unanticipated investment. Now the manufacturers are stuck holding $5 billion more in unsold car inventory than they desire and they will take steps to reduce it. How? The manufacturers cut future orders by $5 billion in new car production. They lay off workers, idle plants and reduce purchases from suppliers. Subsequently, the suppliers will have to cut back their planned activity and they will move to reduce their own inventories. Once these reactions ripple from the original decision to reduce production and work their way through the supply chain, GDP also will have fallen by $5 billion. Call this the industry chain reaction part of the multiplier. But the economic reverberations do not end there. Workers now have less money to spend due to the production decline. Less personal income means less expenditure for personal consumption. If consumers behave according to their usual habits, additional consumption will fall by some fraction of the $5 billion. For example, local shops and restaurants, auto dealers and clothiers notice a fall in store patronage and average customer purchase amounts. Consequently, non-automobile industry inventories also experience unexpected excess supply building up and they, too, take steps to reduce their unwanted inventories. Call this the household sector part of the multiplier. So the effect of one industrys lower expectations of the future and related adjustment comes to be multiplied throughout the economy.
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Multipliers work in both directions; enhancing the effect of both spending increases and spending decreases. The multiplier effect from re-spending rounds to accommodate inventory changes moves the Aggregate Demand curve from its original position to its final position. Multipliers take a year or two to work out. Any new spending change from any sector: households, businesses or government, has an associated multiplier. The economy enjoys the multipliers power when spending is on the rise but also must suffer the contraction impact when spending levels fall. In Sum Economists agree on certain economic goals, but they cannot all be met simultaneously without the government making trade-offs: Full employment, Stable prices, Steady growth, Stable and low interest rates Most mainstream economists accept the following beliefs about the macro economy o Most people have a demand for liquidityholding money o One person can change (increase or decrease) the money they hold by reducing or increasing their expenditures. o All persons in the economy cannot alter the money they hold without consequences. o Households make the choice to consume or save their income based on their personal needs and future outlook. o Businesses make the decision to borrow for investment based on the interest rate and the future business outlook. o Business can make new investments only up to the level of current savings in the economy. The debate on how the economy works centers on what how the economy adjusts in the short run versus the long run. The multiplier represents the additional spending generated to reduce or replenish inventories from spending changes in any sector. The equation of exchange is: MV = PQ o Where M = M1 (money stock), V = velocity, P = average price level and Q = GDP output o The equation shows how the money supply directly affects nominal GDP
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Lesson 17: Fiscal and Monetary Policy

Laissez-faire versus Government Intervention Does the public truly believe in free enterprise and the workings of private markets? Why not let markets lift all businesses in good times and purge weak firms in slow times. Or should government intervene in a market society during an economic crisis? Understanding that there is no economic action without consequences, what are the costs and benefits of government attempts to moderate economic swings? Do government economists and political leaders see the future so much more clearly than the rest of society? These and other compelling questions spur the debate on if, how and when government should manifest its presence in a free enterprise economy. The fact is that individual actions today are based on perceptions of the future. Policies intended to benefit collective behavior toward a desired economic goal, however well intentioned could misjudge the economys needs as well as the collective economic response. The Demand for Money Knowing how much money individuals and businesses demand to hold is important because that is how many federal economic policies most often show upas checks or as the inducement to write checks to spend or invest. First government economists and policy makers must predict how the average household will respond when they receive new money from the government. Each individual and business has a certain demand to hold money for transactions, uncertainty and speculation. If they possess more money than they wish to hold, citizens attempt to spend or invest the difference. If they currently hold less than the desired amount, citizens will curtail spending or liquidate investments until they achieve desired money balance. Incorrect estimates by government economists on how the public will react, given their demand for money, can erode a policys intended economic effect. Why can the economy not easily absorb unexpected or unwanted increases in the money supply? From the view of the total economy, one individual can shed excess money by buying more goods or investing in additional assets. But when all individuals attempt to do so, higher demand for the goods or investments sought with the excess money drives up their price. The reason is that the output levels simply cannot respond quickly, because of industry rigidities, uncertainty, misperceptions or even fear. So inflation shows upas a means to absorb the excess money. Monetary Policy Tools Monetary policy operates through Fed tools, by altering commercial bank reserves to affect the money supply and achieve macroeconomic goals. The Feds seven-member Board of Governors and the Federal Open Market Committee jointly determine
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monetary policy actions for the economy. The tools used to conduct monetary policy are well-defined and, in a mechanical way, do work. Yet the full effect of a monetary policy shift may take as long as 18 to 24 months to work through the system. That places much pressure on the Fed to correctly anticipate future conditions and then be correct in their policy move. Monetary Policyinfluencing the economys money supply, by central bank policy makers to achieve national goals.
Monetary Policies with Effects on Aggregate Demand and Interest Rate

Loose Monetary Policy Fed lowers reserve requirement Fed buys government bonds Fed lowers discount rate Interest rate tends to fall Increase; Shift to the Right Aggregate Demand Tight Monetary Policy Fed raises reserve requirement Fed sells government bonds Fed raises discount rate Interest rate tends to rise Decrease; Shift to the Left Aggregate Demand
For the Fed to achieve its stated targets without making other economic measures worse they must accurately read both the current condition and mood of the economy. The Fed must then correctly anticipate how each major economic sector is likely to respond to their monetary policy change. For example, should the Fed pursue a policy of stabilizing interest rates or stabilizing growth in the money supply, M1cash and demand deposits? If the Fed attempts to keep interest rates low by increasing banks excess reserves and expanding the money supply, short-term interest rates will fall. But over time, interest rates and prices could rise if there is more money than the economy needs to purchase current production. The inflation arises because people want to hold only so much money, so they shed any excess money balances by purchasing other goods or making investments. While one person can lower his or her money holdings, all people in the economy cannot do so without consequences. So, general prices rise from excess dollars chasing too few goods. Banks enter the picture again as they try to preserve the purchasing power of future loan payments by bumping up their loan rates as protection against future inflation. With interest rates now starting to rise, the Fed finds itself having to increase the money supply again to temporarily lower interest rates. This sequence of actions is the beginning of a monetary policy-induced inflationary spiral. So what is the best proscription for the Fed regarding monetary policy? Perhaps to match the growth of the money supply to the long run real growth rate of the US economyabout 3.5% per year. If the Fed were able to control the money supply that closely, at least some relative sense of stability could be achieved. Yet steadfast reliance on this policy can be criticized from two positions. First, it tends to inhibit economic growth above 3.5% per year. Second, it ignores the economys liquidity needs during unexpected economic downturns.
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Fiscal Policy Tools Fiscal policy influences aggregate demand through Congressional legislation that alters federal spending and tax rates to achieve macroeconomic goals. Americas discretionary fiscal policy debut occurred during the Great Depression. Prior to that time, incurring federal debt was unthinkable for a capitalist-based economy and politically supported only as a last resort to finance foreign wars. There are legitimate economic and political reasons why the public should pay for social assets like highways, public education and national defense. As long as tax revenues are raised in a relatively equitable fashion and do not outstrip government expenditures, citizens usually raise little protest. Fiscal policyactions altering federal spending levels via Congressional policy on government programs and taxation.
Fiscal Policies and Effects on Aggregate Demand and Interest Rates

Policy Direction Government spending increase Government transfer increase Government tax decrease Interest rate tends to fall Increase; Shift to the Right Aggregate Demand Policy Direction Government spending decrease Government transfer decrease Government tax increase Interest rate tends to rise Decrease; Shift to the Left Aggregate Demand
The role of government as business cycle steward raises more difficult questions. How much federal government presence in the market is desirable and necessary to stabilize the economy? Does active government spending during times of rapid growth or decline do more good than harm on balance? Fiscal policy management is an inherently political process. Federal legislation to alter spending or taxes is subject to the voting and procedural rules of every congressional bill. The new policy must be crafted, debated, voted on and signed into law. No matter the urgency of the economic need, partisanship is part of the process. Once the legislation is signed into law it may take some time to implement, then more time to have its desired effect. By that point, the economy may have already healed or may be too ill for the legislated remedy to cure the problem. While the US track record on fiscal remedies achieving desired targets is mixed, the logically anticipated effects of fiscal policies on the economy are mechanically direct. National Debt and Fiscal Policy When the federal government spends more than it receives in tax collections, it borrows the difference from society. To authorize the bond sale, Congress must pass legislation approving an increase in the statutory federal debt ceiling. Then, on instructions from Congress, the Treasury prepares new financial instrumentsUS Government Bondsand offers them for sale in domestic financial
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markets in an amount sufficient to cover the anticipated annual debt increase. These US government bond debt instruments have a face value, fixed duration and interest rate stated as a percentage of the face value, as do most bonds. The Federal Reserve System then acts as the Treasurys agent to conduct the initial bond sale in US financial markets. Individuals, companies and banks can buy US government financial instruments to hold in their investment portfolios. Even though their interest yields are lower than other financial assets of similar size and duration, they are backed by the full faith and credit of the US government. Crowding Out Effect of Deficit Financing The US government borrows money from the same pool of net savings from which the private sector draws. Two opposite in direction effects occur on the money supply when increasing the federal debt. First, some part of the public willingly trades money in exchange for US bonds, so the money supply temporarily shrinks, causing private market interest rates to rise. Second, and sometime later, the Treasury spends the newly acquired money on federal programs. Now the money supply increases and interest rates tend to fall, though not necessarily to their prior level. So deficit financed fiscal policy contains an inherent monetary dimension. When the government enters the money market as a borrower, the possibility, and often the actuality, exists that business investment, sensitive to interest rate as an investment cost, might fall as a result. By the time the Treasury spends the money acquired from its deficit-financing, some business investment may have been postponed and some consumer spending may have been curtailed. This occurrence is what economists label crowding out. The result is that public sector program spending partially substitutes for precious private sector activity.
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In Sum The demand to hold money as a liquid asset has direct bearing on the effectiveness of government economic policies. Monetary policy aims to influence aggregate demand using Federal Reserve System tools to alter bank reserves and the money supply to achieve desired macroeconomic goals o Raising the Fed discount rate discourages member bank borrowing while discount rate decreases encourage borrowing o The Fed raising member bank reserve requirements discourages borrowing and reductions encourage borrowing o The Fed buying US government bonds encourages borrowing and selling them discourages borrowing Fiscal policy aims to influence aggregate demand using Congressional processes to alter government and private sector spending, then via tax rates and deficit spending, toward desired economic goals. o Lowering tax rates encourages private sector spending, raising taxes reduces private sector spending o Increasing government spending encourages economic activity and decreasing government spending reduces economic activity o Decreasing tax rates encourages, but does not guarantee, more private sector spending; increasing tax rates reduces private sector spending. o Increasing (decreasing) transfers and subsidies increases (decreases) spending National Debt increases occur when government spending is greater than government tax revenues Crowding Out occurs when the government deficit finances new spending, then increased demand for money from the governments bond sale increases interest rates and discourages some level of private business investment.
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Lesson 18: Gains from Trade

Trade and the Law of One Price For millennia, people have voluntarily traded in goods because both parties to the transaction experience a gain from the exchange. In modern times, domestic producer interests and the national interest do not always coincide. Elected officials can pursue trade policies favoring political aims, despite the economic costs to citizens and businesses. Although most national leaders accept the law of comparative advantage as true, they rarely permit its full benefits to prevail in favor of policies supporting vested economic positions that curry political favor or punish political enemies. In a freely competitive world, identical tradable goods available in the US and a foreign country would sell for the same price as measured in each countrys currency. A direct implication of this statement is that price changes for goods in one country get reflected in the value of that countrys international currency. If a US citizen visited a foreign country and wished to buy a local Big Mac hamburger for $3.49 in the states, they should pay no more than the equivalent of that price at the foreign currencys value. That is how the law of one price operates in principal. Law of One PriceA unit of any one currencysay the US dollarbuys the same quantity of identical goods in all countries, after the currency exchange. Reality gets in the way of this appealing law when we search for identical goods in each of two countries only to find that they may not be precisely the same, save the Big Mac, perhaps. Further, not all goods are mobile or easily tradable. Land, for instance, is not tradable in the usual sense of physical movement. Also, many goods produced domestically just are not traded internationally. Simple and appealing, the law of one price does serve as an interesting gauge against which to assess the relative accuracy of currency exchange rates. Comparative Advantage Theory Prior to 1850, thinkers in international trade theory believed that the ability to produce a product with fewer resources determined the basis for tradethe so-called absolute advantage view. Absolute Advantage-One person or country can produce a good with fewer resources than another country. Classical economist David Ricardo established the correct efficiency logic for trade. He showed that neither the total volume of goods generated for trade nor the disparity between labor wage rates mattered. Rather, the comparative opportunity cost of the goods between the traders was paramount. One merely had to measure the cost of the next best foregone opportunity of producing
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a good in the home country compared to a potential trading partners opportunity cost to see who should specialize and trade which good(s) to the benefit of both countries. Comparative Advantage-One person or country should specialize in producing those good(s) where they have the lower opportunity cost compared to another person or country producing the same good. To see how this law operates, inspect the data in the table below where Sidney and Francis as workers in two separate countries produce either fruit or sugar. For Sidney, one days effort produces one unit of fruit; but she could have made two units of sugar. So, making 1 unit of fruit costs Sidney 2 foregone sugar units. For Francis, one days effort can produce 3 units of fruit or 4 units of sugar, not both. So, 1 fruit unit (3/3 = 1) costs Frances 4/3 sugar units.
Comparative Advantage Example

Person Sidney Francis Fruit 1 In 1 Day OR OR Sugar
2
4
Fruits Cost 1 costs 2 1 costs 4/3
Sugars Cost 1 costs 1 costs
As between the two, who produces fruit with the least real sacrifice? Francis. Her 4/3 (1 fruit costs 1 1/3 sugar units) is less than Sidneys 2 (1 fruit costs 2 sugar units). So, Francis should specialize in producing fruit. It is also true that Sidney should specialize in producing sugar because her cost is units of fruit while Francis cost is units of fruit. After specialization, they can trade the goods between them, where total output would be greater than before and both goods get produced at a lower opportunity cost than before specialization. Any barrier to free trade erodes the comparative advantage one country may possess, reduces the quantity of goods available and increases their relative cost. There may be political arguments for limiting trade by imposing barriers but there always are economic costs in so doing. Barriers to Free Trade Tariffsa tax on imports or exports makes imported goods more expensive and erodes the opportunity cost advantage from comparative advantage. Quotasa quantity limit on imports or exports reduces the gains of comparative advantage by restricting the amount of a named good that can be traded. Embargostrade prohibition against a good eliminates the possibility of any gains from comparative advantage by preventing trade for the named good.
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Currency Markets and Exchange Rates Trade with other countries also contains a transaction complication that carries a cost. Each country legalizes its own currency for use within its borders. US currency legally circulates domestically but foreign goods sellers want payments made in their own currencys denomination. So for every trade of goods or services between countries, an exchange of currencies also must occur. Countries can only trade, buy and sell goods and services with another country, if they possess a sufficient volume of their trading partners currency. They most easily acquire a stock of international currency by selling goods or services, directly or indirectly, to the country with whom they wish to trade. Without enough of the correctly denominated currency, exchange cannot easily take place between two countries. Dollar Exchange RateHow much of another countrys currency one US dollar will buy.
Sample US$ to Aussie$* Currency Exchange Rate

A$ Currency Depreciation Exchange Rate on Feb. 1, 2011 IF 1 A$ = 0.90 US$ (A$ Depreciated) 1 Aussie$ buys 0.987 US$ then simultaneously: and simultaneously: 1 US$ = 1.11 A$ (US$ Appreciated) 1 US$ buys 1.013 Aussie$ Source: www.BEA.gov; *Aussie$ is shorthand for the Australian Dollar US$ Currency Appreciation IF 1 US$ = 1.1 A$ (US$ Appreciated) then simultaneously: 1 A$ = 0.9 A$ (A$ Depreciated)
Reciprocal supply and demand for goods (and, hence, currency supply and demand) between countries largely determine currency exchange rates for international trade. But currencies do not always exchange for price parityequivalent product valuedue to exchange market forces like different national inflation rates, exporter or importer currency price expectations or government intervention that shift currency supply and demand. US Currency appreciationwhen the international currency market requires fewer dollars in exchange for another currency OR the US dollar buys more of another currency, the US dollar has appreciated in value and, simultaneously, the other currency has depreciated in value against the dollar. The other countrys goods become less expensive for US purchasers, increasing US imports and US goods become more expensive to the other countrys purchasers, reducing US exports. US Currency depreciationwhen the international currency market requires more dollars in exchange for another currency OR the same US dollar buys less of another currency, the US dollar has depreciated in value and, simultaneously, the other currency has appreciated in value against the dollar.
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The other countrys goods become more expensive for US purchasers, decreasing US imports and US goods become less expensive to the other countrys purchasers, increasing US exports. Currency exchange rates between trading countries fluctuate based on the demand for and supply of a countrys international currency for trading purposes. For example, if the US demand to purchase more goods from Germany increases, then more international dollars must be exchanged for German marks to facilitate the transaction. So US demand for German marks rises relative to the supply of German marks. As with any market, when demand rises against a fixed supply, the price of the good goes up. Here, the dollar cost of a German mark rises, which also means the US dollar has depreciated in value against the German mark. Currency exchanges complicate international trade transactions but organized international markets provide a relatively efficient mechanism to reduce transactions costs and uncertainty. Finally, barriers to trade, commonly predicated on political or power considerations, erode the economic opportunities revealed by the logic of comparative advantage. The Balance of Payments International transactions get recorded as a demand component of GDP called net exports (exports minus imports) where exports increase GDP but imports do not alter US GDP (because when US consumption rises, US imports rise by an identical but negative amount). All international transactions fall into one of two large categories plus a relatively minor third category: 1) current account, 2) capital account and 3) transfers, gifts and discrepancies. The current account tracks the flow of goods, services and income between countries. US Exports are sales to foreign countries and bring dollars into the US. US Imports are purchases from foreign countries and send dollars out of the US. If US exports exceed imports, then the current account balance is a surplus. If US imports exceed exports, the current account is in deficit. The capital account tracks investment flows, either direct real capital (machinery, land etc.) or financial capital (stocks, bonds). Exports are sales of US-owned real capital or US financial assets that bring dollars into the US. Imports are purchases of foreignowned real capital or foreign financial assets and that send dollars out of the US. Transfers and gifts are one-way flows between individuals in different countries or between governments, as foreign aid. Statistical discrepancies exist because international transactions are difficult to accurately track.
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US Current Account Balance Data, 2009 ($ Millions)

Current Account Categories Exports of goods and services and income receipts Imports of goods and services and income payments Unilateral current transfers, net Net Balance on Current Account Capital Account Categories U.S.-owned assets abroad Foreign-owned assets in the United States Net Financial Derivatives & Statistical Adjustment Capital account transactions, net Net Balance on Capital Account Source: www.BEA.gov $ Amounts 2,159,000 2,412,489) (124,943) $ (378,432) $ Amounts (140,465) 305,736 213,301 (140) $378,432
US Capital Account Balance Data, 2009 ($ Millions)
It is an accounting truism that for every current account transaction, there is an equal capital account transaction. One country always pays another through some financial instrument or money transaction. Current account transactions must equal capital account transactions (and are opposite in algebraic sign), including unilateral transfers, gifts and discrepancies. Trade between countries does not stop just because a countrys trade balance is negative. Rather, the deficit country must offer some asset other than goods or services in return. Most commonly financial debt instruments from private companies or from the government are accepted, as long as the borrowers credit is good. The benefits to trade are large, continuing and within the grasp of any country that produces goods or services desired by another countrys citizens. The law of comparative advantage shows that even developing countries may have an opportunity cost advantage in producing some good or goods and can trade them to their benefit.
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In Sum Law of one pricein principle, the exchange rate between currencies should reflect equivalent values for identical tradable goods between the countries. Comparative advantage means that individuals and countries should specialize in producing those goods with the lowest opportunity cost compared to the opportunity costs of potential trading partners. With specialization: o More total goods will be available and at lower cost o The terms of tradethe good-to-good exchange pricebetween parties must fall between their comparative opportunity costs of production or there is no economic basis for trade. Any inhibition to free trade reduces the amount of goods available and raises the cost (price) of those goods o Tariffsa tax on imports o Quotasa limit on physical volume of imports o Embargosa prohibition on imports or exports Currency exchange ratethe value of one countrys currency expressed in units of another countrys currency o Appreciationa countrys currency buys more units of another countrys currency o Depreciationa countrys currency buys fewer units of another countrys currency Balance of paymentsthe means of accounting for all international transactions o Current accountexchanges of goods and services o Capital accountexchanges of real assets or financial assets o Current account transactions = capital account transactions after adjustments for transfers and omissions.
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Glossary of Key Terms

Absolute advantageOne person or country can produce a good with fewer resources than another country. 99 Aggregate demand [AD]a down sloping line that shows the quantity of GDP demanded purchased at each price level. 90 Aggregate supply [AS]an up sloping line that shows the quantity of goods and services businesses choose to produce and sell at each price level. 90 Business cyclefluctuations in economic activity caused by changes in expectations and business conditions affect income, production, employment, prices and interest rates. 68 Comparative advantageOne person or country should specialize in producing those good(s) where they have the lower opportunity cost compared to another person or country producing the same good. 100 Consumer Price Index (CPI) a measure of the average change in prices over time, paid by urban consumers for a market basket of goods and services. 76 Credit cardA short-term loan agreement that enables holders to enjoy goods and services today by borrowing against tomorrows income for a fee called interest. 57 Demandthe quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other market forces held constant. 13 Derived demandthe relationship between the resource factor's price and quantity wanted by firms directly depends on market demand for the final product(s) the factor helps produce. 21 Dollar exchange rateHow much of another countrys currency one US dollar will buy. 101 Economic decision makingChoose the option in which the expected additional benefit to additional cost ratio is greater than that same ratio for the next best choice. 24 Economicsthe study of how society manages its scarce resources. 1 Equation of exchangeM V = P Q, the relationship between money, prices and goods production. 91
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Excludable goodothers can be excluded from consuming the good, usually because it has been consumed already. 42 Federal Reserve discount rateThe interest rate that the Federal Reserve charges member banks for borrowing as they work to meet the Required Reserve ratio on the one hand and satisfy the needs of business loan demand on the other. 87 Fiscal policyactions altering federal spending levels via Congressional policy on government programs and taxation. 96 Free marketsan exchange system for the production, distribution and consumption of goods and services between buyers and sellers. 4 Gooda product or service that provides value to its acquirer. 3 Income effectIf a certain number of dollars are allotted to making a purchase, when the unit price for the good rises (or falls), the quantity of the good the consumer can willingly afford falls (or rises). 14 Inflationa rise in the average level of prices; equivalently, a fall in the value of the money supply. 76 Law of demandthe inverse (or opposite in direction) relationship between current price and the quantity demanded of a good. 14 Law of diminishing marginal returnsgiven fixed amounts of land, as the quantity of labor incrementally increases, total output will increase but at an eventually diminishing rate. 66 Law of diminishing marginal returnswhen at least one factor input, plant capacity, is fixed, the additional output produced from additions to labor will eventually decrease as more labor is added. 20 Law of one priceA unit of any one currencysay the US dollarbuys the same quantity of identical goods in all countries, after the currency exchange. 99 Law of supplySellers will produce more of a product at a higher expected price than at a lower expected price. Price and quantity supplied move in the same direction along a given supply schedule. 26 Long runa time-period long enough to make changes in the scale of production and where all costs are variable. 22 M1(coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010. 80
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M2M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010. 80 Monetary policyinfluencing the economys money supply, by central bank policy makers to achieve national goals. 95 MultiplierThe effect of additional spending from an initial spending stimulus from either the private sector or the public sector. 92 Natural rate of unemploymentthe rate around which the unemployment fluctuates, in a healthy economy. 72 Nonexcludable goodpreventing others from consuming the good is too expensive. 42 Nonrival goodconsumption by any person(s) does not reduce the amount of the good available to others. 42 Open market operationsBuying and selling existing US government financial instruments from or to willing customers (individuals, businesses and banks) in the economy. 86 Opportunity costthe value of the next best option foregone when making a choice. 24 Opportunity costwhen making a choice, it is the next most highly valued option forgone that measures the cost of the chosen option. 4 Price elasticity of demanda measure of the relative change in quantity demanded in response from a change in current price. 15 Price elasticity of supplyA measure of the relative change in producer output compared to the change in selling price. 26 Profit maximizing ruleoperating at the level of output where market price equals marginal cost will either maximize profits or minimize losses, if they are incurred. 36 Property rightslimits on the use of private property, goods and services that help define the limits of social behavior. 42 Reserve requirementsThe percentage of demand deposits commercial banks must hold as reserves. 86 Rival goodone persons consumption reduces the amount of the good available to others. 42 Scarcityeconomic goods are not naturally available in the form, time or place desired without a cost or sacrifice. 4
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Short runthe time-period during a production cycle, where variable costs are incurred (e.g. wages, materials) and some costs not directly related to the rate of production are fixed (e.g. rent, utilities, insurance). 19 Substitution effectAs the unit price of a good rises (or falls), the consumer substitutes away from (or toward) the good. 14 Supplythe quantity of a good sellers are willing and able to offer at a range of prices, all other market forces held constant. 25 The Coase Theoremstates that if private parties can bargain without cost about how to allocate resources, then they can resolve the externality problem on their own. 44 The economic problemhow to meet societys material needs given scarce resources. 2 Trading-offmaking choices regarding the amount of one good sacrificed to get more of another good. 4 Transactions coststhe costs of negotiating a transaction with all relevant parties. 42 US currency appreciationwhen the international currency market requires fewer dollars in exchange for another currency. 101 US currency depreciationwhen the international currency market requires more dollars in exchange for another currency. 101
The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better economic & financial choices in a global economy.
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Lesson 2: Goals of Economic Systems 7

Lesson 3: Wants and SubstitutesDemand 12

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Lesson 4: Production Costs and the Division of Labor 19

Lesson 5: Opportunity Cost and ChoiceSupply 24

Lesson 6: How Markets Coordinate Exchange 30

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Lesson 7: Competition, Market Power and Economic Efficiency 35

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Lesson 12: Employment and Unemployment 71

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Lesson 14: Money and Interest Rates 80

Lesson 15: Federal Reserve System 83

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Lesson 16: Macroeconomics: Long Run and Short Run 89

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Lesson 18 Gains from Trade 99

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US National Income by Economic Resource Categories, 2009 ($ Bill.)

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